Unleveraged residential real estate beats stocks in the long run, with far less risk and volatility. Even data-driven investors may want to reconsider their strategy.
Almost every traditional financial advisor will tell you that the stock market is unquestionably the ruler of long-term investing. They say, “You can explore other things, but you don’t want to stray too far from reality. Invest the majority of your money in stocks and bonds.” But is this favorable?
Unfortunately, no one had an idea since no classes had ever been conducted. It was too difficult to gather the data because residential real estate was scattered in many different areas.
Until one time, in January 2018, a group of daring researchers disclosed that they’d spent years evaluating the said problem – solving the problem that one no one else was willing to solve. The study (“The Rate of Return on Everything, 1870-2015) by the Federal Reserve Bank of San Francisco has hit investors with a significant surprise.
Let’s delve deeper into this.
“The Theory of Everything”
The research “The Rate of Return on Everything, 1870-2015” looked at the returns of the critical investments: stock market (equity), treasury bills, bonds, and real estate, making it the most complete examination ever undertaken.
The researchers discovered that real estate and the stock market did a tremendous job during that time. The stock market delivered an excellent 7% real return (the term “real” refers to the final return after inflation).
However, real estate performed even better, rising by slightly more than 8%. Over time, that small differential adds to a significant advantage for real estate. (By comparison, bonds returned approximately 4%, and Treasury bills returned about 2%.)
Wasn’t it surprising that residential real estate outperformed stocks? Usually, more robust performance necessitates more risk. However, residential real estate performed better while being less volatile and unstable.
So, on a risk-adjusted basis, real estate beat equity. Also, it is risk-adjusted returns that prudent investors are most concerned with.
Sorry to shatter your optimism, but there may be an issue. The data goes back to 1870, making it detailed. However, the current era of finance (which began after World War II) is entirely different from the late nineteenth century.
Investing in steel and railroads allowed folks to become one of the world’s wealthiest individuals back then. That same investment may not even keep up with inflation today. So, have changes occurred since then?
If we analyze the data, it will only show changes. Residential real estate beat equity by a wide margin before World War II. Following WWII, the stock delivered a more significant raw return than housing. Yet, there was a flaw: equities became more unpredictable and riskier. As a result, it had a worse risk-adjusted return than real estate.
In terms of risk-adjusted return, residential real estate outpaced stocks.
Why Is Mr. Market Temperamental?
Stocks have been more volatile in the modern era due to two factors.
- Capital gains accounted for more of the return on equities than on homes. Hence, capital gains are an investment’s most volatile and risky aspect.
- The second factor is that the stock market correlation changed after WWII. In the past, a loss in the Hong Kong stock market won’t affect your stock in the US or the UK. However, since everything is now interconnected, the rest tend to follow when one falls.
What’s particularly intriguing for real estate investors is that this hasn’t occurred in the housing sector. So, if you own an air B&B rental property anywhere, it’s safer than a residential home. Real estate is more accessible to exchange than stock, giving it an edge in this situation.
The Rate of Return on Everything, 1870-2015 – What’s the Deal
This research is remarkable and dispels various myths. Data-driven financial counselors and astute investors will alter many tactics because of the shared knowledge. Here are the crucial points from my perspective.
- Most investors should not invest 80-90% in public markets and 10-20% in alternatives. Following this blindly increases investment risk while decreasing rewards.
- Large institutional investors have already allocated far more to real estate than usual. I expect all investors to examine their positions more closely and maybe re-allocate.
- Real estate investors may want to explore diversifying into foreign properties to increase their returns.
Before you sell your whole stock portfolio and invest it all in a value-added multifamily real estate fund, it’s critical to understand two key research findings.
For starters, they only looked at one type of real estate: residential properties. Commercial assets are common in most diverse real estate portfolios, but this study does not mention them. As a result, we cannot yet assume that one will have the same long-term performance and risk characteristics as the other. It’s not wrong to be careful.
Second, their actual figures assumed that the real estate was purchased with cash and without the use of any leverage or loans. However, the majority of crowdsourcing and syndication investments are leveraged. When things go well, this enhances the return and increases the chance of loss when they don’t. As a result, you can’t extrapolate one from the other. Again, we’ll have to hope another report looks into this more thoroughly.
Third, the study assessed transaction costs for residential properties over a 10-year holding term. They based this on the average time a person spends in their home. Yet, the typical crowdfunded/syndication investment runs only five years. Hence, long-term returns on shorter-term investments are expected to be lower.
Many people have expressed concern about how low-interest rates have fallen. When the return on a safe investment becomes too low, many people are compelled to make riskier investments. As a result, it produces price increases, which leads to asset bubbles. When they rupture, it can result in a destructive down cycle.
We’re all hoping for “everything to return to normal” in the next 3 to 5 years. However, the investigation discovered something quite surprising and intriguing.
After accounting for inflation, today’s safe rate of return falls in line with the historical norm of 1 to 3%. It appears to be extremely low since the period we’re comparing it to (the 1980s to early 2000s).
These lines are a stunning discovery. If this is correct, the actual safe rate is unlikely to rise very soon. We will probably have to put up with harmful side consequences for a long time, but let’s hope for the best.
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