Additional Reading 5 – SwapRent (SM) Technical Info and Pricing Examples

SwapRent (SM) Technical Info and Pricing Examples

The following information was written for banking regulators, consumer protection agencies, and finance industry professionals that may include structured derivatives bankers, financial engineers and risk management specialists for their advanced understanding on how these new instruments and their markets would operate and could be best managed. It is not meant for the average consumers and therefore it may appear overly complicated.”SwapRent (SM)” is a new invention of an alternative way between the buying/selling and the renting of a real estate property for property owners. The idea is to provide a very simple way in the mind of the property owners to let them protect the gains in their home or commercial property equity value.

As long as a property owner has the mental capability to sign a contract to purchase a house or to sign a lease to rent an apartment he or she will have the ability to sign a SwapRent (SM) contract in order to stay out of the price fluctuation of his/her home or a commercial building that he/she owns for a short or long period of time. The homeowners or commercial property owners do not need advanced knowledge or education in derivatives or any other sophisticated institutional capital markets instruments in order to make the SwapRent (SM) transactions.SwapRent (SM) has two major roles in the new real estate risk management industry – one is to act as a superior OTC property derivatives instrument in the inter-bank and institutional dealing community, the other is to act as bridge between the esoteric institutional derivatives market and the vast consumer finance market.

As a result SwapRent (SM) was also intentionally designed to be a consumer-oriented financial product to be offered to the retail consumers such as homeowners or commercial property owners of office buildings, apartment complexes, warehouses, retail shops, … etc., for them to use as a simple hedging tool.

At the same time SwapRent (SM) could also allow investors to use the same service (in an opposite position) to establish an exposure in the potential property value appreciation or depreciation of a particular type of properties in a particular neighborhood. Banks could be engaged to either be the middlemen in between the property owners and investors or simply as credit guarantors.

The business idea is to design and create a very simple concept and method for property owners to simply “rent” (“SwapRent (SM)”) (to pay a “rent” or to pay a “SwapRent (SM)” to stay in) their own house for a certain period of time and therefore to achieve the objective of not having a potential loss or gain in their home equity value during that same time period, while continuing the existing legal ownership.

Currently the only business method available to a property owner to lock in the gains or loss in the home equity value is to do a “sale and lease back” transaction. This includes the real sale transaction and the renting from the new owner of a house that the property owner had been occupying.

The high transactional cost associated with it as well as the tax and legal considerations are usually the deterrents for property owners to widely accept it as a temporary tool for the purpose of simply locking in the financial gains or loss for a specified period of time. Using exchange traded futures and options could be another way but it does not offer a necessary close hedging ratio and the method is way too complicated for most normal homeowners without advanced derivatives knowledge and experience.

From the consumers’ perspectives, SwapRent (SM) is a synthetic version of “sale and lease back” that only captures the economic benefits of a “sale and leaseback” without the legal title transfer, triggering of tax events or the associated high transactional brokerage cost.  Despite its unique capability to enable the unsophisticated homeowners or commercial property owners to enjoy the economic benefits of the derivatives market due to its simplicity and user friendliness SwapRent (SM) is by no means just a retail product. Its institutional uses far out rank the currently existing instrument such as a TRS or PRS. From a technical stand point, SwapRent (SM) is like a synthetic “rent’ or “yield” for properties, similar to the concept of the lease rate trading for gold.

Through the SwapRent (SM) trading we could develop a fixed vs. floating synthetic property “yield’ swap market itself for both the residential and the commercial properties. The floating SwapRent (SM) market could connect to the current PRS market if they both use the same granular like-kind property neighborhood indices introduced here. The fixed SwapRent (SM) market will be able to provide much more useful information such as implied forward price information for properties. That is the relationship dictated by the interest rate parity.

Through the unique REIO (Real Estate Index Options, i.e. AG and DP SwapRent contracts) trading the options market could be easily developed first and hence the information about implied volatilities. Trading forwards and options will no longer remain wish list items or simply punting games among speculators if they are developed using this systematic SwapRent (SM) approach. The current “forward start” TRS or PRS contract is not really a true traditional forward contract.

