A few years ago a study was released by some researchers at the Federal Reserve called The Rate of Return on Everything 1870-2015. The study looked across a number of wealthy countries and attempted to aggregate data on housing, equity and bonds to determine the long run return on these different asset classes over the very long run.
The results of the study but didn’t exactly solve the real estate versus equity debate that many still have to this day. It found that equity and real estate provided the greatest returns over time with real estate slightly eaking out higher annual growth at 11.06% compared to stocks which returned 10.75% on average.
An important caveat of this being that equity returns have bested real estate returns over time since WWII.
However when we are comparing returns we have to make sure what we are comparing is apple to apples and not apples to oranges. I have written in the past about how over time REIT returns have actually been comparable to actually owning real estate. The FTSE NAREIT Index has outperformed the S&P 500 on a total return basis over the past 25 years with NAREIT returning 12.6% annually and the S&P 500 returning 11.9% annually. Yet we have to be careful when we compare these large and broad numbers when looking at different assets classes and I take issue with some of them.
REIT vs Real Estate vs the S&P
The first is that yes REITs may seem to broadly outperform real estate but we have to ask what that means.
Both REITs and the S&P 500 index are capitalization weighted indexes meaning that those companies which grow earnings and increase their valuation are rewarded with greater representation in the index. Housing data is a little different in that it looks at all the housing markets across the country and then picks either a median or an average and uses that as the housing market’s growth.
As an investor, the housing market as a whole is not an investable asset like the REIT index or the S&P 500 is, it’s just a hypothetical. A real estate investor has a choice of being able to pick their market and then focus on investing in that market or that group of markets, hopefully their bet will then pay off.
In that sense, it’s a bit easier to pick the broadly outlined hottest housing markets over a long period than to pick the best stocks. Domestic migration in the US has been trending west and south ever since the investing of air conditioning and there is no reason to believe that this slow moving trend will let us anytime soon. It may shift, say from California to Arizona, but both still reside west and south of places like Illinois and New York so there is a general trend towards warmer places and away from cooler climates.
Even if an investor would like to move as demographic trends shift, if there is a long time frame in front of them, this can be easily done in a matter of a few years. Think of selling homes which have appreciated in California to then reinvest them in Arizona. For this reason, I think it’s a bit of a misnomer to compare real estate on a national level with cap weighted index returns. It may be a better idea to compare some of the best 3-5 real estate market returns with stocks and REITs and see which one comes out on top.
I also want to differentiate between different types of real estate. The NAREIT index contains a large number of companies which own commercial real estate or trade mortgage securities, these companies are not the same type of risk as an owner who rents a single family home, to say they are directly comparable is a bit of a misnomer.
In addition, we have to factor in the leverage ability of real estate versus other asset classes. Real estate allows for long term fixed rate debt in the US which gives it huge advantages over equity which cannot be leveraged as easily by investors. It seems that the authors of the aforementioned study took this into account but again, they looked across countries broadly, not at their best markets.
A Study of My Own
Thinking of all of this, and not being able to find any studies of the best housing markets versus other asset classes, I decided to run my own little experiment which I will lay out below.
I looked at 5 states, 2 of which are considered low growth demographically and 3 of which have been higher growth states over the past 30 years. I looked at home prices, median income and then made some assumptions on costs and borrowing to come up with a theoretical range of returns which an owner could have experienced within these states during the last 30 years.
I used Federal Reserve data looking at home prices indexes for each state to gauge home price appreciation. I also picked 3 states that saw large net migration to those states over the period 1990 – 2020. Those states were California, Florida and Texas. The slow growth states I picked were Illinois and New York which have experienced net outflows of people over that same period.
Interesting enough, Texas and Florida saw greater home price growth across the state than did California but it didn’t come as any surprise the New York and Illinois lagged.
Next I looked at the growth rate versus the affordability. I gushed affordability by calculating the median home price divided by the median income. The smaller the number the more affordable the housing in that state is. Finally I also calculated a figure I called affordability to growth which measures the growth you buy for the price. Cheaper homes with a higher growth rate will score best in this statistic.
No surprise that Texas and Florida scored high in growth versus affordability but Illinois actually did very well here just due to affordability alone.
Finally I attempted to factor in leverage which assumed 25% equity because that is the maximum leverage banks will allow you have in an investment property as well as annual maintenance costs of about 2.5% of the value of the home. This could also cover the cost of refinance and other costs which may not be captured in the taxes and insurance. I am assuming here that these are residential investment properties and are healed over the long term, where renters make most or all of their payments. Obviously this doesn’t capture the payment risk of renters or taking them to court but the idea here is to get a general sense of reasonable returns in various markets. The results said a lot about where to invest.
From this we can see that Florida offers potential returns of 13.9% annually after costs with Texas and California not far behind. In New York the rate of growth makes the return of the S&P 500 over the last 25 years seem more attractive as it lagged it by about 0.8% annually and in Illinois it was much better to just put your money in the stock market.
Conclusions
What these results show is that where you invest and the leverage used matters. Better real estate markets can offer returns that can potentially beat out both REIT and stock investing and this is the main attraction for real estate. It’s likely the reason why you are seeing large private equity firms like Blackstone buy up entire subdivisions to rent them in Texas, they’re betting the returns are well worth it there and if things will look like the last 30 years they may be right.
At the end of the day it also depends on the type of investor you are. If you like to be hands off and just let your money grow then stocks may be a better way to go. Additionally there is a liquidity premium in real estate which when some researchers strip this factor out, the attractiveness of real estate diminishes, here again, it’s easier to just sell stocks and get your money.
For those investors that don’t mind being hands on and even absentee landlords, the returns can be tempting. Location matters though, which is why diversifying location as well as assets is a good strategy for any investor. The debate may not be settled but hopefully you can see through my brief exercise that higher returns over long periods are possible in real estate.
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