How Real Estate Investors Can Hedge with Options on REITs

Real estate investors can use financial strategies to manage risk during market volatility with the help of REITs (real estate investment trusts). REITs are companies that own and operate income-producing real estate, including apartments, shopping centers, offices, and others. Investors can use REITs as a substantial source of portfolio income, and they provide exposure to real estate without direct property ownership.

Options on REITs can help real estate investors hedge risks, similar to traditional hedging in property investments. In our guide, we’ll address the key benefits and strategies of using REITs as a way to hedge in options trading, including some of the most common strategies—protective puts, covered calls, and protective collars. We’ll also discuss how to choose the right REITs for hedging and some of the common challenges that investors face in this arena.

Understanding REITs and Market Risks

Let’s talk about REITS, what they are, and why they appeal to real estate investors. They come in a few varieties, and choosing the right ones depends on your investment goals and how much capital you can access. We’ll address these differences below, along with some of the significant market risks presented by these investments.

What Are REITs?

REIT stands for real estate investment trusts. These companies own and operate income-producing real estate, including apartments, warehouses, shopping centers, hotels, offices, and hospitals. Investors can use REITs as a substantial source of portfolio income—they can be purchased through brokerage accounts in the form of shares, similar to buying stocks. These real estate investment trusts make money primarily through dividends (90%), which are paid out to the shareholders.

Types of REITs

Investors need to know that there are a few kinds of REITs, though one is overwhelmingly used by real estate investors, who make up over 95% of the total market.

• Equity REITs: These are the most common type of real estate investment trust. They own and manage income-producing real estate, making up about 96% of the total market.
• Mortgage REITs: These real estate investment trusts invest in real estate mortgages or mortgage-backed securities. Another way to refer to them is “mREIT.” They raise capital from investors to buy mortgages from banks or lenders and then collect monthly mortgage payments from the property owner. However, real estate investors don’t own or manage the properties. Mortgage REITs earn income from the mortgage or mortgage-backed securities’ interest payments.
• Hybrid REITs: These are a combination of equity REITs and mortgage REITs. They are real estate investment trusts where investors own properties and also invest in mortgage loans or mortgage-backed securities. These REITs take a more balanced approach, which can profit in environments where interest rates might be rising or falling.

Why do real estate investors choose REITs? REITs are appealing to income investors because they have higher yields, often higher than the average stock. Although they can be appealing, REITs come with their own risks, which are the same as those of any other kind of investment in the real estate market. These include rising interest rates, leasing occupancy, and property value swings.

Market Risks for Real Estate Investors

REITs of different kinds are all subject to market risk. We’ll highlight the most common risks REIT investors face for a clear picture of some of the challenges that might come up along the way. For the most part, these risks impact REITs during times of economic downturns.

• Interest Rate Fluctuations: Lower interest rates aid REITS by bringing down the cost of borrowing. REITs can begin brand-new developments, refinance debt, or expand portfolios more easily. Higher interest rates decrease the value of properties and make it more challenging to borrow money due to higher costs. Rising interest rates can benefit REITs because they signal economic growth.
• Market Volatility: During negative economic events, REITs’ returns increase due to investors’ increased demand, leading to higher REIT volatility. Prices can also decline if interest rates go up in a slow economy.
• Property Value Declines: In a growing economy, demand for financing increases, resulting in higher interest rates, while demand falls in a dwindling economy, and interest rates fall. The value of a REIT’s assets will rise as property values increase and dip as property values decrease. This might come with potential increases or decreases in the Net Asset Value (NAV).

Introduction to Options on REITs

Investors will be happy to know that there are options available on real estate investment trusts (REITs). These are exchange-traded options on the underlying shares of a REIT. Buyers have the right (not the obligation) to buy or sell 100 of the underlying shares of each REIT option contract at a strike price and by a specific expiration date.

However, there’s an important distinction between regular options trading and options trading with REITs must be noted. We’ll address this below and discuss why hedging with options is essential for real estate investment trusts.

What Are Options?

