Is Real Estate a Good Investment? (Part 1)

When I talk to people about investing and personal finance, the topic of real estate inevitably comes up. This is a fairly broad topic, so I have broken up the discussion into two parts: Part 1 covers buying real estate as rental property, and Part 2 covers buying real estate as a home. In both parts, when referring to "real estate" I really mean single-family residential properties.

Let’s start with long-term statistics. Home prices in the long run (50+ years) have only increased by a small amount above inflation (0.26% from 1890-2009, 0.29% from 1959-2009). And at first glance, this return looks absurdly very low versus stocks (6% after inflation) and bonds (2% after inflation). However, to make a fair comparison, we need to calculate the total return which incorporates the rental income, as well as leverage through a mortgage.

The following table summarizes the return and risk analysis using long-term averages. For real estate, I assume a price-rent ratio of 15x. And for scenarios with a mortgage, I use a 6% mortgage rate and 2.24% inflation rate. To estimate the risk of individual properties from the risk of real estate as an asset class, I assumed a correlation of 80% in property prices.

There are a few results to notice.

• From a returns standpoint, buying a home as rental property under these assumptions never approaches the returns you can expect from stocks, but do match that of bonds.
• It takes a down payment of about 50% to make an investment in a single home similar in price risk to an investment in stock index funds.
• Paying down your mortgage will typically lower your returns. Owning a home outright is very similar to investing in bonds, but with more risk.

Now, let’s try to estimate the returns specifically for the next 10 years. I assume US stocks are about 50% overvalued (using Q), and US residential real estate about 20% overvalued (price-rent ratio of 18x). US bond returns are expected to be a little lower than usual, estimated using current 10yr TIPS rates.

You can see the powerful effect of leverage in these estimates. What starts off as a 2% drop in annual returns with no mortgage turns into a 10%+ swing in annual returns with a typical one.

Further, returns are not the only factor in evaluating an investment; risk must also be considered. And in the case of buying real estate properties, many dominant risks are not based on fluctuations in value. Some of those risks are:

• Indivisible: You cannot easily buy or sell in small increments, like you can with stocks and bonds.
• Undiversifed: An investment is a large bet on one property, in one neighborhood, in one city, in one country.
• Illiquid: Buying or selling stocks and bonds can be done in minutes; buying or selling real estate properties can take months.
• Management: Your time and effort is required to be a landlord. You really need to think of real estate properties as small businesses, not pure investments.

It certainly does not look like investing in real estate is an optimal way to build wealth, even when you have no mortgage to pay. But why do these numbers for real estate, both long-term and current, look so bad? One reason is that the assumed price-rent ratio of 15 reflects residential real estate–homes people would buy to live in. And buyers intending to live in the home have rational reasons to pay more than investors:

• Mortgages are cheaper and easier to get for owner-occupied properties
• Tax law makes owner-occupied properties more tax efficient than investment properties
• There are non-financial benefits of owning the house you live in

So as an investor, you are at a disadvantage because buyers who intend to live in the home are bidding up prices beyond where it makes financial sense for investors. This is why you don’t see large real estate companies buying up single family homes to rent them out. They can’t compete against buyers who intend to live in them. These companies do profitably manage almost every other type of real estate: office buildings, shopping malls, apartment buildings, etc.

Let’s take a look at where the price-rent ratio needs to be to make rental properties a decent investment.

This implies that house prices need to drop around 30-40% vs rents (from 15-18x) to make them good investments.

Are all real estate investments bad? Fortunately, no. REIT index funds and ETFs can be used to gain exposure to real estate, without many of the risks mentioned above while increasing returns to more attractive levels. REITs are simply companies that own and manage real estate properties.

• Divisible: You can buy REIT index funds/ETFs by shares, just like stocks and mutual funds.
• Diversifed: REIT index funds/ETFs hold thousands of properties in all sectors and all geographic regions.
• Liquid: Buying or selling REIT index funds/ETFs is just as easy as buying or selling stocks and mutual funds.
• Pure investment: As an investor, you do not need to commit your time and effort. You do not have to worry about broken pipes or bad tenants.
• Better returns: REIT index funds/ETFs own properties that make financial sense, by not competing with buyers looking for a place to live. They also have better economies of scale to make property management more profitable.

In the Part 2, I will discuss the economics of buying a real estate as a home. For you spreadsheet geeks, here‘s what I used to calculate the numbers above.