Investors sell a Real Estate Put Options to create leverage and benefit from property value appreciation and volatility.
Let us walk through a specific example.
As an example, let us take a property in La Jolla, CA and the current derived value is $1 million, which is derived from the last sale date and sale price of the property. Learn how property price is derived.
IRESE underwrites the Real Estate Put Options contract with a term of 5 years and strike value of $0.8 million and sells it to the investor.
An investor believes that property value of that specific property will not go below $0.8 million in 5 years and is willing to take a risk and sell a Real Estate Put Options with a strike price of $0.8m.
In exchange, the investor receives money today which can be leveraged for other investments.
The Real Estate Put Options contract based on the example is a put option for a term of 5 years and
with an expected future value of $0.8 million,
which is called a strike price. Investor can price such an option given data about price volatility and risk-free investment return rate using binominal trees or Blacks-Scholes methodologies.
IRESE provides research tools to help investors to price an option.
In our example, the contract is valued at $3,062 today. The contract is divided into 1,000 units called shares, each valued at $3.062.
Investor can sell a minimum of 1 share and maximum of 1000 shares (up to 100% of any individual contract).
The payoff can be demonstrated with the following graph.
In 5 years, the investor payoff is based on an observed value of the property which is determined from publicly available price index data.
If the observed value is above the strike price of $0.8 million, the investor owes nothing, and the option which expired worthless.
On the other hand, If the derived property value is below $0.8 million, the investor pays the difference.
In our example, if the value is $0.6m, the difference is $0.2m ($0.8 less $0.6) or $200 per share.
A put option position has risk-return tradeoffs similar to selling properties, with following benefits:
- Investors benefit from appreciation in real estate values, similar to selling properties that they do not have
- Investors benefit from real estate values volatility by trading in and out of options contracts
- Investors benefit from diversification with investment in the mixed-asset portfolio
- Investors create a financial leverage