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Shorting the Housing Market: How Does It Work?

Jul 10, 2020 by Tara Mastroeni

Many investors dream of living out the scenario that was dramatized in the movie The Big Short and making it big by shorting the housing market. If you're one of them, keep reading. We'll cover the basics of what you need to know before shorting real estate investments, including what it means to short the housing market, the risks and benefits of making this financial move, and the most accessible ways to make it happen.

What does it mean to short the housing market?

Before you can get into the details of how to short real estate, it's important to have a clear understanding of what it means to short the housing market. Below is an overview of how this process works.

Understanding the basics: Shorting a stock

In investing, to "short" something means to bet against it. Where stocks are concerned, this means betting that the price of the stock will fall rather than rise. When done correctly, an investor can make money by short selling.

The process of shorting a stock is fairly simple. First, you borrow shares of the stock that you want to short from someone who owns shares with the promise to return those shares at a predetermined date. Then, you sell those shares on the open market and for cash. Then, in time, you rebuy the stock to replace the shares you borrowed.

If the price of the stock falls in the way that you've predicted, you'll have the ability to buy back shares of the stock at a lower price than the amount for which you originally sold them, and you get to keep the difference as profit. If however, you're wrong and the price of the stock rises, you'll lose money when you have to buy shares of the stock to replace what you've borrowed.

Applying this concept to the housing market

A similar concept can be applied to the housing market. In this case, shorting the housing market means betting that home prices will fail. However, unlike with a particular stock, there is no direct way to short the real estate market, so investors will trade real estate investment trusts (REITs) and shares of companies within the real estate industry instead.

Over time, if housing prices fall in the way that the short seller suspects, the REITs and company shares will lose value, which will allow the short seller to benefit.

Why shorting the real estate market was so successful prior to the financial crisis in 2008

In order to successfully short real estate, it's not enough to simply bet correctly that housing prices will fall. The other important ingredient is that other investors need to be unaware of whatever problems will ultimately cause housing prices to drop. This will leave real estate assets overvalued, which is exactly what happened in the 2008 subprime mortgage crisis.

Prior to the financial crisis, the vast majority of people believed that the housing market was rock solid, which contributed to the creation of a housing bubble. However, under the surface, an increase in subprime mortgage lending was also leading to a significant rise in the number of borrowers who were making time-limited, interest-only payments on adjustable-rate home loans.

As housing prices continued to rise, mortgage-backed securities (MBS) and other investment vehicles like the credit default swap became popular among investors, who were betting that the vast majority of borrowers would never default on their mortgages.

A handful of investors, namely those depicted in The Big Short and a few others like hedge fund managers John Paulson and David Einhorn, saw that the mortgage market was unstable, as was any collateralized debt obligation (CDO) that was built on mortgages. They began to short the housing market.

Over time, once those low, introductory interest rates expired and the payments on those subprime mortgages began to rise substantially, millions of subprime borrowers began to default on their mortgages, leading to the collapse of the CDO market.

It's ultimately that fundamental disconnect between the instability of the mortgage market and the investors' belief in its solidity that lead Paulson and the others to make millions off of short selling the U.S. housing market.

Is shorting real estate right for you?

Billionaire investor Carl Icahn made waves in the first quarter of 2020 by predicting that the commercial real estate market will soon experience a meltdown similar to that of the 2007 housing market crash. He also revealed that he's currently shorting the commercial mortgage bond market in "his biggest position so far," which has led many investors to wonder if they should do the same.

The reality is that it's inherently risky to short real estate. Each investor and trader needs to weigh the risks and benefits of betting against the U.S. housing market. We've laid them out below for your consideration:

The benefits

The main benefit of shorting the housing market is that, since you're going against the grain, when you win, you often have the potential to win big.

Other benefits include the ability to hedge your investments. Also known as "shorting against the box," this technique involves investing in a short position for a similar number of shares on an asset that you already own. That way, if something happens, the asset that you've shorted will rise by the same amount of any losses from your long position.

The risks

That said, there are also plenty of risks involved in shorting real estate investments. On one hand, there's unlimited potential for loss since, theoretically, the value of the underlying asset could rise exponentially.

For another, investors can get stuck in what's known as "short squeezes," where the value of the asset rises, and as the other short sellers rush to sell their positions, it drives the price of the investment higher and higher.

Four ways to short real estate

If you've done your research and decided that the benefits of shorting real estate outweigh the risks, there are four ways that you can go about it. They are as follows:

1. Shorting a REIT

Investing in REITs is probably the most common way to speculate on the housing market. Investors can short a REIT in the same way that they would a stock, by finding a broker to loan them the shares. However, notably, it is also possible to spread bets by investing in contracts for differences (CFDs), which will allow you to speculate on whether REIT prices are rising or falling.

2. Shorting individual real estate stocks

Alternatively, investors can choose to short the stocks for individual companies in or adjacent to the real estate industry. Often, these stocks are seen as an indicator of the outlook of the housing market as a whole because the prices for the commodities and labor used within these industries will ultimately have a direct effect on home prices themselves.

3. Shorting a real estate exchange-traded fund (ETF)

An exchange-traded fund (ETF) is a type of security made up of a collection of securities, such as REITs, and tracks a particular index. If you're interested in shorting a real estate ETF, you're essentially betting that the price of the ETF will drop.

Generally, as the strength of the housing market declines, the value of real estate ETFs will also drop because the various assets that make up the fund will also lose value.

4. Holding a long position on an inverse ETF

Keep in mind that there are also ETFs that are meant specifically for shorting real estate. These funds are called "inverse ETFs" and, as the name suggests, the value of these funds will rise as the strength of the housing market declines.

In order to short an inverse ETF in the traditional manner, you also need to take a reverse position from the one that you might expect, meaning that you have to hold a long position. If you were to take a short position on an inverse ETF, you would essentially be betting that the house prices will increase.

The bottom line

While shorting the housing market may be risky, it can definitely be done, and when done correctly, it can have significant returns. As with making any investment, you'll want to be sure to do your research into the assets you intend to short. You'll also want to make sure you have a firm handle on the current state of the housing market and mortgage market. When in doubt, don't be afraid to consult with a financial professional.

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