Options are a financial contract that gives the buyer the right to buy or sell assets at a fixed price by a set date. Options’ prices are linked to the cost of something else ( a derivative security). Calls and puts are the two most common options. Call options give the buyer the right to buy shares, and put options give the buyer the right to sell those same shares.

How Are Options and REITs Different?

Options differ significantly from owning actual REIT shares. REITs are subject to market risk, leverage, and liquidity, while options holders risk only the premium they pay to enter the trade. On the other hand, option writers can face unlimited losses.

There are also differences when it comes to growth potential. REITs offer dividend income and capital appreciation over time, while options can leverage opportunities that might only become profitable given more time for development. REIT income can result in higher taxes because it is considered ordinary dividend income, but REITs can bypass these taxes if a portion of the earnings are passed on to investors.

Why Hedge with Options?

Investors can use options to hedge against potential losses in their portfolio’s holdings. It involves the trader or investor taking an opposite and equal position with a similar asset to limit potential losses, which can be applied to both long and short-term positions. Investors can hedge using options by buying put options, creating a protective collar, using index or index-based ETFs, or using something called delta hedging:

• Put Options: In this scenario, an investor buys a put option opposite a call option to sell the stock at a higher price than the market in an attempt to protect against a possible stock price decline.
• Indexes: This involves the investor buying a put option on an index closely correlated with the portfolio to take advantage of unlimited downside protection at a fixed cost. It’s like buying an insurance policy with a one-time premium.
• Protective Collars: Investors use a long put and a short call that lets them set a price target for selling the stock.
• Delta Hedges: This strategy has the investor buying options with a delta opposite to the current options holding.

Investors and traders can enjoy several benefits from using options as a hedge. One of the most notable benefits is that investors can hedge their downside price risk for a period of time while still enjoying potential price gains in the event the market increases. Hedges also protect investors’ portfolios from adverse price movements because put options give them the right to sell the asset at a certain strike price by a certain expiration date.

Hedging with Options vs. Diversification

While some people use hedging and diversification interchangeably, like they’re the same thing, they are two completely different approaches with different end goals in mind. They aim to reduce a portfolio’s risk, but some key differences are worth noting.

• The goal of diversifying a portfolio is to create combinations of uncorrelated assets.
• Diversification reduces portfolio risk through investing in different underlying securities, asset classes, and timeframes.
• Diversifying is a costless strategy—options require costs associated with owning call and put options at once.

Common Options Strategies for Hedging REITs

How can options be used to hedge real estate insurance trusts? You’ll find out in the following sector, where we discuss the most common strategies for hedging using options that can be applied directly to REITs. Three common hedging strategies for options—protective puts, covered calls, and protective collars—can be used for real estate investment trusts to ultimately reduce potential risks that come with volatile market conditions.

Protective Put

Protective puts are a risk-management technique in options trading. Investors buy a put option on a stock or asset they own to limit losses on that asset but still benefit from any capital appreciation that might occur if that asset increases in value during the period of ownership.

Investors pay a premium for the put option, giving them the right to sell the stock at a strike price at a specific date (the expiration date). Protective puts are best used if you feel a stock is due to increase, but you still want to hedge against potential losses if the market turns against your expectations. If the stock goes up, you still have the profit potential, but you’re ultimately protected against unexpected losses.

Hedging Against Declines in REIT Prices

Investors can use put options to hedge against REIT price declines when they purchase contracts on REITs they own. The step-by-step explanation below will walk you through how you can use puts to hedge against these declines in REIT prices for an added layer of protection.

1. First, you must buy a put option by paying the option’s premium. You then gain the right to sell the REIT shares at a specified strike price before the option expires.
2. Choose a strike price that’s slightly below the current REIT price to provide satisfactory protection. Make sure it’s high enough to allow you to profit from the premium you paid.
3. If the REIT falls beneath the strike price, this put option will become valuable. This is a good time to sell because you’ve made a profit and can get out before any change leads to potential losses.

Investors can use protective puts during an anticipated market downturn as insurance against potential losses in their REIT investments. If the REIT price drops below the strike price, the option grows in value, and investors can still sell their shares at the strike price. This move ultimately limits downside risk.

