Hedging Houston

Hedging Houston

Ways to Reduce Your Exposure to a Revenue Slowdown in the Houston Apartment Market

The stunning decline in oil prices during the past year has Houston real estate investors on edge. The obvious worry is that slower employment growth will reduce demand for commercial and residential real estate. As a result of weakening demand, the pace of rent and revenue growth is expected to slow. So given this event-driven risk, what is the best way to hedge your Houston exposure?

HoustonCrude - Chart1 (1)First, you can do nothing. Seriously. Per the chart above, the current West Texas Intermediate (WTI) crude oil price is nearing the long-term average since 1984, which should give us some confidence the bottom is near. With that being said, given the supply glut, the market is still trying to find a bottom and could easily overreact, pushing prices for a barrel of crude oil into the $30s. But at this point, downside risk in oil pricing seems limited. Furthermore, oil exploration and production is viewed as fairly elastic, and the response in the U.S. has been quick not only historically, but also more recently. This is an important fact, since the U.S. has become the swing producer in the global oil market. And with rig counts falling, U.S. production should slow, setting the market up for higher prices down the road.

HoustonCrude - Chart

Another way to hedge the exposure to the Houston apartment market is through the idea of modern portfolio theory (MPT). MPT attempts to maximize through diversification the portfolio’s expected return for a given level of portfolio risk. For apartment investors, this means finding the right mix of metros in order to mitigate risk through a geographical diversification strategy. The benefit of geographical diversification is increased by combining metros with a lower correlation to one another. In the case of Houston, there are a few metros where this works really well.

HoustonCrude - Chart1 (2)MPF Research examined the pattern of quarterly revenue change from 4th quarter 2004 to 4th quarter 2014 for 22 large metros and found only 10 readings out of a possible 231 different combinations among all metros where the correlation coefficient was below .30. Said another way, most markets over the past 10 years act in a similar manner and diversification across metros has become tougher to achieve. The good news for Houston investors, six of those 10 correlation coefficient readings below .30 involve Houston. Specifically, Philadelphia, Detroit, Chicago, Miami, Washington D.C. and Minneapolis all offer good prospects to diversify the revenue risk in Houston. In summary, geographical diversification is much more effective in Houston than in other metros plus it offers an effective solution against a revenue slowdown.

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