Hedging your real estate risk is an important asset and property portfolio management strategy, during periods of economic and/or financial turmoil.
Economic and financial stress leads to drastic reduction of demand for real estate that causes dramatic downturns in prices of all property types and create an environment of high uncertainty which keeps prices on a downward path.
The investor must hold a position in another investment instrument or vehicle that will register a counterbalancing that will increase in value, when the value of the particular real estate held by the investor decreases due to the economic/financial shock.
Property derivatives may allow a real estate investor to take such hedging positions but a caution is required in evaluating the cost of such derivatives and the true hedge that they provide against potential decreases in the values of the particular real estate assets held.
For example, taking a counterparty position in a total return swap based on a property index during periods of rising prices, in order to create a hedging position against an unexpected economic shock, that will result in value declines and negative returns may be highly risky. In such an environment of rising prices, it is more likely that the counterparty will be paying the swap buyer, and if such a strategy is employed for many periods the cost of such protection may end up being higher than the gain that will be realized when the unexpected shock takes place eventually.
Real estate risk is not limited to the risk of declining capital values. It includes also some other major risks that need to be hedged, such as significant reduction of Net Operating Income due to drastic reduction in market rents. Furthermore, it includes the interest rate risk , in case that a mortgage loan with an adjustable rate is used to finance part of the investment, and the exchange rate risk in the case of investments located in foreign countries that use different currency.
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