Client Memo: Real Estate Isn't The Investment Most Think It Is

"Your Home Is Your Biggest Asset"... Or Is It?

Real estate has become a quasi-obsession in the United States, especially after some significant drawdowns in the stock market.  The truth is that real estate is a poor investment for most investors.   

You hear a lot that your home is your largest asset (“investment”).  Other idioms you often here are “you’re throwing away money when you rent” or “real estate always goes up” or “it’s a tangible asset” and “buy land: they’re not making any more of it.” 

Robert Shiller, a Yale Professor who is one of the foremost experts on the housing market, published research that showed farmland has compounded at an average of +1.1% per year, after accounting for inflation.  Home prices have been slower to increase in value at an average of just +0.6% after inflation.  

The Hidden Power of Leverage

The largest factor that people feel that they make more wealth on real estate is because they are leveraged so excessively.  A mortgage is a 30-year amortizing loan that splits your home purchase into 360 smaller payments.   

By putting 20% down and paying the rest over 30 years, you are taking some significant leverage – about 5x.   

Your wealth can be amplified massively by simply buying more house than you can afford early on, banking on earning more income to make the home payment more affordable, and having that leverage compound your wealth much faster than if you bought that cheaper home. 

Investors ‘feel’ like they ‘ve done well investing in real estate, but all they did was bet heavy on their home and it happened to pan out.   

The Work That Doesn't Show Up on a Spreadsheet

In reality, stocks and bonds are a far more rewarding investment over time.  Stocks have compounded at approximately 6.5% (when reinvesting dividends and after inflation) – far higher than real estate over the last century.  The Denver-Lakewood Home Price Index, an actual index maintained by the Federal Reserve Bank, has appreciated by 5.51% per year since 1995.  At the same time the S&P 500 has returned 10.3% per year in nominal terms.  Gold has risen about 6.2% annually since 1995.  The Bloomberg US Aggregate Bond index has averaged 4.6% annually over the last 30 years. 

The reason is simple.  Most people overestimate their real estate returns.  For example, someone buys a house for $200,000 and twenty years later sells it for $500,000, they think, “Great!  I’ve made $300,000 and more than doubled my money!”   

But in reality, they’ve had a ton of expenses along the way including (but not limited to) property taxes, HOAs, maintenance and repairs, real estate transaction fees like closing costs, capital gains taxes, homeowners insurance, flood insurance, and any mortgage fees if they refinanced over that period. 

Once you factor in those costs, Schiller says your real return is just 0.6%.  Even when not including those expenditures, the gross return was just 4.7% per year ($500,000/$200,000)^1/20 -1 = 4.71%.  After inflation it is less than 2%.  Again, before those expenses. 

We haven’t even discussed the intangible costs like the amount of time it takes to keep up a home or maintain an investment property.   

The Allure of Real Estate... and the Reality

In other words, having a diversified asset allocation outperforms real estate over nearly every time frame.  But having a bunch of funds – both equity and bond – aren’t as exhilarating as real estate.  As I noted earlier, the media has glorified real estate investing with all these shows on HGTV and other TV channels about buying/selling/flipping/remodeling homes.   

I am not making the case that you shouldn’t own your home nor should you avoid investing in real estate.  It’s not a bad asset class.  It’s just the most overrated asset in history.  The obsession with it has simply put it up on this podium that it likely can never live up to. 

As always, we are here to answer any questions you may have. 

Best,

Mark J Asaro, CFA

Noble Wealth Management