The novel coronavirus is causing an economic slowdown in the US housing market. Home sales are dropping at the moment and many believe home prices will decline as a result. This is why many people are speculating a housing market crash in 2020. Accordingly, some real estate investors are thinking of shorting real estate to take advantage of the possibility of declining home prices. But what does it mean to “short” the housing market? How did real estate investors who shorted the housing market in the early 2000s benefit from the events leading up to the 2008 financial crisis? And does shorting real estate make sense right now? Keep reading as we answer these questions and more.
Related: The Impact of the Coronavirus on the US Real Estate Market
What Does Shorting the Housing Market Mean?
Before we discuss what it means to short real estate, let’s explain what it means to “short” something in general. Basically, to short an asset is a way of placing a bid against it. Traditionally, short-selling involves borrowing the asset in question from a broker (with the promise to return it at a later, agreed-upon date) and selling it immediately at the market price. If that asset declines in value between when you borrow it and when you must return it, you’d sell it back to your broker and earn a net profit from the difference in price. However, if the asset has risen in value, you’d have to buy back the asset at a higher market price and suffer a net loss on the transaction.
In this case, the asset in question will be related to the real estate market and would allow you to make money. Sometimes, you might hear the phrase “short-sell a house”, but this is not the same strategy. This refers to the act of selling a house at a lower price than is currently owed by the homeowners in order to avoid a foreclosure.
Shorting real estate, on the other hand, is speculating that the price of houses will fall. In other words, it’s a way of placing a bet against the housing market to cash in on declining home prices. Obviously, shorting the housing market isn’t done directly. Instead, real estate investors and traders will trade alternative assets such as real estate investment trusts (REITs) or shares in companies within the industry. If homes saw a decrease in value and the housing market declines as they speculated, those who have shorted the housing market will benefit.
How to Short Real Estate
There are a few different ways that you can follow for shorting real estate. These include:
#1. Shorting an Individual REIT
The most common way of speculating on the housing market is by investing in REITs. These are companies that buy income-producing real estate assets. REITs are classified as publicly traded companies, meaning real estate investors can either buy and sell shares of a REIT itself or invest in an exchange-traded fund (ETF). There are a variety of different REITs including industrial buildings, residential properties, hotels, hospitals, and student housing. If you think that the housing market is going to decline, you can short real estate through a REIT. Shorting a REIT in the traditional sense requires you to find a broker who is willing to loan you the shares. However, when you spread bet or trade CFDs, you can be speculating on the price of REITs whether they are rising or falling.
#2. Shorting a Real Estate ETF
Exchange-traded funds (ETFs) are instruments that track a basket of assets – such as a stock index, the shares of companies involved in the housing market (house builders, material suppliers, etc.) or REITs. By opening a position to short an ETF, you are speculating that its price will drop. If you choose to short an ETF and the housing market declined, it is likely that the ETF would also decline as the constituents of the stock index lose value and, in turn, you’ll earn a net profit. On the other hand, if the ETF increased in value instead, your position to short would decline in value and you’d suffer a loss, as mentioned earlier.
#3. Going Long on an Inverse ETF
There are also exchange-traded funds specifically made for shorting real estate purposes – they’re known as inverse ETFs. The price of these assets rises as the housing market falls in price. If you’re interested in shorting the housing market, you would do so by “going long” or buying an inverse ETF, as the tracker is inherently short-selling the market. This means that pessimistic real estate investors and traders can get exposure to a declining housing market immediately. If you wanted to take a short position on a reverse ETF, you would do so by speculating that the housing market would rise in price.
#4. Shorting Individual Real Estate Stocks
Finally, traders and investors can choose to go short on shares of individual companies that are involved in the real estate industry – mainly homebuilders and building material suppliers. Real estate stocks are closely tied to and are seen as a leading indicator of the outlook for the US housing market 2020 as a whole. This is because everything from builder confidence, labor costs, and commodity prices can have an impact on home prices. For example, if commodity prices increase, it’ll become more expensive for these companies to buy raw materials and their revenues would suffer. As a result, home prices could increase and buying real estate property could become less affordable.
