The lack of development in the real estate futures market

Summary

– For at least twenty years, several economists, notably Karl Case and Robert Shiller, have been advocating the creation of a large futures market based on real estate prices.

– As households often hold a significant portion of their wealth in non-financial assets such as real estate, this market could enable them to protect themselves in part against fluctuations in real estate prices.

– However, this market has not yet really developed.

– In this article, we present some plausible reasons for the lack of development of this market, as well as the theoretical basis for its social utility.

Real estate futures: what is their social utility?

Economic theory has long been interested in risk management. Keynes, for example, when he wrote The General Theory of Employment, Interest, and Money, had as his main goal to avoid the significant fluctuations that characterized the Great Depression. Similarly, at a more microeconomic level, one of the basic assumptions is that individuals are risk-averse, a hypothesis necessary for the existence of insurance markets (when insurance is not imposed by the government).

From this point of view, an insurance market capable of mitigating fluctuations in real estate prices would be justified. However, if an individual decides to purchase insurance that would perfectly protect the value of their property, they may not maintain it properly and, when selling it at a lower price due to lack of maintenance, demand payment of the difference between the initial price and the resale price. This presents a moral hazard problem that would justify the non-existence of such a market.

An insurance market based on futures does not have this moral hazard problem. Indeed, let us imagine a simplified futures contract [1], based on a real estate index (generally the Case-Shiller index for the United States) for a homeowner who wishes to protect themselves against fluctuations in real estate prices. In this case, if the index falls, the homeowner will receive a sum of money. If the opposite occurs, they will have to pay a sum of money to the other party to the contract. In this way, the homeowner will be partially protected from price fluctuations.

The insurance is certainly not perfect because it does not cover the actual price of the insured’s home but rather a real estate index that must be correlated to the price of the home (at constant quality, i.e., excluding possible improvements or deterioration of the property). For example, if a household decides to buy an apartment in Paris in district X, it can protect itself by selling a real estate futures contract [2] based on the real estate price index in district X of Paris. Since the owner has no control over this index, the problem of moral hazard no longer arises. As recent events have shown, real estate prices can be subject to significant fluctuations that can render many households insolvent. In this sense, the social utility of such a product would appear to be justified.

But why is it so small?

Several potential explanations have been put forward in the economic literature to try to understand why this market is so small today. Without claiming to be exhaustive, here are some of the most interesting explanations.

Three explanations could justify the limited size of a real estate futures market: (1) lack of liquidity, (2) the legal environment, (3) the fact that owning real estate can protect against fluctuations in other markets with a view to a future purchase, and (4) the disconnect between aggregate variables and the individual price of a property.

First, an underdeveloped market has a lack of liquidity. This can cause some reluctance among speculators or institutions to purchase futures. Robert Shiller uses the metaphor of a « nightclub. » When a nightclub opens, its success will depend on potential customers’ belief in the success of the nightclub itself. In other words, you want to go there if you think others will also decide to come. Since other individuals act in a similar way, several factors must come together for the nightclub to be a success. The same logic applies to almost all new financial markets. Therefore, it may take several attempts before the market attracts enough participants and thus becomes more liquid.

Another issue related to the creation of a new market is the legal basis required for futures-based insurance contracts . For example, in Syracuse in the New York region of the United States, as part of a project to revitalize the city, a product similar to the one described above was introduced. However, those involved in the project had great difficulty determining which legal regime applied to the product in question. For example, New York State law states that such a product could be considered insurance if the person in question has a material interest in the insured item. However, while the value of your home may be strongly linked to the price index in your region, you do not have a direct material interest in that price index. As a result, this product could not be classified as insurance. It therefore took some time for those involved to bring the product within a legal framework. This shows that inadequate legislation can make it difficult to introduce certain products, even when they are clearly beneficial from a social perspective.

Another reason put forward by Todd Sinai and Nicholas Souleles is that homeownership can protect against price fluctuations in other real estate markets. For example, if you buy a property in a region where prices are correlated with those in a market where you plan to buy later, you are in a sense insuring your real estate consumption in the second market. You can resell your property in the first market and use the money you get from the sale to buy in the second market. If prices are correlated, then in general, even if prices have risen in the second market, prices in the first market should also have risen. However, Sinai and Souleles show that in the United States, the markets with the most variation are also those that covary [3] the most with other markets. In this case, the type of products described above is no longer so attractive. This amounts to « uninsuring » oneself against price fluctuations in the second market.

However, it is reasonable to think that this covariance is not the best way to insure oneself. At first glance, it would seem more interesting to sell futures on the primary market (to partially insure the resale price) and buy them on the secondary market (to insure the price of the new purchase) [4]. We are therefore entitled to wonder whether this explanation is sufficient. This is all the more so as it does not seem to apply, for example, to retired households with low mobility, who appear to use their real estate as insurance against dependency.

Finally, Martin Droës and Wolter Hassink showed in a 2013 paper that, for the Netherlands, aggregate real estate price variables explain only a relatively small portion of the individual price of a property. If this is true in other markets, it reduces the appeal of futures as an insurance product, since it would reduce the insured portion of price variations.

Conclusion

The real estate index futures market has not yet managed to develop, despite the potential interest in an insurance product for households with significant non-financial wealth that is highly exposed to real estate prices.

There are several possible explanations for the lack of interest in these products. As a reminder, we have presented four:

1. lack of liquidity,
2. the legal environment,
3. the fact that owning real estate can protect against fluctuations in other markets with a view to a future purchase,
4. the disconnect between aggregate variables and the individual price of a property.

To date, there have been several unsuccessful attempts to establish this market, particularly in the United Kingdom and the United States [5]. In general, despite some promising beginnings, none of these markets has really taken off. However, it is conceivable that in the future, households will seek to better insure themselves against fluctuations in the value of their real estate assets, particularly given the significant fluctuations that have been observed in this market recently. This could lead to renewed interest in the development of a genuine real estate futures market, with potentially greater success than previous attempts.

Notes:

[1] A futures contract is a type of standardized contract that stipulates the purchase or sale of an asset in the future at a price set in advance. For example, if a European company has to pay a bill in dollars in six months’ time, it may want to protect itself against the possible appreciation of the dollar by buying dollars forward via a futures contract. In this case, the contract will stipulate the number of euros it will have to pay in exchange for the amount of dollars it wishes to obtain in order to settle its bill. This allows it to avoid the risk of a dollar appreciation that would increase the euro value of its payment.