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Replicating Residential Real Estate Returns with Liquid Market Instruments a Case for Risk Factor Models for Everything and Everywhere

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Replicating Residential Real Estate Returns with Liquid Market Instruments a Case for Risk Factor Models for Everything and Everywhere Replicating Residential Real Estate Returns with Liquid Market Instruments A Case for Risk Factor Models for Everything and Everywhere Emilian Belev, CFA and Richard Gold Northfield Information Services, Inc. January, 2017 Webinar Is Residential Special? • Valuation of housing inventory in the USA north of $30 Trillion • Increased interest in direct investment from domestic and foreign institutions and individuals • About a quarter to a third of this valuation is covered by outstanding mortgage debt; Lenders and households exposed to the downside: notoriously so in 2007-2009, a.k.a. GFC • Homeowners, especially those intending to sell will be interested in products that will help hedge the value of their homes • First time home-buyers saving for a down payment will be interested in investment products that mimic the returns of their intended purchase www.northinfo.com Slide 2 Is it Special (cont’d) ? • Real estate backs MBS and property taxes back municipal obligations. Both of which are trillion dollar asset classes • By implication, the credit worthiness of these securities determines liquidity of interbank lending and as such the stability of the financial system • Finally, but equally important, residential real estate is the biggest household assets for the vast majority of Americans, and as such one of a handful of key gauges of consumer confidence and national prosperity www.northinfo.com Slide 3 Comparison with Commercial Real Estate • Commercial Real Estate values are derived from rental lease streams. • Investor value is the value net of debt on the property. • Residential real estate, unless purchased for investment purposes, in which case it starts to resemble more multifamily commercial real estate, derives its value from the utility of prospective residents to have a roof over their head. • Instinctively, some economists try to measure this utility by “substitute” – rental values. Even empirically this has proved flawed as there are prolonged periods of time where rents and home values don’t move in lock step. • Instead, we employ a concept of Effective Economic Rent www.northinfo.com Slide 4 Effective Economic Rent Explained • To identify it we strip the effect of leverage and the borrowing costs from home prices • What remains is the effect of the “natural” purchasing power of prospective residents in the locality (a.k.a. “demand” or “income effect”), against the supply of housing inventory there. • Rent is only as much a substitute as there is a clear equivalence of quality of rental and housing properties. Given that they normally appeal to different market segments, that assumption holds only partially. • Buyers will be enticed to rent if the discount is sufficient to compensate for the compromise on quality. Renters will be enticed to buy if the home price discount is sufficient to compromise on flexibility and risk, but also face borrowing constraints. Inside this “collar” there is “substitution” effect between renting and homewnership. www.northinfo.com Slide 5 Effective Rent Explained (cont’d) • The effective economic rent is a concept that empirically takes into account both the “income” and “substitution” effects simultaneously • Provided a house price level “Asset”, leverage “LTV”, average economic life of residential property “T”, mortgage rate “c”, mortgage payment “M”, periodic personal benefit “PPB “ while paying mortgage, and personal discount rate “d”, we derive economic rent “R” using the following identities: • Asset = Equity + Liability • Asset = PPB/(1+d)^T + M/(1+c)^T + [(R/d)/(1+d)^T] • LTV = M/(1+c)^T / Asset • PPB + M = R www.northinfo.com Slide 6 S&P CoreLogic Case-Shiller Home Price Indices • Repeat sales index: • Calculates change in value for a home adjusted for size and quality • Coverage: 20 U.S. metros as well as three price tiers (low, medium, and high) • Individual market and composite indices available for 10 and 20 city averages • Monthly index but employs three month moving average to bolster sample size arising from delays in data flows from county records www.northinfo.com Slide 7 Federal Finance Housing Agency HPI • Sample from securitized or purchased by Fannie Mae or Freddie Mac started in 1975 • Broad measure of home price movements: • Geographic coverage: • All-Transaction Index – All metro areas and states • Purchase-Only Index – Top 100 metros and all states • Data from conforming Freddie and Fannie mortgages • Both refinanced loans as well as sales depending on index used www.northinfo.com Slide 8 Differences Between Case-Shiller & NHPI 1. NHPI’s geographic coverage is broader: a) Includes transactions in all states and more metro areas. 