September

Predicting House Prices with Equity Lending Market Characteristics

By Pedro Saffi, CERF Fellow 

Investors in financial markets must cope with the arrival of a myriad of news, which arrive relentlessly every day non-stop. This information must be interpreted and used in the most efficient way possible to update investment strategies. Most academics also spend their careers trying to identify variables (e.g. GDP growth, retail sales, unemployment) that can help forecast the behavior of financial market variables (e.g. stock returns, risk, and exchange rates). While less common, many articles show how financial markets’ data can be used to predict the behavior of variables in the real economy.[1]

In the article “The Big Short: Short Selling Activity and Predictability in House Prices”, forthcoming at Real Estate Economics, CERF Fellow Pedro Saffi and research collaborator Carles Vergara-Alert (IESE Business School) look at how U.S. house prices can be better understood using a previously unexplored set of financial variables.

Investors can speculate on a decrease of prices using a strategy known as “short selling”. This involves borrowing the security being sold from another investor, selling at the current price, and repurchase it in the future – hopefully at a lower price to make a profit. The market to borrow shares is known as the equity lending market, a trillion-dollar part of the financial system that allows investors to borrow and lend securities needed for short selling. While investors cannot bet in house price decreases by shorting houses directly, they can use a wide-range of financial securities to do. Dr Saffi examines use data on short selling activity from a specific type of security whose returns are highly related to house prices – Real Estate Investment Trusts (REITs) –  that are essentially portfolios of underlying real estate properties.

The authors’ main hypothesis is that REITs are strongly correlated to fundamentals of housing markets. Thus, an increase in REIT short selling activity can forecast decreases in housing prices, which is exactly what is found by the authors in the data. Furthermore, REITs invested in properties located in areas that experienced a housing boom during the expansion cycle in the 2000s are more sensitive to increases in short selling activity than REITs invested in properties located in areas that did not experience a housing boom. The study divides the US property market into four regions – Northeast, Midwest, South and West – and classifies each month in each region as being a “boom,” “average” or downturn” period. Although during boom and average periods there is little correlation between REITs short-selling and the subsequent month’s housing prices, “the correlation is significantly positive during housing market downturns.”

Using his research findings, Dr. Saffi constructs a hedging strategy based on short selling intensity to reduce the downside risk of housing price decreases, showing that investors can limit their losses using REITs’ equity lending data. The figure below (Figure 4 in the article) shows the cumulative returns for Dr. Saffi’s trading strategy (based on using the On Loan variable as a proxy of short selling activity) relative to the performance of the FHFA Housing Price index returns from July 2007 through July 2013.  These results show the usefulness of the hedging strategy in regions that experienced large house price run-ups during the years prior to 2007, i.e., Northeast and West to limit investor losses during the 2008 financial crisis. Its performance is satisfactory for the South and absent for the Midwest, where we observed a smaller house price run-up in the same period. Panel B shows similar results if we examine the performance using diversified REITs to hedge against price decreases in the aggregate FHFA index.

Overall, short selling can be a useful tool for market participants to hedge against future price decreases. Regulators can track measures from the equity lending market to improve forecasts of house prices and implement policies to prevent real estate bubbles. Furthermore, imposing short selling constraints on stocks like REITs—which invest in assets subject to high transaction costs—matters for price efficiency and the dissemination of information.