In addition the main arguments for liquidity is that through SwapRent (SM) trading arbitrage opportunities could exist when SwapRent (SM) levels are compared to the actual rental levels in the real world of the similar like kind properties in the same neighborhoods, for both residential and commercial properties. The existence of arbitrage opportunities is vitally important in growing any new derivatives markets.

As a derivatives instrument, SwapRent (SM) could be used with any kind of property price indices or no index at all (by using appraisal or real transaction prices). However, the special usefulness of SwapRent (SM) for hedgers could be demonstrated when a special set of granular indices is created. These granular indices are based on a concept of the weighted average price information per square area of the “smallest definable neighborhoods of like-kind properties” and their aggregates in any country. This methodology is called SPIM (SwapRent Property Indexing Methodology).

Here below is what some house price index based SwapRent (SM) rates might look like for a sample local city and how they could be collectively determined by the market participants of homeowners and investors.

As of Friday October 12th, 2007, given the then negative sentiment for the near term outlook on US residential real estate, a SwapRent (SM) market rate levels (mid-point between bid and offer rates) for MSA (Metropolitan Statistical Area) of Los Angeles could look like the following as one of the arbitrarily suggested example scenarios for illustration purpose only:

1Y        2Y        3Y        4Y        5Y       …..      10Y        15Y        20Y
15%     10%     5%        3%       2%       …..      1%          0%        -2%

If the Mortgage Funding Cost (MFC) stays the same at 5% for all maturities, it means the annual subsidies from the “economic landlord” investors to the “economic tenant” homeowners (i.e. the MFC minus GSR, the Generic SwapRent (SM)) are as follows:

-10%     -5%     0%        2%       3%      …..      4%         5%         7%

The break-even points for the investors of cumulative general US residential real estate market appreciation (negative sign means depreciation) represented by the MSA level property index are when these indices will have to go up by this amount (without considering compounding and the time value of money for illustration simplicity):

-10%     -10%   0%        8%       15%     …..      40%       75%      140%

Since SwapRent (SM) rates capture more than the information of the current physical rental rates in a given neighborhood or city in the real world and it also reflects the market expectation of the expected return from the price changes during the holding period, the very high Generic SwapRent (SM) rates for the shorter maturities indicate the extreme bearishness in the US residential real estate market at the moment.

As long as the drop in prices at the end of the contract period as represented by the local MSA index does not go below 10% for a 1-year contract the investors will come out ahead. The same is true for the cumulated returns for a 2-year contract. The flat annual subsidy and expected return for a 3-year contract simply indicates that people may think the market could recover to where we are at today in 3 years’ time. Starting from a 4-year contract there will be positive annual subsidies for the homeowners, ditto for the even longer term maturity contracts.

As could be seen by these examples, the supply and demand as well as the general market expectation will drive where the Generic SwapRent (SM) rates could be traded in a given local market although they will also be bound by any risk-less arbitrage opportunities that might exist.It also illustrates that in the current environment if the homeowners want annual subsidies such as in the case of the defaulting subprime borrowers whose ARM rates had been reset higher may need to commit to longer terms contracts, say 4 or 5 years and longer in order to attract investors’ interests.

The homeowners could always unwind their SwapRent (SM) positions that were built in their SwapRent (SM) embedded mortgages after one or two years for the remaining maturities whereas the market levels and the general real estate market sentiments may have already changed by then.

These examples only serve as an illustration of how the trading mechanics of the Generic SwapRent (SM) rates could be like under the current bearish market outlook for the US residential real estate market. It could change drastically when the market sentiments change, just like how market rates behave in any other financial markets.

If the SwapRent (SM) markets had been implemented and made widely available soon enough, a general US real estate market recession could well have been avoided. This should easily be understood since if the existing lending banks start offering these 5-year or 10-year SwapRent (SM) contracts soon enough to the distressed homeowners, these borrowers would have been able to avoid defaults, foreclosures and held on to their homes.

Massive foreclosures could have been avoided or at least be postponed for another 5 years, 10 years or longer. So there would not have been massive selling pressure in the real estate market and of course the market would have been able to hang on without a major collapse.

For further information, please see the original concepts and methods design white paper on SwapRent (SM), HELM, FVCM, REIDeX, SPIM etc. written in July 2006.

 

 

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