“The only bad time to buy real estate is later” cites investment wisdom. But, when interest rates soar high, real estate investments can and do hurt.
Last week FOMC reiterated its resolve to fight inflation down to its target 2%. Inflation has been stubborn and sticky. It has shown signs of trend reversal towards resurgence. Chair Powell’s made clear that rate cuts may take longer to arrive than anticipated.
Elevated rates are restrictive for businesses. It leads to shrinking sales and profits. However, recent earnings show heavyweights posting robust growth. While others have shown disappointing earnings. The difference boils down to the industry and sector.
Some sectors fare worse than others. Real Estate is extremely sensitive to rates. Higher rates directly impact mortgages impeding buyers from getting into long-term mortgages.
Unsurprisingly, the Real Estate Select Sector index has been the lowest performing sector since the start of the Fed’s rate hiking campaign. Underperformance has continued well into 2024 and has also been observed during periods of market rallies.
With sustained headwinds facing real estate, underperformance is likely to continue. This provides suave investors a tactical spread opportunity consisting of a long position in the wider S&P 500 index using CME Micro E-Mini S&P 500 futures and a short position in the CME S&P Real Estate Select Sector futures to harness a reward to risk ratio of 1.5x.
FED REAFFIRMS HIGHER FOR LONGER
Fed fund rates will remain at 5.25%-5.5% for longer given the stubborn inflation trend over the last 12- months.
Forget rate cuts. Those hopes are diminishing. The CME FedWatch signals just two rate cuts this year as of 5/May, down from six expected at the start of the year.
Chair Powell’s speech hinted that even two rate cuts is overly hopeful stating that the expected inflation may not be enough to cut rates this year.
HIGHER RATES WEIGH ON REAL ESTATE SECTOR
Higher rates adversely impact the Real Estate sector. Elevated rates push up mortgage and financing costs. Large financing costs constrains demand.
Last October, the 30-year mortgage rate climbed to its highest level in 23 years at 7.79%. Following that peak, the mortgage rates eased to as low as 6.6% in December as expectations of rate cuts started to firm up.
Since then, the rates have rebounded. As of 29/April, the 30-Year mortgage rate average (calculated by Freddie Mac) hovers at 7.22%. A measure calculated by the Mortgage Bankers Association showed that as of 1/May, the mortgage rate continues to rise and is now at 7.29%.
Higher rates are forcing housing demand lower. New home sales have declined 5% and existing home sales have fallen by 25% since the rate hiking cycle.
Home prices continued to rise despite a slowdown in sales. House price index is almost 10% higher since 2022 as inventory of houses hovers near an all-time-low.
COMMERCIAL REAL ESTATE FACES IDIOSYNCRATIC RISKS
Commercial Real Estate (“CRE”) has been hit with a double whammy from dwindling office space demand and prohibitive cost of financing.
Office space vacancy rate reached a new record high of 19.8% in Q1 2024 as per Moody’s data reported on Bloomberg. Recovery in office space demand remains unlikely in the near term pressing CRE sector down.
HYPOTHETICAL TRADE SETUP
The real estate sector has been hammered. The S&P Real Estate Select Sector Index is 20% lower since the rate hiking cycle began. The benchmark S&P 500 declined at first but has since recovered and now stands 13% higher.
For investors to build a directional short is not prudent as the sector has suffered brutal markdowns. This paper argues in favor of a spread between S&P 500 and the Real Estate Select Sector Index using CME futures.
S&P 500/XLRE spread has delivered a stunning 45% outperformance since 2022.
Investors can utilize CME Micro E-Mini S&P 500 futures which provides exposure to USD 5 x S&P 500 Index. This is one-tenth the size of standard E-mini futures enabling granular risk management.
The CME Micro E-mini S&P 500 futures first launched exactly five years ago on 6/May/2019. The demand for these micro contracts has spiked. In April 2024, these contracts witnessed an Average Daily Volume of more than one million contracts which represents 15.7% YoY growth and 22.7% MoM growth.
Micro futures allow for smaller position sizes. It broadens market access and allows for granular and effective hedging by matching notional values closely in spreads.
This hypothetical trade consists of a long position in 2 lots of Micro E-mini S&P 500 June futures (MESM2024) with a notional size of USD 51,615 (= 2 (number of contracts) x USD 5 (contract size) x 5161 (index value)) and a short position in 1 E-mini Real Estate Select Sector futures (XARM4) with a notional size of USD 45,500 (= 1 (number of contracts) x USD 250 (contract size) x 182 (index value)).
Consider the two scenarios which can lead to a shift in the spread ratio:
1) S&P 500 rises from 5161.5 to 5408.6 while Real Estate Select Sector index remains unchanged at 181.8. The ratio becomes 5408.6/181.8 = 29.75. The overall profit, which comes entirely from the S&P 500 position would be (5408.6 – 5161.5) x 5 x 2 = USD 2,471.
2) S&P 500 remains unchanged at 5161.5 while Real Estate Select Sector index falls from 181.8 to 173.5. The ratio becomes 5161.5/173.5 = 29.75. The overall profit, which comes entirely from the Real Estate Select Sector index would be (181.8 – 173.5) x 250 = USD 2,075.
