Four Ways to Hedge Against Falling Home Prices

Consider strategies to reduce the risk of losing money on a big asset.
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Homeownership has become risky business.

And when business gets risky, investors hedge.

Your house is no longer the bottomless piggy bank it was when home prices rose 40 percentage points above rentals in just five years. Which means -- in investor-speak -- there's huge downside potential.

And many people's housing prices have already started to drop: Nationwide housing prices fell 5.8% in 2007, according to the National Association of Realtors.

There's no surefire way to protect your most important asset, but there are ways to try to reduce your risk.

Homeowners planning a move can rent until the market bottoms out. In some cities, homeowners (who also happen to be sophisticated investors) can turn to the futures market to hedge against their local real-estate market. A handful of cities offer home-equity assurance programs as a way to encourage development. The extreme measure is to negotiate with a lender to see if it will allow you to short-sell your own house.

Here are four ways to hedge against falling home prices:

1. Wait It Out as a Renter

Forget the American Dream. Buying a home in a tanking real estate market isn't going to turn you into Andrew Carnegie any faster.

Your best investment may be a rental.

Consider an example. You buy a single family home in Los Angeles for $510,000 and you stay in it for seven years. Assume rental prices are an accurate proxy for real home appreciation, and they continue increasing at the same rate they have been. If the housing market adjusts, in seven years you'd be selling your home for less than $354,000.

In the end, you'll have paid almost $10,000 than you would have if you put your monthly mortgage payments toward renting, assuming a 20% down payment and a 30-year fixed-rate mortgage at 5.7%. And you're saving on home maintenance fees.

Think this is unrealistically bearish?

It's not.

Those who bought into L.A.'s last housing boom at its peak and sold at its trough faced roughly equivalent declines. And the runup in prices wasn't nearly as dramatic.

If you already own a home and you intend to stay in it for years to come, of course, selling now probably doesn't make much sense: the commissions and fees of a sale can easily wipe out the gain.

But if you don't own a home -- or if you're moving for other reasons -- these fees will be extra savings.

The long and short of it: rent paid may be money in the bank.

2. Play the Futures Market

The obvious hedge against falling home price is to bet against the residential real estate market in your area.

In 10 major markets, the Chicago Mercantile Exchange offers housing futures and options that are tied to the S&P/Case-Shiller Home Price indices. Bearish investors can go short on securities and invest in the right or obligation to sell borrowed securities up to a later, specified date. If the security loses value, the investor gains money.

Theoretically, if you own a home and go short on the index, should the real estate market in your area plunge, your house will lose value, but the loss will be offset by a gain in the futures market. Conversely, if the market does well, your home will increase in value, and you'd lose on the futures investment.

But the strategy is far from guaranteed, and playing the futures markets can be both costly and confusing for the small investor. The value of a single home in any given neighborhood will not necessarily rise or fall with the larger market. If many investors are bearish on the market, the market may have to fall significantly before you make any money on the investment. And even if you're confident that the market is going to fall, you have to have a sense of the timing of its fall.

"This is not for the unsophisticated investor," says Rick Miller, a certified financial planner and founder of Sensible Financial Planning, an investment-advice company.

3. Take Out Home-Equity Assurance

A select few of those looking for more direct protection have another option: a handful of cities -- including Syracuse, N.Y., Florissant and Ferguson, Mo., and parts of Chicago -- offer home-equity assurance programs.

Though home-equity assurance programs work differently, they typically appraise a house when a homeowner registers for the program, and then pay the homeowner the difference if the house sells for less than the appraised value or if neighborhood property values fall.

Programs are typically created as part of development plans, with the goal of encouraging investment in neighborhoods or cities that are experiencing population loss or to spur development.

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Typically, homeowners must live in a home for a certain period of time -- generally 3 to 5 years -- before becoming eligible for protection from losses. Some of the programs cost next to nothing to join: those who live in Chicago neighborhoods covered by Southwest Home Equity Assurance Program can protect their homes after paying $125 to have their house appraised.

But the vast majority of residents haven't taken the program up on its offer to protect their housing prices. Despite twice-yearly mailings, frequent print advertisements, and a walk-a-thon event, only about 10% of eligible residents have signed up, says Ken Pannaralla, the program's executive director.

Many residents haven't signed up simply because they're not concerned that their houses will lose value, he says. And thus far the confidence has been well placed: since he became executive director in 2004, Pannaralla says the group hasn't paid out a single claim.

4. Engage in Short-Selling

For those who don't live in cities with protection plans -- or who simply didn't enroll in them -- and who find their home loans worth more than their home, there may be another option: the short sale.

Short-selling houses has one major advantage to short selling stocks: there's no downside risk. Arranged properly, the lender, not the borrower, takes the loss.

In a housing short sale, the borrower sells his house for less than the amount of the mortgage, takes a hit on his credit report, and moves free and clear of any housing debt.

If it sounds like there must be a doozie of a catch, there is.

Lenders must agree to the short sale. And typically they'll only do that if the house is at risk of foreclosure, and they believe a short sale will be more cost effective.

But lenders are increasingly finding it in their interest to agree to short sales. When housing prices were rising, homes were virtually never worth less than the outstanding mortgage. Now over 10% of the almost 129,000 Los Angeles County homes listed on ZipRealty are short sales.

Homeowners must be sure the bank has agreed to forgo the deficiency when they set up short sales, says John McConnin, partner in the San Diego-based UpsideDownRealEstate. Otherwise, the lawyer and real estate agent says, homeowners may be better protected by going into foreclosure.

But though some homeowners may be able to mitigate their losses, others can do nothing but wish they had bought into the market at a better time.

"If you buy an asset and the value declines you've taken a loss," says Miller of Sensible Financial. "There's no undo button."

Here's a look at the current average rates nationwide on home-equity loans: