Turns out, un-leveraged residential real estate outperforms stocks over the long term, and with much less risk and volatility. Data-driven investors may want to adopt a tectonic shift in strategy.
(Disclaimer: I'm not a financial advisor or attorney. Consult your own financial and/or legal advisors before making any investment or legal decisions.)
Virtually every traditional financial planner will tell you that the stock market is the undisputed king of long-term investments (along with a mix of bonds). “Sure, you might dabble in some other things, but you don’t want to deviate too far from the time-tested way. Keep most of your money in stocks and bonds.” But is this actually true?
Interestingly enough, before this month, no one actually knew. That’s because no comprehensive long-term study had ever been done on the major asset classes. The data is spread out into so many different places, it was too much of a pain to assemble.
Well, this month, several intrepid researchers revealed that they’ve spent the last several years doing what no one else was willing to do, taking on this problem. They released their paper (“The Rate of Return on Everything, 1870-2015”) through the Federal Reserve Bank of San Francisco. And the result is a bombshell that has major implications for investors.
“The Theory of Everything”
Their study analyzed the returns of the major investment classes: equity (stock market), bonds, treasury bills and housing (real estate). And it analyzes returns from 1870 through 2015, which is the most comprehensive look that’s ever been done. Here’s what they found.
They found that both real estate and the stock market performed admirably well over that time. The stock market returned a very impressive 7% real return (“real” means final return after inflation). But real estate did even better at a little over 8%. Over time, that small difference is a substantial advantage for real estate. (In comparison, bonds did about 4% and treasury bills about 2%.)
Even more striking was how residential real estate beat stocks. Normally higher performance requires higher risk. But residential real estate actually did better while being less volatile and risky.
This is the financial equivalent of having your cake and eating it too. And it was a lot of cake: real estate was half as volatile as equities:
So real estate actually outperformed equity on a risk-adjusted basis, too. And risk-adjusted returns are what prudent investors look at most closely.
But What Have You Done for Me Lately?
There could be one potential hitch with the above. The data looks all the way back to 1870, which makes it comprehensive. But the modern era of finance (starting after World War II) is a completely different animal from the late 19th century. Back then, you could become one of the richest people on the planet by investing in steel and railroads. Today that same investment might not even keep up with inflation. So maybe things have changed since then?
The data shows there have been some changes. In the pre-World War II era, residential real estate outperformed equity by a large margin. After World War II, equity produced a higher raw return than housing did. But there was a fly in the ointment: equity also became more volatile and risky. As a result, its risk-adjusted return was less than real estate.
Bottom line was that residential real estate’s risk-adjusted performance still beat stocks.
Why so Temperamental, Mr. Market?
Two things have caused stocks to be more volatile in the modern era.
First, capital gains produced a larger part of the return on stocks than they did on housing. And capital gains are the riskiest and most volatile part of an investment. (Stock dividends and real estate income are less volatile).
The second thing that happened is that stock market correlation changed after World War II. Before that, a drop in the Hong Kong stock market wouldn’t make much of a difference to your stock in the US or the UK. Today everything is interconnected, so when one goes down they all tend to go down with it.
What’s very interesting for real estate investors is that this hasn’t happened on the housing side. So if you have an air B&B rental property in Madrid, it’s remained pretty insulated from a residential property in say, Houston. Real estate is a lot less liquid and less easily exchangeable than stock, which gives it an advantage in this situation.
What does this mean?
This study is groundbreaking and debunks numerous myths. Data-driven financial advisors and studious investors will be changing a lot of their strategies. Here are the key takeaways, from my point of view.
The traditional advice, that most investors should be 80-90% in public markets (stocks/bonds) and 10-20% in alternatives, is not data-driven and is out of date. Blindly following it is unnecessarily increasing investor risk and reducing returns.
Large institutional investors (including the Yale endowment, which has outperformed the market for years) already put in a much higher allocation to real estate than they “should" (20-40% of their portfolio). I expect all investors will be examining their positions more closely, and perhaps re-allocating.
Real estate investors may wish to consider diversifying into overseas properties to minimize their volatility, decrease that risk, and improve overall portfolio performance.
Before you’re tempted to dump your entire stock portfolio and put it all in a value-added multifamily real estate fund, it’s crucial to understand two important things about the study.
First, they only looked at one narrow section of real estate: residential properties. Most diversified real estate portfolios also have commercial properties (office, retail, apartments, hotels, self storage, etc.). This study says nothing about that. So we can’t yet assume that the long-term performance and risk characteristics of one will be the same as the other. (I just hope we won’t have to wait another 145 years for that report!)
Second, their performance numbers were based on the real estate being purchased with cash and without any leverage/loans. I personally have a residential rental portfolio like this, and feel it’s an excellent risk-adjusted return. But most crowdfunding and syndication investments are leveraged. This increases the return when things go well, but also increases the risk of loss when things don’t. That will most definitely change the risk-adjusted performance. So you can’t extrapolate one from the other. Again, we’ll have to hope another report will take a more definitive look at this.
Third, the study calculated transaction costs based on a holding period of 10 years on the residential properties. And they based that on the average time a person lives in their house. However, the average crowdfunded/syndication investment runs only 5 years. This means double the transaction costs, which are fairly significant in real estate. So the long-term returns on shorter-term investments would be expected to be lower (and possibly equal to or lower than the return on stocks).
On the other hand, the study does confirm the strategies of investors who choose long-term real estate investments (typically 10 years). And the same is true for buy-and-hold strategies, which should also perform similarly well.
The Really Big Picture
Many (including me) have complained about how interest rates have dropped so low. When the return of a safe investment gets too low, it drives lots of people into riskier investments. This causes prices to go up, which causes asset bubbles. And when they burst, this can cause a bad down cycle. All of us are patiently waiting for “things to get back to normal” in the next 3 to 5 years.
But the study found something very surprising and interesting. Once inflation is taken into account, today’s safe rate of return falls in line with the historical average of 1 to 3%. It just seems really low because the time frame we’re comparing it to (1980s through early 2000s) were a weird historical aberration. The authors put it this way:
“Viewed from a long-run perspective, it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today. The puzzle may well be why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
This is a shocking finding. If it’s true, we’re unlikely to see the safe real-rate go up anytime soon.
Or to put it in another way: the crazy “quest for yield” and all its unpleasant side effects are something we’re probably going to be putting up with for a long time. And any investors waiting for CDs and treasury bills to return a decent amount over inflation probably shouldn’t be holding their breath.