Analyzing the Real Return on Real Estate
In doing research for a post that I want to write on the inflation adjusted returns of various investments, I ran across some interesting data on real estate. One of the most widely touted pieces of information that I am running across is the graph of nominal vs real home prices from 1890 to present made famous by the research of Yale economist, Robert Shiller.
This data indicates a real rate of return of about 0.4-0.5% annually since 1890 and is being used as an argument to invest in stocks which have historically returned about 7% on average after adjusting for inflation. But is this a fair comparison? If you think logically about what this information is saying, I think you will agree that the fundamental conclusions made about real estate investing when using this data is flawed.
What Does the Data Actually Tell Us?
First, let me say that I am not disputing the accuracy of the data one bit. I can’t accurately comment on how it was collected or whether it was the right information to collect, but my understanding is that data looks at sales data for existing homes from 1890 to the present. Assuming the data is correct, what is this saying? It is saying that the inflation adjusted capital gains for real estate over the last 120 years is about one-half percentage point per year. That’s it.
But who in their right mind would invest in real estate solely for capital gains? Not a true real estate investor. There are four ways to make money in real estate, and capital gains represent only one of them. I would also suggest that capital gains (ie real appreciation) are not the most important.
The Purpose of Investing in Real Estate
Investing in real estate should primarily be about cash flow and the rents that the real estate can generate. In this respect, a piece of rent producing property is more like a stock that pays out a dividend. So if we want to compare our real estate investment, which just manages to maintain its value after inflation, to stocks, then we need to know if real estate will yield 7% after inflation.
That means we check out the capitalization rate. If the capitalization rate of a piece of property is about 6.5-7%, then real estate makes sense compared to stocks. Realistically, the capitalization rate is about 8-10% for most real estate investments in my area of the Midwest. Now you could do all sorts of sophisticated analysis to account for inflation of maintenance costs, inflation of rents, etc to adjust the cap rate over time, but the bottom line is that real estate investing compares favorably to stock investing provided the purpose is to rent out that real estate.
Of course, that doesn’t hold true with a personal residence. In that case, over the long term, you shouldn’t gain or lose all that much provided you don’t initially overpay. At least, this information should offer some comfort knowing that wealth should be maintained when placed in a personal residence. This is as it should be since the primary purpose of a personal house is to live in it.
So, what do you think? Have you seen the data by Shiller and written off real estate? Do you know anyone who has? Real estate investing when operated as a business is just like any other business in the stock market so it makes sense that the inflation adjusted returns would be similar. Do you believe this? I would love to hear your comments.