Hedging Rental Increases with REIT Options

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This post talks abut a thought exercise and simplifies several complicated concepts. More detailed assessment and research is advised before following any of the below.

For most expats, rental expenses will likely be the biggest single expense that they have to budget for in any financial planning.

Many countries, such as the Philippines, have restrictions on foreign citizens owning real estate which forces expatriates into the rental market. Whilst other expats, even when the legal system permits, shy away from property ownership outside their country of citizenship and continue to rent often owing to feelings of mistrust in the local legal system, or the often temporary nature of expat residency.

It is little surprise then that the vast majority of expat workers around the world find themselves in the rental market and often beholden to the demands of landlords demands for higher rental payments.

Some countries, such as Germany, have very favourable legal systems for tenants that outline rental increases, eviction requirements, etc. Others, such as some Asian nations, have far fewer protections for tenants and allow the rental market to conduct itself with all parties seeking to act in their own best interests.

In theory, a region with no legal control over rental increase caps, the rental market is controlled entirely by “invisible hand” of the free market supply and demand forces.

In such a free market, the rental price of an apartment would be the convergence point between what a tenant is willing to pay, and what a landlord is willing to accept, in an “arms length” transaction.

If we take an example where the tenant is willing to pay no more than $12,000 a year, and the landlord is willing to accept no less than $10,000 a year.
This gives an area of $2,000 overlap in which an agreeable price can be found.

Rental Price Range
The rental price should fall in the crossover between $10,000 – $12,000

These two opposing sides of the transaction are controlled by the supply of, and demand for, housing. If the local market suddenly has a large volume of housing built, then prices should fall as supply increases faster than demand. If a large number if people move to the area, prices should rise as demand increases faster than supply.

What we need to consider here is the broader impact that the effects of supply and demand for housing has on the real estate market.

In theory, the same forces that dictate the rental price will also dictate the property value.
If demand for real estate pushes prices up by 20% in a year, then the level of rental income should also rise by 20%

Year Rent price Property Value Change
Year 1 $20,000 $500,000
Year 2 $22,000 $550,000 10.00%
Year 3 $23,000 $575,000 4.55%
Year 4 $25,000 $625,000 8.70%
Year 5 $28,000 $700,000 12.00%
Year 6 $30,000 $750,000 7.14%
Year 7 $32,000 $800,000 6.67%
Year 8 $36,000 $900,000 12.50%
Year 9 $39,000 $975,000 8.33%
Year 10 $42,000 $1,050,000 7.69%

To understand this we need to understand the “Cap Rate” or “Capitalization Rate” of an investment property.
If an apartment is for sale today at $500k and has a rental yield of $20k the apartment’s capitalization rate is 4%

The 4% can be assumed with the CAPM (Capital Asset Pricing Model) to show the implied risk of the investment. Assuming the underlying risk factors don’t change, the 4% cap rate should remain fairly steady.

A property with a high cap rate could be considered to carry more risk, whilst a property with a lower cap rate could be considered to carry less risk.

Rental Price vs Property Price
Rental Price vs Property Price

If in the following years (Year 4 in the chart)  the rental price for the property has risen to $25k a year due to demand outstripping supply, with all other variables being equal, then the cap rate should remain at 4% and give a fair market valuation of the property at $625k

$25k / 4% = $625k

That is to say, an investor who would be willing to accept the same 4% yield on the property would be forced to pay $625k today for it.
So it is easy to see how the rental price is tied closely to the value of the property, and the two move in step.

A higher rental yield makes the investment more appealing, and as such the price that an investor is willing to pay is higher.
A lower rental yield makes the investment less appealing, and as such the price that an investor is willing to pay is lower.

The theory then would be that if you could invest one years rental payments into a real estate investment today, then the value of that investment next year should equal your expected rental payments next year.

REIT Futures Options

With other financial products or commodities, if an investor wishes to protect against future price changes in the market he or she can take advantage of the futures contracts to agree a fixed price for an item at a point in the future:

Provided that you can find a REIT that is specific to your local market, and is traded on a public exchange, there should then be the option to purchase futures options on that as a way to lock in the future price of the real estate market and therefore any rental payments.

Futures “call options” give the investor the option, but not the obligation, to buy a specific item in the future at a pre-agreed price.

If the price of the security rises above that pre-agreed price, the investor can use the option and profit from the difference.
If the price of the security falls, the investor simply chooses not to use the option and loses only the premium paid for the option:

For example:
Let’s say our investor, Nick, lives in Hong Kong and signs a rental agreement for 1 year at a cost of $20,000.
Nick would like to continue living in the same apartment next year, but fears the rental price will go up and he wishes to try and hedge any potential increase.

Nick finds a Hong Kong specific REIT, that covers 100 properties in the city of Hong Kong only, that trades as an ETF on the Hong Kong public exchange, and currently trades for $20 a share.
Nick enters into a futures options contract to buy 1,000 shares at $20 each one year from today.
For the contract, Nick pays a premium of $900.

Nick now knows, that all things being equal, the most he will pay for rent next year will be $20,900 regardless of any potential movement in the real estate market either up or down.

A year later, the Hong Kong property market has risen by 10%.
The Hong Kong REIT now trades at $22 a share and Nick’s landlord has hiked the rent up to $22,000 a year.
Nick exercises his futures contract to buy 1,000 shares of the REIT at $20 a share, and then sells them at the market price of $22 a share.

Nick takes a profit of $1,100:
$22 – $20 = $2
$2 * 1,000 shares = $2,000
$2,000$900 Contract premium = $1,100
Nick takes the $1,100 and adds to it $20,900 to make the $22,000 in rent that is due for the year.

By using a futures option on the REIT, Nick was able to cap his rental payment at $20,900 even though his rent increased up to $22,000.

Had the real estate price fallen, Nick would simply not have executed the futures option and instead taken the $900 premium as a loss, on top of his new rental payment.

The main issues with this as a hedging strategy are:

  • The REIT will likely not track the value of your individual apartment accurately, and gives a fairly large margin of error.
  • Finding a REIT that tracks only real estate in your market may be difficult or even impossible
  • Trade volumes on the futures options of a specific REIT will be very low and the premiums thus very noncompetitive
  • Premium prices may well be prohibitively high and thus negate any potential hedging

However, REITS are gaining in popularity and speciality.
There are already REITs that cover Hong Kong (The Link REIT), a Selection of Japanese REITS (Also known as J-REITs), and a UAE specific REIT (Emirates REIT)

However, it seems that while the viability of using REIT call options is far from perfect, the idea may provide at least some level of hedging against rental price increases.

As always, you should be sure to do thorough research before making any such investment decisions.

I hold no positions in any of the securities mentioned in this article

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