Reasoning Through A Housing Trade Out Loud

Today I’ll share a personal investing story. It’s in the thinking-out-loud category. I can see the spots where someone could say “that’s stupid” (don’t let that deter you from pointing them out). And that’s why I want to share it — this is the messy process of making a decision. It’s imprecise. It has more “vibes” than I’m supposed to admit. But at the end of the day, there’s an irreducible amount of “putting your finger in the air” with most investing decisions.

The Housing Trade

At the start of 2022, I felt housing might be screwed. Home prices and inflation were red-hot and the risk of the Fed’s hand being forced to raise interest rates was beginning to materialize. Mortgage payments were extra sensitive to bond duration math if rates were to start lifting from such a low base. This would slow housing demand. On the supply side, there were still materials and labor supply shortages. Superficially this is bullish housing but that was already in the price. Looking ahead, this combination felt (notice the vibes…I’m not looking any data up. It’s pure staring out the window) like it could destroy demand. The idea of demand destruction reverberates from my oil trading past. OPEC doesn’t optimize for the maximum price the way you might expect from a cartel. They can be quick to supply the market because they don’t want to kill their customers. Sure a high price means the inventory in the ground is worth more but the business of producing oil, the business that enjoys a multiple, is burnt toast.

The most vulnerable part of the stack felt like the homebuilders because, like an oil refiner, they sit in between the raw materials and the finished goods. They would be squeezed on both sides. Cancellations + high costs.

I pulled up a chart in March of 2022 (this is what it looks like through this weekend of course).

Since the beginning of the year, in less than 90 days, XHB underperformed SPY by nearly 20%.

The market was well ahead of me. Dammit. It appears there’s nothing to do. In the liquid market at least.

I had 2 ideas that could be applied to stale markets.

1. Decline to invest in the next batch of Austin flips. We had been bankrolling a friend’s short-term flips in Austin since the pandemic. We were just receiving our return from the most recent one and while we’d normally just re-invest, we took a break.
   
2. Sell the house we bought in Texas the prior summer. We had a renter in place and we still hadn’t owned the house for a year (meh, short-term gains). We asked our realtor what he thinks the house could fetch and he indicated the market was still hot. He thought we could get 35-40% more than we paid the prior July (which is really nuts since the house had already appreciated since the pandemic and our purchase price was a 12% overbid to the listing price). The realtor’s number sounded optimistic but looking at comps I thought there was maybe a 15-20% chance of catching his number and in most other cases get some kind of quick profit. But I wasn’t really pricing it off profit. I was worried about risk. The cap rate would be terrible if rates went up even 1% and since we were committed to CA we didn’t want the property anymore anyway. The liquid markets were a sell signal. The illiquid market was lagging.

A family with small kids and another on the way was renting the house so our ability to move quickly was a bit hampered with respect to showing but we did get the house on the market by April. We immediately caught a bid above our ridiculous asking price! 2 days later, the stock market dove. Yinh and I were convinced they would back out.

We were right. A day later we got the call. They’re out. Apparently, their financial advisor told them to cancel. I feigned annoyance while secretly thinking “smart advisor”.

Skipping ahead, we cut the price and caught one single bid. But we needed to agree to a long closing period. We’d wake up every day “please no whammy”.

It finally closed in October. We made a touch over 20% before commission which felt so lucky. By now it was also a long-term capital gain.

But what do we do with the cash?

Rebalance.

You sell the thing up 20%, what’s on sale to buy?

We would reallocate the cash to stocks on a relatively vol-neutral basis (if we sold $1 of house, maybe buy about $.50 of stocks if we think stocks are twice as volatile as residential RE).

But there was another risk on my mind.

Being renters ourselves we were effectively “short” or underweight housing after selling the property. From a liability-matching investing lens, this was unsettling. Conveniently, the homebuilders were now down about 40% compared to SPY — the thing I wanted to short a few months earlier I now wanted to buy because it filled a risk hole AND was pricing in pain. So we put 1/4 of the proceeds from the house sale into IWM and 1/4 into XHB.

(I just cut half the position a couple weeks ago as we reduced our net equity exposure and rolled into T-bills. I keep our equity exposure in a band and I chose to sell XHB based on its outperformance.)

Things I believe

1. Markets are smart. Liquid markets adjust quickly.
2. My life’s work is not figuring out what prices are right, so my allocations are driven by desired exposures or non-exposures to risk. That’s the best I can do given how much time I am willing to spend thinking about things I have no control over.
3. Within that framework, my choice of diversified exposure is relative value voodoo and vibes. But you know what…even in my professional trading that was true. In that case, my life’s work was to measure option prices at much closer resolutions than anything I’m doing here, but pulling the trigger felt pretty much the same. What’s the liquid market telling me about about fair value and what do I do with that info? Any individual trade is noise, but if I’m disciplined about risk then no decision carries the risk of the whole portfolio and the framework is left to converge to its logic over time — capture a risk premium without mortally wounding yourself along the way.
4. Luck will betray you one day so enjoy it when she smiles upon you. We felt like we caught the last bid in America on that house. If we listed the house a few months earlier (which we might have except for the complications with the tenant — no fault of anyone was just a matter of details) we would have been extra lucky, but we would have gotten a worse price on our stock buys.And if we don’t make the sale? Pain parade. We miss the profits, don’t get to rebalance, and I curse myself for getting into an illiquid asset. I hate illiquidity already. As I get more experience, I want to rule out illiquidity more and more. Ruling-in needs to be for a justifiably unique exposure. The option to rebalance has a value — whether you choose to ignore it or not is up to you. See How Much Extra Return Should You Demand For Illiquidity?

A note on taxes

We will pay LT gains taxes of about 30% between Fed and CA. Why not 1031 exchange? Well, I thought real estate prices would be too sticky (ie they won’t come down enough) before our 6-month window to close on a new property. I expected wide bid-asks as sellers locked into low fixed rates try to wait out market weakness. I didn’t want to sell something up 20% to buy something down 5 or 10% when I could buy something down 40% (which is more standard deviations — again, think in vol-adjusted terms. This is also why buying high growth wasn’t attractive even if they were down more than housing…they are higher vol plus the skew in their distributions means volatility is understating the risks — that’s a post for another time).

More generally, let’s examine the math of 1031 tax savings. Imagine the house I sold went from $800k to $1mm. My tax liability is about 30% of 200k or $60k. But the brokerage cost of what I buy on the backend is pretty close to that (5% of $1mm when I eventually sell the 1031 property). It’s true that the cost is deferred but the cost is also inflation indexed since it’s a percent of the home value. You are not saving nearly as much as you think because you are forced into a high transaction cost asset and the cost is a percentage of the entire asset value, not just the profit.

[Note 1: If you don’t have to pay that fat state tax and your LT gains rate is closer to 20% than this argument is even stronger.]

[Note 2: This argument is much less compelling if you plan to never sell and get stepped-up basis for your heirs. But you get stepped-up basis on stocks when you die too. But anyway, I’m not in the never-sell camp because the tax tail isn’t going to wag my risk dog. There’s always a price that warrants saying “sold” to. If a HODLer wins they get concentrated. That might be ok for your human capital but that’s not a strategy for a random number generator. And from my unenlightened seat, the market’s job is to set prices for great assets so that they are effectively random. If you disagree, you should invest for a living. I heard you can get rich doing that. Actually, you have a better chance of getting rich by convincing people you could do that.]