• Entry: 28.5
• Target: 29.75
• Stop Loss: 27.5
• Profit at Target: USD 2,471
• Loss at Stop: USD 1,620
• Reward to Risk: 1.53x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Last week FOMC reiterated its resolve to fight inflation down to its target 2%. Inflation has been stubborn and sticky. It has shown signs of trend reversal towards resurgence. Chair Powell’s made clear that rate cuts may take longer to arrive than anticipated.
Elevated rates are restrictive for businesses. It leads to shrinking sales and profits. However, recent earnings show heavyweights posting robust growth. While others have shown disappointing earnings. The difference boils down to the industry and sector.
Some sectors fare worse than others. Real Estate is extremely sensitive to rates. Higher rates directly impact mortgages impeding buyers from getting into long-term mortgages.
Unsurprisingly, the Real Estate Select Sector index has been the lowest performing sector since the start of the Fed’s rate hiking campaign. Underperformance has continued well into 2024 and has also been observed during periods of market rallies.
With sustained headwinds facing real estate, underperformance is likely to continue. This provides suave investors a tactical spread opportunity consisting of a long position in the wider S&P 500 index using CME Micro E-Mini S&P 500 futures and a short position in the CME S&P Real Estate Select Sector futures to harness a reward to risk ratio of 1.5x.
FED REAFFIRMS HIGHER FOR LONGER
Fed fund rates will remain at 5.25%-5.5% for longer given the stubborn inflation trend over the last 12- months.
Forget rate cuts. Those hopes are diminishing. The CME FedWatch signals just two rate cuts this year as of 5/May, down from six expected at the start of the year.
Source: CME FedWatch
Chair Powell’s speech hinted that even two rate cuts is overly hopeful stating that the expected inflation may not be enough to cut rates this year.
HIGHER RATES WEIGH ON REAL ESTATE SECTOR
Higher rates adversely impact the Real Estate sector. Elevated rates push up mortgage and financing costs. Large financing costs constrains demand.
Last October, the 30-year mortgage rate climbed to its highest level in 23 years at 7.79%. Following that peak, the mortgage rates eased to as low as 6.6% in December as expectations of rate cuts started to firm up.
Since then, the rates have rebounded. As of 29/April, the 30-Year mortgage rate average (calculated by Freddie Mac) hovers at 7.22%. A measure calculated by the Mortgage Bankers Association showed that as of 1/May, the mortgage rate continues to rise and is now at 7.29%.
Higher rates are forcing housing demand lower. New home sales have declined 5% and existing home sales have fallen by 25% since the rate hiking cycle.
Home prices continued to rise despite a slowdown in sales. House price index is almost 10% higher since 2022 as inventory of houses hovers near an all-time-low.
COMMERCIAL REAL ESTATE FACES IDIOSYNCRATIC RISKS
Commercial Real Estate (“CRE”) has been hit with a double whammy from dwindling office space demand and prohibitive cost of financing.
Office space vacancy rate reached a new record high of 19.8% in Q1 2024 as per Moody’s data reported on Bloomberg. Recovery in office space demand remains unlikely in the near term pressing CRE sector down.
HYPOTHETICAL TRADE SETUP
The real estate sector has been hammered. The S&P Real Estate Select Sector Index is 20% lower since the rate hiking cycle began. The benchmark S&P 500 declined at first but has since recovered and now stands 13% higher.
For investors to build a directional short is not prudent as the sector has suffered brutal markdowns. This paper argues in favor of a spread between S&P 500 and the Real Estate Select Sector Index using CME futures.
S&P 500/XLRE spread has delivered a stunning 45% outperformance since 2022.
Investors can utilize CME Micro E-Mini S&P 500 futures which provides exposure to USD 5 x S&P 500 Index. This is one-tenth the size of standard E-mini futures enabling granular risk management.
The CME Micro E-mini S&P 500 futures first launched exactly five years ago on 6/May/2019. The demand for these micro contracts has spiked. In April 2024, these contracts witnessed an Average Daily Volume of more than one million contracts which represents 15.7% YoY growth and 22.7% MoM growth.
Micro futures allow for smaller position sizes. It broadens market access and allows for granular and effective hedging by matching notional values closely in spreads.
This hypothetical trade consists of a long position in 2 lots of Micro E-mini S&P 500 June futures (MESM2024) with a notional size of USD 51,615 (= 2 (number of contracts) x USD 5 (contract size) x 5161 (index value)) and a short position in 1 E-mini Real Estate Select Sector futures (XARM4) with a notional size of USD 45,500 (= 1 (number of contracts) x USD 250 (contract size) x 182 (index value)).
Consider the two scenarios which can lead to a shift in the spread ratio:
1) S&P 500 rises from 5161.5 to 5408.6 while Real Estate Select Sector index remains unchanged at 181.8. The ratio becomes 5408.6/181.8 = 29.75. The overall profit, which comes entirely from the S&P 500 position would be (5408.6 – 5161.5) x 5 x 2 = USD 2,471.
2) S&P 500 remains unchanged at 5161.5 while Real Estate Select Sector index falls from 181.8 to 173.5. The ratio becomes 5161.5/173.5 = 29.75. The overall profit, which comes entirely from the Real Estate Select Sector index would be (181.8 – 173.5) x 250 = USD 2,075.
• Entry: 28.5
• Target: 29.75
• Stop Loss: 27.5
• Profit at Target: USD 2,471
• Loss at Stop: USD 1,620
• Reward to Risk: 1.53x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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