2. NHPI is an equal-weighted index while Case-Shiller is a value-weighted index. a) Expensive homes have a greater impact on the Case-Shiller Index 3. The NHPI calculates two indices: a) The “All-Transactions” Index which contains both sales and refinancing transactions with the latter relying on appraised-values b) The “Purchase-Only” Index which uses only sales price data c) Therefore, appraisal bias is less prevalent in the Case-Shiller if the NHPI All- Transactions Index is used. 4. FHFA's data comes from Fannie Mae and Freddie Mac conforming mortgages. S&P/Case-Shiller relies on data secured from county assessor and recorder offices. www.northinfo.com Slide 9 The Global Total Portfolio Risk problem • Multiple portfolios with diverse characteristics • Across countries, across asset classes • Asset classes such as convertible bonds and derivatives have complex properties • Asset classes such as private equity, private equity real estate, and infrastructure, have no visible pricing, return, or risk information www.northinfo.com Slide 10 Segregated Solutions • One approach: model asset class separately and aggregate risk only through covariance matrix: • Overall covariance matrix resembles a chessboard where each square is a sub-model segment of the covariance matrix • As aggregate number of factors increases relative to the limited number of observations, the matrix becomes unstable • Fixing the problem by extending the historic observation period of the sub-models discounts the importance of the dynamics in the market place embedded in more recent observations • Illiquid Assets Compound the Total Portfolio Problem. Current Illiquid modeling practice produces yet another silo factor set in the total portfolio covariance matrix www.northinfo.com Slide 11 Fully Integrated Approach • Employ a single parsimonious factor model across all asset classes across all geographies • All investable assets are related to the same consistent set of factors, so interrelationships are easily observed and understood • Limited number of factors allows for stable estimation of factor relationships, and fluid regime shifts www.northinfo.com Slide 12 The Everything Everywhere (EE) Risk Model • GEOGRAPHY: Five regional indices • INDUSTRY: Six sector indices with global constituents • ECONOMIC: • Return of Salomon Smith Barney WGBI • Percent changes in oil prices • INVESTOR SENTIMENT / STYLE: • Dividend Yield • Market Development • Size www.northinfo.com Slide 13 EE Factor Structure (contd.) • CURRENCY: 69 currency factors indicating the denomination currency of a position • CURVE: • Parallel Shift in Treasury Term Structure of Interest Rates • Changes in Slope of Term Structure – “Twist” • Changes in Curvature of Term Structure – “Butterfly” www.northinfo.com Slide 14 EE Security Universe • Global Equities (~70 thousand instruments) • Global Sovereign and Corporate Bonds (~600 thousand) • 2013 PRMIA Award for New Frontiers in Risk Management • Asset-Backed Securities, Structured products, and customized coverage (~1.5 million) • Municipal Bonds (~1.3 million) • Futures, forwards, options on equities, currencies, interest rates, and bonds, Interest Rate and Credit Default Swaps (on demand OTC processing) • Mutual and Hedge Funds (40 thousand global universe of funds, extensible on demand) • Direct Real Estate, Infrastructure, and Private Equity (virtually all markets around the globe) • 2015 ARES Best Practitioner Research Award www.northinfo.com Slide 15 - - Replication 4 2 0 2 4 6 8 05/01/2010 07/01/2010 average a moving incorporate portfolio replicating in returns stock Note: 09/01/2010 11/01/2010 01/01/2011 03/01/2011 Portfolio Replicating CS Rent Economic 05/01/2011 Fits: Economic Rent 07/01/2011 09/01/2011 11/01/2011 www.northinfo.com 01/01/2012 03/01/2012 05/01/2012 07/01/2012 09/01/2012 11/01/2012 01/01/2013 03/01/2013 - 05/01/2013 Based on CS 07/01/2013 09/01/2013 11/01/2013 01/01/2014 03/01/2014 05/01/2014 07/01/2014 Slide Slide 09/01/2014 11/01/2014 16 - - Replication Fits: USA 0.5 1.5 0.5 1.5 2.5 - - 0 1 2 1 2 05/01/2010 07/01/2010 09/01/2010 11/01/2010 01/01/2011 03/01/2011 05/01/2011 07/01/2011 09/01/2011 11/01/2011 www.northinfo.com 01/01/2012 03/01/2012 - 05/01/2012 2014 07/01/2012 09/01/2012 11/01/2012 HPI_US_2014_fit Replicating Portfolio Replicating 01/01/2013 03/01/2013 05/01/2013 07/01/2013 09/01/2013 11/01/2013 01/01/2014 03/01/2014 05/01/2014 07/01/2014 Slide Slide 09/01/2014 17 11/01/2014 Replication - 0.5 1.5 2.5 0.5 - 1 0 1 2 05/01/2010 07/01/2010 09/01/2010 11/01/2010 01/01/2011 03/01/2011 Fits: USA 05/01/2011 07/01/2011 09/01/2011 11/01/2011 www.northinfo.com 01/01/2012 03/01/2012 - HPI_US_2016_fit Portfolio Replicating 05/01/2012 2016 07/01/2012 09/01/2012 11/01/2012 01/01/2013 03/01/2013 05/01/2013 07/01/2013 09/01/2013 11/01/2013 01/01/2014 03/01/2014 05/01/2014 07/01/2014 Slide Slide 09/01/2014 11/01/2014 18 Replication
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