This post is part of a series. Read Part 2 here: Deviations from Mean Returns in Real Estate, Part 2: Return Distributions
The real estate crash, and subsequent financial chaos, of 2008 disabused millions of people of the notion that real estate is an easy investment with stable, predictable returns. More recently, Yale professor Robert Shiller examined real returns in real estate prices from 1890 through 1990. He found that real estate returns, when adjusted for inflation, averaged around 0.2% per year. Updating the study with Professor Shiller’s data reveals a slightly better, but still unimpressive 0.6% real return.
Of course, this analysis is incomplete as it ignores rental income (or the value of living in the property). It also ignores inflation, as nominal annual returns on homes averaged around 3.4% in the same data set. Given that most people “invest” in real estate by buying a home with a mortgage and look only at actual rather than inflation-adjusted values, that sub-par return can look pretty good. If one buys with a 20% down payment and the combination of interest, property taxes, and tax deductions is roughly equivalent to the rent one would have to pay, that 3.4% nominal return is transformed into a much larger number.
Meanwhile, back in the real world, I know I have never experienced an “average” rate of return in my life. All my investment returns seem to have been well above the average or well, well below. So, perhaps the more interesting question is not what is average, but what is extreme. We should want to know if the data tells us we can rely on receiving these average rates of return over any given holding period.
How great have the historical drops in home prices been? And how frequent? If one had bought, or worse yet, lent in the wrong market at the wrong time, how quickly was equity wiped out, exposing owners to loss of investment and foreclosure, and exposing lenders to loan losses?
Conversely, how quickly have home prices rallied? If one failed to buy, how much of appreciation was missed? And given that not everyone’s income is neatly indexed to inflation or home prices, how painful could the increase in housing costs be?
Well, let’s see what the data tells us.
First, let’s look at drawdowns from peaks in real estate prices on the national level.
The drops are significant and not nearly as infrequent as one might have expected.
But no one owns national real estate. We own real estate in local markets, usually where we live. So, we should look at geographic regions.
The data does not reach back as far for either of these markets as it does for the national index, but we still see two significant declines in each. These price declines are invisible in the national data, as they are averaged out across all markets. But if you were a buyer or a lender in either market, the declines were quite real.
Some markets avoided drops in the 70’s, 80’s, and 90’s. Miami, for instance, was stable for decades. The drop, when it came, was a monster. Perhaps, overconfidence led to the greater drop. Perhaps, it was other factors, but the scale of the decline wiped out homeowners, home builders, and lenders in huge numbers.
So, should one avoid real estate ownership? Looking at the other side of the ledger suggests no, at least not always. In the following chart, we look at 10-year, nominal returns on national real estate indices.
The first thing that stood out to me is that the great real estate bubble of the early 2000’s is the third largest price increase. This was a surprise. Again, it is certainly not clear cut that real estate should be avoided.
As it turns out, U.S. real estate is far from the most volatile. A 2012 NYU study, “No Price Like Home”, by Katharina Knoll, Moritz Schularick, and Thomas Steger, shows that many markets worldwide have shown significant volatility.
The best chart by far, in of its sheer dramatic impact and the mind-boggling level of relief one experiences at having not participated, has to be the urban Japanese property market from 1985 to 2016. This chart from the Japan Real Estate Institute, showing commercial, residential, and industrial land prices in the six largest cities in Japan, gives us the thrill of the 1980’s bull market and the terror of a 25-year bear market, without our having to commit a single Yen. Not only have prices not recovered their previous peak, they really haven’t even shown any sign of meaningful increase.
Finally, we return to Shiller’s annual return numbers. As helpful as these numbers are, it is clear that they don’t give us the full picture. Nor do I believe he intended them as a complete summation of the real estate market.
His data, as I mentioned in the beginning, showed a 3.2% nominal return on average, as well as a 0.38% real return. But precisely how often was that 3% annual return realized? 11 out of 129 years.
Returns in real estate seem, at this level, to be like returns in other markets. Not well distributed around the mean, with significant increases as well as declines. It should not be approached naively, but with appropriate caution and every risk management tool available.
This post is part of a series. Read Part 2 here: Deviations from Mean Returns in Real Estate, Part 2: Return Distributions
Sources:
SHILLER, ROBERT J., “Why Home Prices Change (or Don’t).” The New York Times, April 13, 2013, accessed January 25 2017, http://www.nytimes.com/2013/04/14/business/why-home-prices-change-or-dont.html.
Knoll, Katharina, Moritz Schularick, and Thomas Michael Steger. “No price like home: Global house prices, 1870-2012.” (2014).
“Urban Land Price Index.” Japanese Real Estate Institute. Accessed January 23, 2017. http://www.reinet.or.jp/en/pdf/2016/ULPI-SixLargeCityAreas-Nov.pdf.