When my videos on the decision to rent or buy a home came out,
I received a ton of comments about how great real estate is as an investment. Those videos
were not about investing in real estate, they were about how to pay for your own housing.
But when I had to make a video addressing all of the real estate-loving commentators.
I can’t disagree that real estate, specifically housing, has historically been a great asset
class. In fact, it has been the best performing asset class in history.
Better than stocks. This was documented going back to 1870 in a 2017 paper from the Federal
Reserve Bank of San Francisco titled The Rate of Return on Everything, 1870–2015.
As great as the returns of the housing asset class have been,
real estate has some unique characteristics that make it next to impossible for any
individual investor to access the asset level class returns.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode of Common Sense
Investing, I’m going to tell you why investing in real estate only looks good on paper.
Before we get going it is important to note that the real estate return
includes both the price increase of the asset, and the net rental income. Each
makes up about half of the total return. Buying a house to live in means forgoing
the net rental yield portion. It is not investing in your own residence that has
had great historical returns - it is buying property and renting it out.
The mean real return on global housing from 1870 to 2015 was 7.05% compared to 6.89% for
equities. The housing return also came with a substantially lower standard deviation.
More returns with less risk? Seems pretty great. It gets better. As time has passed
equity markets around the world have become increasingly correlated with each other,
but global housing markets have remained uncorrelated.
As good as this sounds, there are some cracks that will begin to show. That global housing
return of 7.05% meant that you had to invest in all of the houses in all sixteen of the
countries in the study. If you had only invested in housing in Australia, France, Japan, Portugal,
Spain, Italy, Switzerland, the UK, or the US, you would have been better off investing
in global equities. If we are talking about stocks this is fine. We all know how important
global diversification is, so we buy index funds. It is not so simple with real estate.
Real estate trades in very high unit values. It is a challenge for most people to get enough
cash together to buy their home, let alone invest in property. Unlike corporations,
the assets are not divisible or homogeneous. A corporation can be split up into shares,
and all of the shares of each class of a company are the same. They can be easily
traded. If the price of a share gets too high, a company may split its stock,
or issue a new class of shares with a lower price. None of this is true with
houses. Most investors do not have sufficient capital to invest in many houses at once.
Even if an investor has enough capital to purchase houses all over the world,
they need to be able to manage the properties. One of the best characteristics of owning shares in
public companies is that you don’t have to manage the company. A landlord, on the other hand, is
responsible for maintaining the physical property, finding tenants, negotiating leases, collecting
rents, and responding to urgent tenant issues. Of course, it is possible to hire a property
management company to handle these issues, but that comes at a high cost, which reduces returns.
It’s one thing to have to run down the street to your rental property when the tenant has a water
leak. Imagine if your properties were scattered across each continent. This is beyond impractical.
The risk of investing in any one asset is not a compensated risk. Uncompensated risks can
be mostly diversified away by investing in the whole asset class, like we try to do with index
funds for stocks and bonds. As I have mentioned this is much harder to achieve with real estate.
With that in mind, and without any way to effectively model the specific risks
of any one housing asset, let’s look at an example of investing
in a rental property in Ottawa based on some expected return assumptions.
The average 2017 price for a home in Ottawa was $378,000. Assuming a 20% down payment of $75,600,
a $4,000 land transfer tax, and $2,000 in closing costs,
an investor could purchase a property of this value for a total initial investment
of $81,600. A 3.09% 25-year mortgage payment in this situation would cost $1,448 per month.
We can estimate property taxes at 1% of the property value per year,
and maintenance costs at 1% of the starting value, increasing with inflation each year.
This amounts to a total monthly operating cost of $2,078 to start. We will assume
that the mortgage interest rate remains at 3.09% for the duration of the projection.
Higher interest rates could hurt the returns on the property investment.
The average 2017 rent in Ottawa for a three or more-bedroom dwelling was $1,568. We will give our
landlord the benefit of the doubt and assume that they can rent this unit out for $1,650 per month,
resulting in a monthly loss of around $430. This loss will decline over time assuming that
the mortgage payment stays the same while rent increases with 2% inflation annually.
We will assume that the real estate asset grows at a rate of 3% per year. A 3% growth rate with 2%
inflation puts our expected real capital housing return at 1%. A 2018 paper by Dimson, Marsh,
and Staunton showed that the real estate price return has beaten inflation by 1.3% from 1900
to 2017. We will assume for our example that real estate beats inflation by 1% per year on average.
Based on these assumptions, this investment will have averaged an annual return of
7.29% per year after 25 years before taxes are considered. For context,
a globally diversified portfolio of index funds returned an identical
average pre-tax return of 7.29% per year for the 20-year period ending March 31, 2018.
If the landlord experienced one month of vacancy every two years, as opposed to full occupancy for
25 years, the average annual return drops to 6.40% per year. If the unit can only be
rented out for $1,568 per month, as opposed to $1,650, the average annual return drops to 6.03%.
While the expected returns of this hypothetical investment are competitive with an aggressive
portfolio of equities, the expected return must be considered in context of the known risks and
unique characteristics of direct real estate ownership. If an investor owns many properties
on multiple continents, it may be reasonable to achieve the expected return of this asset class.
If only one property on one continent can be owned, the idiosyncratic risk of that continent,
country, city, and property can easily swamp the expected return of the investment. If you want to
know more about idiosyncratic risk, I addressed it in a video titled 'How Much Risk Should You Take?'
This is not to say that the risk of a concentrated investment cannot work out
well – ask anyone who invested in a detached home in Toronto
ten years ago. But I would not rely on the expectation of recreating that experience.
In a 2018 paper titled Real Estate Betas and the Implications for Asset Allocation, Peter
Mladina broke down real estate returns in terms of known factors that explain equity and fixed income
returns. His factor model included the Fama-French market beta, size, and value equity factors,
plus the term and default fixed income factors. This modified factor model was shown to adequately
explain real estate returns. In other words, adding real estate to a portfolio does not
provide factor exposure that could not be attained using traditional equities and fixed income.
To realize the on-paper expected results of the housing asset class,
an investor should aspire to build a globally diversified portfolio
of properties. If this is not attainable, the asset-specific risks of an individual property,
or group of properties in a single country, are likely to result in actual performance
substantially exceeding or trailing the expected performance of the asset class.
It may be far more cost effective and statistically reliable to gain the factor
exposure that real estate offers through a factor-loaded portfolio of stocks and
bonds. This factor exposure can be accomplished cost effectively using low-cost index funds.
Before everyone floods the comments with their Vancouver or Toronto investment property stories,
that’s like me telling you about the price of one tech stock increasing in
price one hundred fold therefore stocks are a great investment.
Is real estate your favorite investment? Tell me why in the comments.
Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense
Investing. I’ll be talking about a lot more common sense investing topics in this series,
so subscribe, and click the bell for updates.