Hedging US Real Estate

[dbh21 62]

Hoping I could get some advice from those here on how to hedge a US real estate portfolio.

I think a recession is looming. It might be this summer or within the next two years. We have some US real estate that we cannot liquidate, but I would like to protect. 

So here is what I have come up with. The IYR is a liquid US real estate ETF with plenty of OI. It is also as good a correlation to our private portfolio as we could get. My initial thought is to buy a back ratio. Something like the following

This is a 2:1 spread. 10 contracts hedges about 68k, with a cash margin requirement of around 5k. If I plan to roll within 2 months of expiration, I would execute the trade at least twice a year, which makes the annual risk to hedge 68k, 10k, or about 14% of the portfolio value.

However, I can assume that it is very unlikely to face a full loss. I ran some quick dirty tests and found that a 25% loss could be faced if we rolled with 2 months and the market slowly declined to the worst case scenario. But Vol is also at historical lows, providing some wind in my sail.

So, if I assume a 25% max loss, then the cost of the hedge is more like 3.5% of the portfolio value.

I can play with the expiration data, strikes and the ratio, but I was wondering if others thought this was a sound approach, or whether there are other strategies I should look at instead.

Thanks in advance for any advise.

[Christof+ 272]

@dbh21, possibly a bit too late but anyway... Now, this is personal but I don't like using options for pure hedging purposes so much. The hedge will mostly end up being quite expensive, especially if you are looking for a continuous hedge like you do. For hedging, you will always want to have a some sort of convex payout profile with positive gamma, hence costly negative theta.
Therefore, another quite different approach you could take is to stick with 'conservative' instruments with linear payoff (i.e. etf itself) and make the hedging overlay dynamic over time (kind of 'construct the non-linear payoff manually'). You can adapt rules on when to enter or exit the hedge from the Tactical Asset Allocation space. IMHO, Momenutm based rules are especially interesting due to their simplicity and their proven usefulness over decades and over a large variety of assets. While they can also be off at times, on a longer time frame they do a decent job, especially in the case of large drawdowns. And that with no time decay and very low efforts needed (many rebalance monthly, so that would be roughly 1h of work each month). For example, you can construct a very simple momentum rule like the one outlined in Meb Faber's well-received paper https://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461, or a bit more involved but possibly faster one like David Varadi's percentage channels (which is nothing else than momentum) at https://cssanalytics.wordpress.com/2015/02/08/a-simple-tactical-asset-allocation-portfolio-with-percentile-channels-for-dummies/. (Be clear that performance figures will not fit in your context, those TAA models diversify over a broad set of assets, you have only one asset which you overlay. But your goal is also a different one).
As instrument you could either long a far ITM put, or just short the etf itself (comes with additional cost of course).
Instead of IYR you could also consider Vanguard's VNQ, which is cheaper (0.12% vs. 0.44%, daily volume is still >200M per day).