Covered Call

The covered call strategy involves investors selling call options on a stock they already own. The goal is to generate income from the sale of those options. Investors will sell one or more call options for every 100 stock shares. It’s a good strategy to use in moderately bullish or flat markets. Once they’ve sold their call options, investors must wait to see if the call is exercised or options are received.

The covered call can be used by traders or investors who hold a REIT investment and want to generate some additional income. Investors will sell call options on their REIT shares. They receive a premium from other investors for the right to buy their shares at a specific strike price and expiration date. This established a steady income stream for the investor while simultaneously allowing them to maintain ownership of the REIT. The only exception is in the event that the option is exercised and the shares are called away.

Using covered calls when REITs are expected to remain relatively flat is ideal because most investors using this strategy are interested in the capped potential upside that results in regular income from the premiums collected on the options. The steady income stream from the premiums is only possible when investing in REITs that tend to have less volatile price movements.

Collar Strategy

The protective collar strategy is a popular hedging strategy in which investors protect long stock positions from a potential market decline. This technique has limited potential gains, though it helps investors avoid unnecessary capital gains taxes, which can be deferred.

The collar strategy involved buying a put and selling a call simultaneously, with the same expiration date and out-of-the-money. The put option protects the investor against potential losses, and the call option finances the put’s purchase. The collar offers short-term downside protection through a cost-effective method that protects against losses and allows the investor to make money still if the market goes up. This technique is best used when the stock’s share price has increased with the intent to protect profits.

To set up a protective collar on a REIT to lock in a specific range of returns, follow the step-by-step instructions below:

1. Choose an out-of-the-money put option to buy and an out-of-the-money call option to sell on the same number of REIT shares you own.
2. Choose a strike price for the put option that’s slightly below the current REIT price (it provides downside protection if the price declines).
3. Choose a strike price for the call option slightly above the current REIT price, limiting potential upside profit.
4. To balance your position, buy the same number of put contracts as you sell call contracts. Choose expiration dates for the call and put options corresponding to your investment or trading plan.

The protective collar crests a protective layer against substantial price declines, but it also limits upside gains up to a specified price point. Your position is “collared” within a defined range, but investors can reap the benefit of collecting the premiums that come from selling the call option. This offsets the cost of buying the put option.

How to Choose the Right REIT for Options Trading

If you’re uncertain how to begin using REITs in options trading, knowing which REITs are the best to use is important. Keep reading to learn how liquidity, volume, market volatility, and REIT sectors are critical for selecting the right REITs for online options trading.

Liquidity and Volume

Liquidity refers to investors being able to buy and sell REIT’s stock readily. It’s important to investors because it reduces the risk of being unable to sell a stock when needed, helps to minimize transaction costs, and ensures that investors can enter and exit positions they desire. When it comes to real estate investment trusts, liquidity is necessary because:

• Those with assets in more liquid markets can invest more money.
• Investors can acquire properties at a discount when capital resources are either too expensive or scarce.
• Those with higher asset liquidity have lower debt costs and a higher debt capacity.

Let’s look at the trading volume of REIT options. It’s a vital indicator of market activity and investor interest. Trading volume is traditionally measured by the number of shares traded for a stock and the number of contracts traded for futures and options.

• During an increase in trading volume, prices will generally move in that same direction.
• Low volume can indicate a lack of interest in a security—investors feel indecisive or lack conviction about these securities.
• High volume typically shows that investors are interested in a security.
• Trading volume helps investors know the full extent of a trend or a security’s momentum.
• Volume works hand in hand with liquidity because it indicates the supply and demand for securities.

Choosing REITs with high liquidity and trading volume for options trading is ideal because they indicate that investors are interested in investing in them and can be bought and sold quickly. Check out the most popular REITs with liquid options markets:

• iShares US Real Estate ETF American Tower
• Digital Realty Trust Prologis
• Realty Income Schwab US REIT ETF
• Arbor Realty Trust Crown Castle
• Equinix Iron Mountain
• iShares Cohen and Steers REIT ETF SPDR Dow Jones REIT ETF
• VICI Properties Inc. Equity
• Extra Storage Space Public Storage
• Stag Industrial Vanguard Real Estate ETF

Volatility Considerations

REITs have higher returns and volatility than direct real estate. There’s a greater likelihood of a REIT co-moving with the equity market instead of co-moving with direct real estate. A REIT’s higher volatility can lead to higher option premiums as there are greater expected price fluctuations in volatile market conditions.

