Last week housing price futures contracts expiring in August 2008 began trading on the Chicago Mercantile Exchange and investors appear to have taken all the recent bad real estate news to heart.  Investors are expecting deep declines in many formerly hot markets with Miami expected to fall 9.4%, Las Vegas 9.2% and Los Angeles 8.4% by the end of the second quarter of 2008.  Markets expected to fall the least are Chicago at 5.3%, Denver 6.6% and San Francisco 6.8%.  For the overall 10 city composite index, prices are expected to fall 6.4%. Investor expectations are reflected in housing price futures and options traded on the Chicago Mercantile Exchange which are based on a subset of the S&P/Case-Shiller® U.S. National Home Price Indices.  These property derivatives are traded on indices for a ten-market index and the component markets of that composite.  Expectations of future price changes are implied by the percentage difference in the index value for the relevant market (most recently published on August 28, 2007 for  June 2007 period) and the current price of the four traded futures contracts expiring in November 2007, February 2008, May 2008 or August 2008.

So how do investor expectations compare to recent housing price trends?  This week Standard & Poor’s released its S&P/Case-Shiller® U.S. National Home Price Index for June 2007.  The composite index of 20 markets was down 3.5% over the twelve month period from June 2006 to June 2007.  The 10 city composite was down 4.1%, so investor expectations of a housing price decline of 6.4% by the end of the 2nd quarter of 2008 imply a significant acceleration in the rate of decline. As always there are large differences in housing price trends in local markets.  Of the 20 markets tracked by the indices, 15 showed price decreases and 5 showed price increases over the last 12 month period.  Seattle was up 7.9%, Charlotte 6.8% and Portland 4.5%.  Both Atlanta and Dallas showed a nominal increase of 1.6%. Several markets were down dramatically with Detroit off 11%, Tampa 7.7%, San Diego 7.3% and Washington, D.C. 7% during the 12 months between June 2006 and June 2007.  

The composite index and its regional sub-indices use the repeat sales pricing technique to measure housing markets by collecting data on single-family home re-sales, capturing re-sold sale prices to form sale pairs. Price appreciation or depreciation is more accurately reflected by the change in value of the same properties over time across entire market areas rather than the more volatile median home prices published by NAR.  

As always, it’s worth remembering that the CME futures contracts are thinly-traded relative to much more established contracts for commodities and foreign exchange so they reflect the collective wisdom of fewer investors.  But it’s one more data point for your crystal ball and not one that leads to a very optimistic conclusion about the future direction of the real estate market.

This posting also appeared as my monthly column on Inman News.

Last week, another player launched a set of residential property indices in the race to enable trading in derivative instruments and financial products. Morgan Stanley, Lehman Brothers and Merrill Lynch signed licensing agreements with New York-based Radar Logic Inc. for its Residential Property Index, or RPX.

Radar Logic uses proprietary modeling techniques to create “daily prices” derived from actual prices paid for U.S. residential real estate. The indices are based on the price per square foot in 25 markets and a composite index, and will be published nine weeks after the actual closing date. The indices will be published each day for several time periods: daily, seven days and 28 days.

Also last week, the Chicago Mercantile Exchange announced that housing futures and options contracts based on the S&P/Case-Shiller U.S. National Home Price and Composite Indices would be extended out to five years. These indices are published each month for a one-month period. The most recently released indices were published on July 31 for the May 2007 period.

The S&P/Case-Shiller and RPX indices differ not only in timeliness but also in market coverage and methodology. The S&P/Case-Shiller indices cover 20 markets (with CME contracts only trading for 10 markets) while the RPX indices cover 25 markets. The S&P/Case-Shiller indices use the repeat sales pricing technique to measure housing markets by collecting data on single-family home resales, capturing resold sale prices to form sale pairs. The indices track the appreciation or depreciation occurring for resale properties across a market area but do not include condo, new home or foreclosure sales.

The RPX indices are computed based on price per square foot — not just sale price — and include resale, foreclosure, condo and new-home property transactions. The “daily prices” are likely to be quite volatile based on the actual sale prices paid for properties sold on a specific day nine weeks prior to the actual publication date. The results will not be adjusted for seasonality.

Both sets of indices are being used by Wall Street to create new financial products to enable trading, for hedging or speculative purposes, in the residential real estate market. According to Federal Reserve statistics, the aggregate value of residential housing assets was $22.9 trillion as of March 31, 2007. That’s larger than the U.S. equity market.

For property investors, developers and owners, these tools should ultimately mean lower risk and greater efficiency. According to Michael Feder, president and CEO of Radar Logic, “Property developers usually negotiate interest-rate caps to manage their rate risk on condo developments, and now they will be able to buy a series of puts to essentially lock in prices for a development before breaking ground.” This is very much as farmers lock in prices for all or part of their crops at the time of planting. Right now a lot of home builders with rapidly decreasing book values would probably liked to have hedged the price risk on their new home or condo developments a couple of years ago.

This article was published in Inman News.

The Chicago Mercantile Exchange last week announced that housing futures and options contracts based on the S&P/Case-Shiller U.S. National Home Price and Composite Indices would be extended out to five years. Trading of these contracts is scheduled to begin on Sept. 17.

Contract months extending out 18 months will be listed on a quarterly cycle of February, May, August and November. Contracts listed 19 to 36 months out will be available on a biannual schedule of May and November contracts. An annual November listing schedule will apply to contracts listed 37 to 60 months out into the future.

The CME began listing housing futures and options in May 2006. The 10 cities include Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York City, San Diego, San Francisco and Washington, D.C., in addition to the composite index containing all 10 cities.

These short-duration contracts have been very thinly traded compared to mature markets like commodities and foreign exchange. The slow growth has been due to the fact that residential real estate is often a long-term investment. Property developers, builders and other investors need tools that allow them to hedge risk over multiyear periods. The contracts initially listed in May 2006 only had durations of up to 12 months.

Fritz Seibel, director of property derivatives at Tradition Financial Services, “expects the U.S. housing futures market to trade in a two- to three-year forward ’sweet spot’ that reflects the natural timetable of housing. This sweet spot allows for a change in the equilibrium of the housing market (changes in housing inventory, starts, permits, sales, demographics, credit, etc.) to manifest itself in housing pricing. It is as if the spot market for housing is some two years in the future at any given time. These future prices will be discovered through trading.”

For real estate pessimists who want to speculate on an extended downturn in the market, these contracts provide a vehicle as well. Residential real estate markets, unlike stock markets, are often characterized as “sticky downwards.” If homeowners don’t get offers they like, many choose to simply take their home off the market until demand firms up and prices rise.

As a result, real estate slumps can last for extended periods of time. For example, the last major downturn in the Los Angeles market lasted nearly six years, beginning in June 1990 and continuing until March 1996. During that period the market declined just over 27 percent.

This article was also published on Inman.com