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Brain food


Predicting house prices

An increase in short selling of real estate investment trusts (REITs) can help forecast a decrease in housing prices the following month, finds new study co-authored by Dr Pedro Saffi of Cambridge Judge.

For Sale property agency sign posted outside English terraced houses.

Even if you do not own stock in Company X, you can speculate on its share price going down by borrowing from someone that owns them, sell the shares at current market prices, and purchase them back later at, hopefully, a lower price – a practice known as short selling. Likewise, people can hedge against a depreciation of the pound by selling some of their currency for euros, dollars, or Swiss francs.

But if you own a house and are worried that house prices may soon fall in your area, your options may appear fairly limited: there are extremely high transaction costs with real estate, and “you can’t sell half a house,” says Dr Pedro Saffi, University Lecturer in Finance at Cambridge Judge Business School.

Yet there are still indirect hedging options available.

Dr Pedro Saffi

Dr Pedro Saffi

A new study co-authored by Pedro finds that an increase in short-selling activity of real estate investment trusts (REITs), funds that only invest in property assets, forecasts a decrease in house prices the following month.

“Short selling REITs can be a good strategy to speculate on housing market downturns or to hedge the downside risk in housing markets,” says the study just published in the journal Real Estate Economics, which is based on US equity lending and house price data from 2006 through 2013.

The study divides the US property market into four regions – Northeast, Midwest, South and West – and classifies each month in each region as being a “boom,” “average” or downturn” period. Although during boom and average periods there is little correlation between REITs short-selling and the subsequent month’s housing prices, “the correlation is significantly positive during housing market downturns.”

A chart in the study compares the cumulative performance of the Federal Housing Finance Agency (FHFA) House Price Index with an investment strategy that combines a long position in the FHFA House Price Index with a short position on REITs – with the latter hedging strategy outperforming the FHFA in the South, West, and particularly in the Northeast.

Unlike houses, REITs are very liquid and have low transaction costs, with an average stock loan fee (for short selling) of just 0.23 per cent a year. As of January 2014, there were 204 publicly traded REITs in the US with a total market capitalisation of $719 billion.

While some REITs have assets that are geographically disperse, others are highly concentrated in certain regions – so these REITs are particularly useful in measuring the connection between REITs short selling and the subsequent month’s house prices in that region. The study found such a negative correlation strongest in areas that had just experienced a house price boom, meaning the Northeast and West.

“The study shows that looking at REITs short selling is a way to measure bearish sentiment in the housing market, because financial markets move much faster than the real economy,” says Pedro.

This is a useful tool for central banks and regulators, who can track signals from the equity lending market to improve their forecasts on house prices and thus take steps to help prevent property bubbles.

The study – entitled “The big short: short selling activity and predictability in house prices” – is co-authored by Pedro Saffi of Cambridge Judge Business School and Carles Vergara-Alert of IESE Business School in Spain.