Opportunity in property value underwritting?

[akula]

Just wanted to get feedback on whether there is an opportunity in this idea i've been thinking about.

Problem: for millions of people, their home is their biggest investment, and their largest retirement asset. the dependance on a consistently increasing value of the family home is so high, that when a downturn happens (such as in 2009), a drop in the value of the family home can send people bankrupt...especially if the homeowner has lost their job, needs to sell the house because they can't afford the mortgage, but find out that the value of their house is less than the value of their loan.

Solution: a residential property underwritting service which sells a put option to the homeowner, giving the homeowner a right to sell their property to the option writer at a specified price, during a specified perioud.

e.g. i just bought a house for $500k in 2010. i am worried that the value of the house might drop in the future. to solve the problem i buy a put option for 20k giving me the right to sell the property for $500k at any time prior to 2015. now, i don't have to worry about my property value going down because i bought insurance at 4% of the purchase price

what do you think?

[pacificfame]

So, if the buyer of the insurance decides to sell, the insurance company has to purchase the home back for 500k? Is this correct?

I guess the great thing about this is, if the insurance company has to purchase the home back they are still left with an asset. Not a total loss.

A lot of risk and variables to think about, but this idea is making me think pretty hard.

[akula]

yea..that's right...the insurance company makes money from the 20k premium and has the obligation to buy the property for 500k if the insured exercises their option...which they might not if house prices are rising and the option is out of money..in which case, the underwritter just keeps the premium

it's a complicated issue to think about...because for example, one way homeowners can make extra money from their properties is to sell call options on their houses...which is a whole other area

in essense, i'm interested in seeing a functioning derivatives market with respect to residential and commercial real estate..which is an opportunity valued in the trillions of dollars

what does everyone think of that? why don't we have an electronic derivatives market for RE?

[kameron]

Way to think outside of the box.

Keep the brain storming going.

This has gotten me thinking quite hard. Keep mind mapping and developing you may be onto somthing

[akula]

yea i've been talking to some people about it...property derivatives are used quite often on a wholesale level by institutional investors...like a large scale developer who wants to hedge their exposure by profiting if property prices suddenly decrease during construction etc

but...i can't seem to find anyone marketing this at a retail level to garden variety home owners or residential RE investors...and i want to know why that is..

hints? anyone?

[DerekS]

Although I cringe at the thought of further complicating the business of real estate (as if the rampant speculation of the last 5 years wasn't insane enough), I really like this idea.

Now seems like the prime time to do it. Figure that, barring a global apocalypse, we should be on the upswing over the next few years. Cash rich insurance companies could offer these policies and as long as the slow upward trend continues, there's a good chance that most people won't be needing to exercise their option to sell. As long as mass hysteria doesn't cause everyone to bail, it seems like a good profit generator.

Of course, we'll find ways to screw it up. Like financing the premium (hell, we finance our mortgage insurance- the racket that it is), fudging appraisals to force a sale, or whatever.

The idea is pretty cool though and if the details could be hashed out, I bet the concept could be sold earnestly.

[willh512]

I think it's an interesting idea.

The problem, though, is that I think this would be wayyyy too much risk. If property values decline across the country, as they just have, then you will owe a damn large sum of money.

Also, it'll be hard to get people to pay 4% on their house for insurance. That's $20,000. Hell, even 2%.

At 4%, even if the house depreciates $19,000, they would still be losing money by having the insurance. Any appreciation of the house's value would also be set back by the huge premium.

In my opinion, this could only work if there are very extreme price changes expected in home values. I think almost everyone would rather sit on their small loss or take a small gain over paying insurance premiums on an investment as large as a home.

[akula]

I think it's an interesting idea.

The problem, though, is that I think this would be wayyyy too much risk. If property values decline across the country, as they just have, then you will owe a damn large sum of money.

Also, it'll be hard to get people to pay 4% on their house for insurance. That's $20,000. Hell, even 2%.

At 4%, even if the house depreciates $19,000, they would still be losing money by having the insurance. Any appreciation of the house's value would also be set back by the huge premium.

In my opinion, this could only work if there are very extreme price changes expected in home values. I think almost everyone would rather sit on their small loss or take a small gain over paying insurance premiums on an investment as large as a home.