Related: US Housing Market Predictions 2020 for Spring
Shorting the Housing Market in the Early 2000s
If you’ve seen the film “The Big Short”, then you probably have an understanding of how he profited from shorting real estate in the early 2000s. But if you haven’t, here’s a quick summary:
Michael Burry is the doctor-turned-investor who made a killing betting against the housing market in the lead-up to the 2008 financial crisis. In 2003-2004, he had studied the underlying loans that made up a pool of mortgages being stuffed into the bonds. He saw that borrowers with no income were taking up a larger share of the mortgages and that they were increasing the demand for the subprime market. Lending standards had collapsed in the face of this demand as lenders created more and more elaborate means to justify loaning money to clearly un-creditworthy borrowers. These loans were then being repackaged into bonds and sold off by the big banks.
Based on his analysis, he correctly predicted that the housing bubble would collapse as early as 2007. And in 2005, he began targeting the subprime market because of his belief that it was unusually overvalued. When no one thought the housing market could crash, Burry decided to short real estate by diving into the world of credit default swaps. Credit default swaps are basically a financial instrument that investors use to short the housing market. Michael Burry bought millions and millions of them to bet against the housing market. When his speculations were right and the housing market started to collapse in 2007-2008, not only did he make a big profit privately (over $100 million), but he also earned his investors $700 million.
Does Shorting Real Estate Make Sense Right Now?
If you were to short the housing market, this means you’re betting against it and speculating that home prices are going down. In other words, you’d bet that the US housing market will crash in 2020. However, research shows that, despite home sales dropping, a national housing market crash on the scale the US saw back in 2008 is unlikely. What’s more likely to happen, however, is that a slowdown will lead to a slowing of home price growth as fewer people will be motivated to buy houses.
Experts at Zillow did a study on how the coronavirus pandemic will affect prices and they concluded that prices will stay stable or see a slight decrease. Housing and financial experts also believe that this looming real estate downturn may not even develop into a recession. They have a positive outlook on what will happen after the crisis is over, saying that the US housing market will recover quickly. Lawrence Yun, the chief economist for the National Association of Realtors, basically summed it up, saying:
With fewer listings in what’s already a housing shortage environment, home prices are likely to hold steady. The temporary softening of the real estate market will likely be followed by a strong rebound once the economic ‘quarantine’ is lifted, and it’s critical that supply is sufficient to meet pent-up demand.
Related: Will the Housing Market Crash in 2020?
Moreover, while the idea of shorting real estate has been glamourized by films like The Big Short, it is very much a risky business for a number of reasons. One of the most crucial risks of shorting the housing market is the potential for unlimited loss as, theoretically, the underlying asset could rise exponentially. Furthermore, real estate investors and traders can get stuck in “short squeezes” if the market price rises and short-sellers rush to exit their positions. This will drive prices higher and higher.
Finally, it’s important for investors to be aware of real estate cycles as well as interest rate cycles. When interest rates are low, borrowing costs are less which makes mortgages more affordable to a larger number of people. As a result, the housing market will likely boom and prices will be higher. However, when prices skyrocket, it can lead to a financial crisis and a housing bubble. In 2006, for example, banks and mortgage brokers offered loans to pretty much all applicants in order to meet the demand for housing. And when the Fed raised interest rates, it led to mortgage rates soaring and house prices falling as borrowers defaulted on their loans. In turn, this led to the 2008 financial crash.
Fortunately, government regulations these days have made credit requirements stricter to create a stable mortgage industry and, in turn, a stronger real estate market. Meaning, mortgage borrowers today are better qualified making it unlikely that what happened 12 years ago will happen in 2020. These are all the reasons why experts don’t encourage shorting real estate right now.
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