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Making Real Estate More Liquid November 29, 2006

Posted by federalist in Finance, Real Estate.
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Real estate typically combines two distinct and risky financial assets.  One is the underlying property, whose value can fluctuate widely in response to interest rates and localized demand.  The other is the cashflow of the property, which consists of income from rents and costs from taxes, insurance, maintenance, etc.

Compounding the risks of these real estate components is that fact that neither is very liquid: Securing rental income for a property requires finding and maintaining renters.  Properties themselves can typically only be liquidated in “units” that start in 6 figures, and the transaction costs associated with buying or selling property can run upwards of 10%.  (Dot-com entrepreneurs take note: We’re still waiting for the internet to work its magic on this market!)

Finally, there is no way to buy insurance against property or rental declines.  In contrast to equity and fixed income, you can’t really sell short, buy puts, or otherwise hedge a long exposure to a particular real estate investment.  (You can, however, hedge the risks of appreciation using long-term leases.)

Granted, it is possible to buy diversified real estate exposure in a liquid fashion, through REITs (Real Estate Investment Trusts) and other real-estate-intensive companies.  But most people will still end up locked into a single, often highly-leveraged piece of real estate: their home.

If you are a property owner and you want to hedge against a decline in your property value, your options are neither extensive nor palatable:

  1. Sell, and become a renter instead.
  2. Sell, and move to a different region where you believe there is less risk of a decline in values.

Individual real estate is clearly a market ripe for innovations in liquidity.  Due to the size of the market, any entrepreneur who introduces practical liquidity mechanisms stands to make an enormous fortune.

Likely innovations would:

  • Separate the cashflow component of real estate from the underlying property component.
  • Subdivide the property component into more tradable parcels.
  • Allow owners to hedge against declines in both cashflow and property value.

Today a venture called Rexx Index was announced that’s making steps in this last area, albeit only for commercial real estate.

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1. federalist - April 6, 2009
2. federalist - May 7, 2009

Update:

Created by MacroMarkets LLC, the MacroShares Major Metro Housing Up Trust and Down Trust … will raise a combined $1.1 billion. The trusts will begin trading May 11 on the New York Stock Exchange under the symbols UMM (for “up” bets) and DMM (for “down” bets).

The two exchange-traded products are the only way that retail investors can play the housing market without actually buying real estate, said MacroMarkets Chief Executive Samuel Masucci III. They also will allow institutional investors, ranging from pension plans to banks with heavy exposure to residential housing, to hedge those portfolios.

“The problem is that people who own real estate usually have too much of it. The others who don’t have it and want it can only do so by buying a house,” Mr. Masucci said.

The underlying value of the two trusts tracks three times the percentage change in U.S. single-family home prices as measured by the S&P/Case-Shiller index. The index is recalculated on the last Tuesday of every month, so if the index rises by 2%, the MacroShares multiplies that by three, and 6% of the assets of the Down Trust are moved into the Up Trust.

The money in the trusts is invested in U.S. Treasurys and cash, and the trust prospectuses said they may pay out dividends. The trusts have a 5½-year term, with a new set of trusts created every year to track the market one more year out.


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