Thanks for the feedback..you have some great points

I’m still not sure how the premium would be priced...as that depends on several factors, including historical property values..and the historical volatility of those values, but for the most part i haven't been thinking about it because the solution I find interesting is a derivatives marketplace that connects different investors who want to buy and write puts, rather than setting up a financial services biz that writes the puts it self..in other words, it's investors them selves who determine the premium.

That said, in terms of pricing, the way I see the marketplace working is this - different property owners have different financial objectives, risk preferences and different perceptions of future property values.

so for example; an investor with a $500k property may want to lock in a 5% inflation beating return on their property over 10 years by buying a put..so, the guaranteed sale price they they want is (500*(1.05)^10)=$814k (or a return of $314k). so how much would this investor pay to guarantee themselves a $314k profit...let’s say 10%..or $31k (i.e. the premium price)..but who would be willing to sell the put, take this $31k premium and risk buying this property for $814k (strike price) in 10 years? well, someone who is bullish on RE markets and thinks that the 10 year return on this property will be higher than 5%.

If the bull is right and the return is the historical 7% rather than 5%, what happens is that they earn themselves $31k, the property value (spot rate) rises to [(1.07)^10]=983k and the option lapses (as it is out of money). on another hand, if the bull is wrong, and the return is 3% over 10 years (or [500*(1.03)^10])...then the option is in the money and the homeowner sells the $671k worth of property for $814k..earning the option writer a total loss of [31-(814-671)]=$112k.

But, how likely is it that property earns 3% over 10 years? not very..and also, the writer of the option can hedge their risk of a $112k loss by selling some calls (or buying puts) on this same property..so that in case they have to buy a $671k property for $814k, their loss is offset by the premium they received from the sale of the call and the profit they make by exercising their put and on-selling the property for higher than $814k to another investor who also thought the 10 year return will be higher than 5%.

all in all: that's one way of looking at it...how many people can be found that fit the scenario above..i.e. homeowners who want a guarantee for the increasing value of their property and bullish counterparties who have an innately rosier outlook on property...that's what i'm interested in.

what do you think?

[DerekS]

Here's where you lose me. Trying to predict future values of real estate is what everyone spent the last 5 years doing and it destroyed the market.

Buying a hedge against losses in real estate is one thing: as it is a relatively stable investment historically. People feel inclined (out of fear, ego, whatever) to cover their asses and this is where selling insurance policies plays perfectly into people's insecurities (example: all the idiots that buy extended service policies on EVERY item that they buy.)

Once we start trying to predict or guarantee returns within a certain timeframe, all bets are off.

[akula]

Here's where you lose me. Trying to predict future values of real estate is what everyone spent the last 5 years doing and it destroyed the market.

True that. I mean this is obviously a pandora's box of issues...i.e. how does forecasting of values relate to capitalism specifically, and social order in general...so it's not that relevant as such..

The more relevant question is, going from the example above, would you sell the put option? would you earn your self a $31k fee in return for a possible obligation to have to buy a piece of real estate at a loss, if that asset failed to appreciate in value in line with inflation over 10 years?

Essentially, your upside is a 100% probability of a $31k gain, and your downside is a probability of a $112k loss. What is the probability of the loss occuring? Looking at historical prices for real estate....it may be 0%. Between 2000 and 2010 I'd guess that all properties in USA (for that holding perioud) have appreciated in value by at least 3% p.a. on average (Ummm..I dunno, have they?)

And that's interesting..because if the probability of the property value failing to keep up with inflation over 10 years is 0%, then why would the property owner buy the put in the first place? The reason of course is prospect theory and loss aversion, which has convincingly demonstrated people's tendency to strongly prefer avoiding losses to acquiring gains...which is basically what you underscored in your post...

So, yeah, who is gonna put their hand up to take $31k for doing nothing other than bearing some improbable risk? Anyone? I think I'd do it.

[kameron]

All I can say is keep going. Keep the train of thought moving. And give me a shout when you get your ducks in a row

I think its a great concept. I think some further research and future projections are going to be required but the development of the concept could be quite valuable.

Essentially you would be creating a whole new market.

I'd Do it

[akula]

holy smokes this is hard...
i'm trying to code a financial model for quoting homeowners the cost of their "home value" insurance
erhh...black scholes anyone?
i'm going all wrong about this..