As an investor, you know that the market can be unpredictable and volatile. One way to protect your portfolio from potential losses is by using a strategy called "shorting". In this blog post, we'll explain what shorting is, how it works, and why it can be a powerful hedging tool for real estate investors.
What is Shorting?
First, let’s start with explaining what shorting means and looks like in a traditional securities market. “Shorting selling” is an investment or trading strategy that speculates on the decline of a given security or market.
When you short an asset, you essentially borrow it from someone else and sell it, with the hope that you can buy it back later at a lower price. If the price does indeed fall, you can buy it back at the lower price, return it to the person you borrowed it from, and pocket the difference as profit. However, if the price goes up instead of down, you could end up losing money.
This strategy is sometimes thought of a something that should only be used by experienced investors or traders – but why?
In a traditional – spot – market, shorting requires several steps and participants to express the speculative view that a security or market will go down.
How to short in a spot market:
- To receive permission – or a locate – from their broker which make the stock available to that investor to borrow.
- After borrowing the stock, the investor will “short sell” those borrowed stocks and will receive and keep the proceeds – capital from the sale.
- The investor at this point waits in hopes that the value of the stocks that they short sold goes down so that they can buy them back at a lower price and keep the proceeds
- When closing a short position, the investor buys the shares back – or what is called covers their short – in order to give them back to the broker that lent the shares to them.
The borrowing component as well as the many participants required to facilitate a borrowing/lending market for securities requires many checks and balances to ensure an efficient market.
Shorting Real Estate, a hedge against inflation
There are several different ways to short real estate, but they are not straight forward. One of the most common methods is to use futures contracts, which are essentially agreements to buy or sell an asset at a specific price at some point in the future. You can also short real estate using options, which give you the right (but not the obligation) to buy or sell an asset at a specific price. Finally, you can use inverse ETFs (exchange-traded funds), which are designed to move in the opposite direction of the underlying asset.
One reason to short the real estate market is the potential for a downturn in the economy. If an investor believes that the economy is headed for a recession, they may choose to short the real estate market as a way to hedge against potential losses in other investments. By using shorting as a hedging strategy, an investor can potentially protect their portfolio and generate passive income in the process.
Challenges of Shorting Real Estate
So, why would it be challenging to short-sell in a physical real estate market? it would require that someone is willing to lend an investor a home, the borrowing sell the home and keep the proceeds in hopes that the value of the home declines. The investor would have to buy the same home back at a lower price in order to make a profit and fulfill their requirement to return the borrowed home back to the lender.
Whoa, that’s complicated. Makes sense why there’s no market for this.
Shorting Residential Real Estate on Parcl
On the soon to launch Parcl Protocol, traders simply can select the individual market (e.g. San Francisco, Phoenix, Brooklyn) they would like to short, and trade against a pool of traders. Learn more on how the Parcl Protocol works.
Who would want to short real estate?
There are many use cases for why individuals or institutions would want to short real estate:
- Speculation → If an investor believes that a real estate market is overheated, and that a downturn is coming, shorting can be a way to profit from that potential decline. Residents of cities and neighborhoods around the world may want to speculate on the residential real estate markets around them because they have a fundamental understanding of what cities and neighborhoods have to offer and how they will impact real estate prices.
- Hedge Home Value → Homeowners who believe their home’s market may go down may want to short a fraction of the value of the home in order to lock in some of their gains if the market was to in fact go down.
- Physical Real Estate Portfolio → Institutional investors with large real estate portfolios that are difficult to unwind due to the lack of liquidity in physical real estate could short real estate to hedge the downside risk of their portfolio falling in value. This would help offset some of those losses and protect their overall portfolio.
- Commercial Real Estate Investors → Developers build town centers, outdoor malls, and indoor malls in areas that may be “up and coming.” However, there’s always the risk that the surrounding residential real estate doesn’t pan out and end up being so up and coming after all. These investors could short the surrounding residential real estate as a hedge against this risk.
Overall, shorting the real estate market can be a way to diversify your portfolio and potentially increase your overall returns. By adding short positions to your portfolio, you can potentially profit from market declines and reduce your overall risk.
Shorting as a hedging strategy
In summary, shorting the real estate market can be a way to profit from a potential decline in the value of real estate, and give investors and traders alike a vehicle to express a view on the market or hedge existing physical real estate exposure.
Of course, shorting real estate is not without its risks. If the housing market starts to rise instead of falling, your short position could quickly turn into a big loss. Before deciding to short the real estate market, you should carefully consider your investment objectives, risk tolerance, and financial situation.