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Equities Set To Outperform Rickety Real Estate

Long
Investment wisdom states that “the only bad time to buy real estate is later.” Every rule though, has its exceptions. Current US real estate is clearly in exception territory given recessionary fears, high mortgage rates, and dim fundamentals.

Real estate sector is the largest store of wealth. It is also the source of significant job creation. Crisis in this sector has massive adverse consequences. Hence, policy makers typically leave no stone unturned in defending the sector. Despite the headwinds, new data released last week show rising mortgage applications on softening rates and real estate prices. This collectively makes an outright short position perilous.

Instead, this case study argues that a measured approach would be a spread with a long position in S&P 500 Index combined with a short position in S&P Real Estate Select Sector index .

An entry at 20.611 with a target at 22.119 supported by a stop loss at 19.749 will deliver a compelling 1.75 reward to risk ratio with ample upside and limited downside.


INTEREST RATES INVERSELY AFFECT ASSET VALUES

The value of a financial asset is the cumulative discounted value of all future cash flows. Higher the discounting rate, lower the value. Persistent and sticky inflation is compelling the Federal Reserve to keep rates higher for longer.

High mortgage rates are forcing out first time buyers while squeezing leveraged asset owners. Future rents discounted to present value is sharply lower relative to a period when federal funds rate was near zero.

With the US Federal Reserve having hiked interest rates by 4.5% in 2022, mortgage rates have doubled in the same period, touching a 20-year high of 6.2%. This has made real estate investments less attractive. With no rate reversals in sight, mortgage rates are likely to stay elevated despite recent softening. Mortgage rates are down a full percentage point from recent peak but still double what they were a year ago.


Absent a sector specific relief, real estate stocks will underperform relative to the broader S&P 500 index . Since 2017, this ratio of the S&P 500 index to the Real Estate Select Sector has risen by a stunning 54% over the last 6 years.



WEAKENING US HOUSING MARKET


After peaking in July 2020, new home sales in the US have trended 37% lower and down to pre-pandemic levels. Existing home sales exhibit similar trend, which have fallen for eleven (11) straight months, point to a frail US housing market.

New data released last week point to rise in mortgage demand as rates soften and real estate prices ease.


DISTRESSED DEBT IN REAL ESTATE & RISING REDEMPTIONS FROM PROPERTY FUNDS

Global property market faces $175 billion of distressed debt. As rates rise, rising financing costs will force leveraged owners to foreclose at fire sale prices.

Abrupt stop to years of easy money supply has sent shock waves to the sector. Compounded by a pandemic that has changed the way people work and live, commercial real estate owners are in a precarious place. This predicament is showing up in property funds facing rising redemptions.

US-based investment manager - KKR - has imposed limits on redemption from its $1.5 billion KKR Real Estate Select Trust fund (KREST). KKR's cap on redemption echoes a move by Blackstone which announced in December that it would limit investor withdrawals from its $69 billion private real estate fund (BREIT). Starwood Capital also placed caps on redemptions late last year.

Investors are hankering for redemption as fears of price correction stemming from high mortgage costs, persistent inflation and an uncertain economy amplified by recessionary gloom.


GLOOMY REAL ESTATE OUTLOOK

The sector is pessimistic about current and future home sales as evident from NAHB’s Housing Market Index. Over the past six months, new building permits have collapsed drastically as participants see lower demand for new homes.

Vindicating these fears are a sharp drop in new building permits which are down 30%. Home order cancellations are also on the rise sharply.

With all the impact combined, a rise in unsold inventory hit the markets, with marginal & first time home-buyers priced out of the market due to expensive mortgage rates.

The US Federal Reserve is determined to tame inflation down to 2% even at the expense of hurting labor market. Should that occur, a soft labor market reduces appetite for expensive mortgage payments. That would set a real estate contagion in motion, pushing property prices even lower.



TECHNICALS POINT TO BOUYANT S&P 500 AND SHAKY REAL ESTATE SELECT SECTOR

Since bottoming in November 2022, the S&P 500 Index has rallied 11% as it faces resistance at its long term ( 200-day ) moving average. The S&P 500 Index is trading below its point of control.


In contrast, the S&P 500 Real Estate Select Sector index points being overbought based on RSI and is yet to reach its long-term moving average. The index is trading above its point of control making it wobbly and prone to downward correction.


TRADE SETUP

Spread trade requires that the notional value of a long leg is equivalent to the short leg of the trade.

Therefore, five (5) lots of long position in CME E-Mini Micro S&P 500 Futures expiring in March 2023 requires two (2) lots of short position in CME E-Mini Real Estate Select Sector Futures in March 2023. CME offers margin credits for spread trades. Clearing brokers might charge differently from the Exchange imposed margins.

CME E-Mini Micro S&P 500 Futures (5 lots): 5 x USD 5 x S&P 500 Index = 5 x 5 x 4015.25 = ~$100,381

CME E-Mini Real Estate Select Sector Futures (2 lots): 2 x USD 250 x S&P 500 Real Estate Select Sector Index = 2 x 250 x 194.65 = ~$97,325

Entry: 20.611
Target: 22.119
Stop Loss: 19.749
Reward/Risk Ratio: 1.75
Profit at Target: ~$7,350
Loss at Stop Loss: ~$4,200


MARKET DATA

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DISCLAIMER

Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

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