Use the following tools and resources for measuring REIT volatility:

Beta

A component of the Capital Asset Pricing Model, Beta is a metric used to measure REITs’ volatility relative to the stock market. REITs move along with the market with a Beta of 1.0, are more volatile than the market with a Beta of more than 1.0, are less volatile with a Beta of less than 1.0, deliver returns independent of market returns with a Beta of 0, and have a negative correlation with the market with a Beta of -1.0.

Calculate Beta by taking the covariance (between the stock and the broader market) and dividing it by the variance of the total stock market.

Historical Price Movement

• The compounded variation of daily prices (price movements expressed as a percentage) can be used to measure volatility.
• REIT volatility (jumps in REIT indices) occurs every five days or so, and this can reflect the magnitude of realized volatility.
• Volatility can also affect stock return volatility. This includes factors such as financial leverage, economic activity, trading activities, and macroeconomic volatility.

REIT Sector Analysis

There are different types of REITs based on real estate sectors, and each requires a different hedging strategy appropriate to each situation.

• Retail REITs: A popular choice for investors due to shareholders earning dividends from other investors, retail REITs rent space to tenants and own and manage retail properties. Sales are generated through leasing, sales, and commissions.
• Industrial REITs: Use futures markets to find assets with returns that correlate with industrial REIT stocks. Take short positions if the correlation is positive and take long positions if the correlation is negative. Investors can also use caps and swaps, derivative contacts where variable interest rates can be converted to fixed rates. Diversify risk by using REIT mutual funds and ETFs. This allows exposure to a wide range of real estate sectors.
• Residential REITs: To hedge against a downturn in the housing market, investors can borrow shares of REITs and sell them at the current market price, then purchase them again at a lower price. Residential REITs also protect investors against interest rate increases, as these contracts fix the variable interest rate on debt once it reaches a certain level.

For your convenience, we’ve added a list of the most common REIT sectors and their unique risks:

• Office: Interest rate risks are the most prominent as office buildings are expensive and require REITs to borrow money to buy and develop these properties. Interest expenses increase as interest rates rise. REIT stock prices usually fall as interest rates increase (REITs must increase dividend yields for investors for the stock’s higher risk profile).
• Mortgage: Changes in short—and long-term interest rates can affect net interest margins, leading to increased costs and reduced interest income. When mortgage borrowers refinance their loans, mortgage REITs are forced to reinvest the repaid loan proceeds in the current interest rate market.
• Healthcare: REITs that build too much supply in their development plans risk having vacant space, which isn’t good because healthcare REITs need to match their development plans with demand.
• Hotels/Hospitality: There are economic risks due to hotels and hospitality being discretionary expenses. This sector can be easily impacted by tough economic times, so financing and lines of credit are key for these industries to weather the storm. Hospitality REITs need to maintain a low debt-to-capitalization ratio to avoid being a disaster if rent runs dry.
• Industrial: Industrial properties and spaces are vulnerable to environmental contamination, so that any possible clean-ups can affect an industrial REIT’s financial health.
• Residential: These REITs come with several risks, including leasing occupancy, fluctuations in property value, and geographical demand. They can be sensitive to changes in interest rates, which can lead to occupancy demand or an increase in property value.

Risks and Considerations When Hedging with Options

When REIT investors hedge with options, they run up against risks worth considering, especially if they have specific trading and investment goals. This section of our guide will go over the downsides to using hedging strategies with real estate investment trusts—these are ways that hedging can work against you when overhead costs, tax implications, and losing money on expiring options.

