Volatility Index Short Paper final.pdf

2019 Volatility Index

Introduction

In their groundbreaking 1987 paper, Karl Case and Robert Shiller revolutionized the residential real estate industry by launching the Case-Shiller index, a benchmark index for home price appreciation in the United States. They noted that “65 percent of all households owned their homes, and for most of those households the net equity in their homes represents the bulk of their net worth.” Since then, an amazing amount of diligence has been applied to portfolio allocations spanning equities, fixed income securities, and alternative investments. Yet, “home equity is the largest part of a typical household’s net worth, but it is rarely considered in an asset optimization.” Case and Shiller have provided us with an invaluable tool for benchmarking long run expectations of home price appreciation. However, if we wish to properly integrate homes into a modern financial plan, benchmarking our expectation of risk is equally important. To solve this problem, we need a volatility index for single family, owner-occupied homes, which is what this paper introduces.

In addition to a demonstration of the volatility index, in this paper we offer three insights:

01

A single home is a risky asset. The annualized volatility of a home is in line with that of a public equities index.

02

Homeowner portfolios are too risky. Homeowner portfolios have residential real estate risk exposures far beyond the optimum, driven by the banality of very low down payment, high-leverage mortgages. This problem is most severe with recent home buyers, because they have the highest leverage at purchase (and haven’t had time to accrue equity).

03

Home risk is mostly diversifiable. The major component of home risk is diversifiable; it dissipates in a large diversified portfolio of homes. This makes single-family homes a far more attractive investment for institutional investors than for homeowners.

The paper concludes by proposing the emergence of an efficient equity market for residential real estate, a conventional solution for distributing financial risk. To help make this solution a reality, a measure of individual home risk needs to be adopted. With the volatility index presented herein, we hope to inspire individual households, financial advisors and institutions to re-engineer the modern household portfolio.

Inevitably, homeowners will be able to sell equity in their individual homes into large diversified institutional portfolios. When this happens, trillions of dollars of value-at-risk for homeowner households will be eliminated.

A Volatility Index for a Single Home

Figure 1 illustrates the dynamics of single-family residential real estate since the year 2000. The series is generated by estimating the dynamic volatility parameter which best explains the dispersion of returns of tens of millions of American homes purchased and sold between 1994 and 2019.

Figure 1
Figure 1: A volatility index for individual homes in the U.S. The index represents the annual volatility of individual home returns over the previous 12 months.

The long run average annualized volatility of home returns has been approximately 15% per year. Notably, the index spikes to more than 35% per year in the heat of the 2008 financial crisis, stoking the fear that, like equities and fixed-income securities, financial risk of residential real estate is amplified during a financial crisis.

A Single Home is a Risky Asset

Figures 2a and 2b compare the annualized volatility of an individual home with the volatility of asset classes that are commonly held in a homeowner’s portfolio. It should come as a surprise that the volatility of a home is on par with that of an equity index, especially considering that a home buyer who borrows 95% of the value of their home is taking 20x leverage on this investment.

Figure 2a
Figure 2a: The annualized volatility (rolling 12 months) of an individual home is compared to asset classes (Source: Bloomberg) commonly held in a homeowner’s portfolio.

Figure 2b
Figure 2b: The average annualized volatility of an individual home is compared to asset classes (Source: Bloomberg) commonly held in a homeowner’s portfolio.

Table 1 summarizes the volatility and representative indices for each asset class.

Table 1

Table 1: Summary of annualized volatilities and representative indices for asset classes commonly held in a homeowner’s portfolio.

Homeowner Portfolios are too Risky

Modern portfolio theory states that if an individual is presented with a multiplicity of portfolios with the same expected return performance, the one with the lowest expected volatility is preferred. If we take these claims for granted, we’re led to the same conclusion presented famously by Harry Markowitz when he claimed that diversification is “the only free lunch.” Diversifying investments across large numbers of different equities and bonds can minimize the risk of a portfolio without sacrificing return.

In the modern financial world, diversification is a mainstream strategy, popularized by mutual funds and exchange-traded funds (ETFs) which invest in and track large portfolios of assets. When it comes to a portfolio of stocks and bonds, a financial advisor can achieve very efficient trade-offs between risk and reward by constructing a portfolio of ETFs.

Consider now, that this same financial advisor recommends taking your entire net worth, borrowing between 5x and 20x this amount with a mortgage, and betting all of it on a single undiversified asset, your new home. If this were any other asset, you would immediately lose respect for this professional. Yet, when it comes to a home, millions of Americans make this trade every year and, as for the past 5 years, half will borrow a mortgage worth 95% of the value of the home and pay the expensive private mortgage insurance mandated by such a high leverage loan (Source: Urban Institute Housing Finance At A Glance, A Monthly Chartbook, April 2019). A home is where you live and it’s illiquid - it should be the place to be conservative.

How much risk are American homeowner households taking if we include the home in addition to the brokerage account? To answer this question, we will compute the portfolio volatility, an industry standard measure of risk representing one standard deviation of returns after one year, of the median homeowner household portfolio both with and without including the home.

Conclusion

Classical analysis of the affordability of home prices focuses on two constraints: (1) households looking to buy a home need enough savings to afford a down payment and (2) households with a mortgage need enough income to cover monthly payments. Since the early 1980s, mortgage rates have been decreasing steadily. Freddie Mac 30-year average mortgage rates have dropped from 18% in 1981 to just under 4% in 2019. In addition, the mainstream adoption of low-down payment mortgage programs has driven half of home buyers with a mortgage to borrow 95% of the value of their homes (compared to 80% in the early 2000s). If we only consider these two constraints, so long as rates and down payment requirements continue to decrease, homes can theoretically continue to be affordable at unbounded price levels. However, adding a third constraint on the latent but crucial dimension of household financial risk underscores the desirability of engineering a technology to allow homeowners to offload the risk of home price volatility if homes are to remain affordable at current price levels.

Unison’s solution to this problem, inspired by public equity markets for corporations, has been to develop an equity market for residential real estate wherein investors may buy a partial claim on the future change in value of homes. This benefits the homeowner household who is taking far too much risk on one undiversified asset. It benefits the institutional investor who, to date, has been unable to invest in a portfolio of diversified residential real estate. Finally, it benefits the public by reducing the harsh negative externality of household debt.