Cost of Hedging

Hedging involves buying options, and there are some associated costs along the way, including fees like margin requirements, brokerage commissions, and bid-ask spreads. If the hedging strategy works, investors face these costs, cutting into their total profits, while their losses could be worsened if the strategy proves ineffective. Hedging can be complex, no matter your skill level, so there’s the risk that it doesn’t work out and you are hit with losses you weren’t expecting.

Over-hedging is another risk that REIT investors face. Some people hedge more than necessary, which can lead to extra costs and missed opportunities. Investors using derivatives also run the risk of the other party defaulting on their obligations. Simply put, hedging can sometimes reduce overall returns due to premium costs or other mistakes like over-hedging or counterparty risk.

Timing and Expiry Dates

The expiration date should align with your trading plan, but timing the market and choosing the correct option expiration dates are of great importance. Selecting the wrong expiry can negate the benefits of a hedge. The farther out the expiration date, the more time you have for the trade to be profitable. However, the option will be much more expensive. Choose an expiry date that isn’t too soon that you cannot make a profit but not so far out that you eat up a lot of capital with purchasing the position.

Tax Implications

Some potential tax consequences of options trading exist, specifically the dreaded “60/40 Rule.” Internal Revenue Code section 1256 requires that 60% of the gain or loss be taxed at the long-term capital tax rates, while 40% is taxed using the capital tax rates for short-term positions.

We aren’t tax professionals in the slightest. You might consult a financial advisor or tax professional for more information on the tax implications or consequences of options trading.

Case Study—Hedging a REIT Portfolio with Options

Are you interested in a specific example of hedging a REIT portfolio with options? The case study below should highlight the key concepts and ideas covered in our guide on hedging with options on REITs.

Scenario Setup

Let’s consider a hypothetical investor holding $100,000 worth of REITs. Certain market conditions might prompt a hedge, such as rising interest rates or an upcoming market correction.

Recommended Actions

• Investors should hedge if they feel the market is due to fall soon. The hedging strategy should only cost a percentage of their total capital, the percent they see the market dropping by.
• Hedging against a recession is done well using retail or healthcare REITs, but not so much hotels or hospitality.
• Holding REIT investments beyond a crisis is an effective hedge against inflation. These long-term investments can become quite useful!
• Exposure to a wide range of REITs is good portfolio diversification and works well to hedge against uncertainties like rising interest rates.
• Traders should consider holding their REITs long-term to benefit from dividend payments.

Applying the Strategies

Now, let’s look at how you can apply some common hedging strategies effectively to the options you hold in your portfolio. Follow the directions below to get started with protective puts and covered calls.

Protective Put

1. Choose a brokerage app, create an account, and transfer money for trading and investments.
2. Search for options, stocks, or ETFs to add to your portfolio.
3. Choose a put option.
4. Choose an expiration date, strike prices, and premium (price paid to enter the trade).
5. Buy and enter the put option into the options chain to find puts on your investment.

Covered Call

This strategy can be used to generate additional income during market stagnation. Follow the steps below to create a covered call:

1. Look over your REIT holdings and choose the best for a covered call.
2. Select a strike price slightly above the current market price for each REIT.
3. Choose a moderate expiration date that is long enough to earn a good premium without leaving you exposed to risk from price changes.
4. Find out how many shares you want to use for the covered call. Divide the number by 100 to determine the number of contracts you must sell.

Options Can Be Used to Hedge for REIT Investments

Real estate investment trusts (REITs) are used to generate additional portfolio income. Still, they also use the options on REITs to hedge risks using strategies and techniques like covered calls, protective collars, and protective puts. Guard against potential losses in your portfolio’s holdings by taking the opposite and equal position with a similar asset (this can be applied to both long-term and short-term positions). Investors can hedge using options by buying put options, using index or index-based ETFs, or even delta hedging.

Continue exploring these strategies to protect your real estate portfolio during uncertain times. The more you learn about these hedging techniques, the better you can face risks like interest rate fluctuations, market volatility, or property value declines. Check out some of these additional resources for more information and insights!

• Options Trading Strategies
• Risk Graphs & Risk to Reward Ratio
• Choosing the Right Trading Strategy
• Best Options Trading Brokers