When I released my videos on whether to rent or buy a home – here and here – I received a ton of comments about real estate as an investment. These past videos were about how to pay for your own housing, versus how to make money by owning and renting property to others. So, let’s take on that possibility today, for my real estate-loving commentators.
It’s true that real estate has historically been a relatively dependable asset class for investors – especially the housing versus commercial kind. In fact, over the long haul, it’s performed even better than stocks, as documented in a 2017 paper from the Federal Reserve Bank of San Francisco entitled, The Rate of Return on Everything, 1870–2015. The mean real return on global housing from 1870 to 2015 was 7.05% compared to 6.89% for equities, and it came with a substantially lower standard deviation. More returns with less risk? Sounds pretty great. And 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 relatively uncorrelated.
As appealing as it may seem on paper to become a high-flying real estate mogul, I can offer a number of reasons why cracks begin to show if you take a closer look. That’s exactly what I’ll be doing here, and in my accompanying video.
Before we continue, I’ve got a couple of caveats. First, today’s discussion refers to direct, private real estate ownership, versus REITs (Real Estate Investment Trusts). As an investor, you can readily use low-cost, evidence-based REIT funds to allocate a sensible portion of your portfolio to this asset class.
Instead, for some reason, many people seem to be drawn to buying actual properties. Everybody seems to know somebody with a dazzling success story from having done so.
Also, in talking about specific properties, it’s important to note that your return is driven by two components: the increase or decrease in the property’s value, and your net rental income. Each typically makes up about half of the total return. That’s why buying your own residence doesn’t really count as an “investment.” You’re already forgoing about half of your potential return by living in it instead.
Next, let’s explore some of the challenges inherent to seeking your fortune in private real estate.
We all know how important global diversification is in investing, so we buy index funds. It is not so simple with real estate. That 7.05% global housing return I mentioned above? of 7.05% That was based on all of the houses in all 16 of the countries in the study. Concentrate in one or a few countries, and all bets are off. If you can’t go global, you may be better off sticking with stocks.
Real estate trades in very high unit values. It is a challenge for most people to scratch up enough cash to buy their own home, let alone invest in multiple properties.
Even if you are wealthy enough to purchase houses all over the world, you’d need to manage them. If you buy a company’s stock, nobody expects you to make sure the lights stay on. But as a landlord, you get to maintain the property, find tenants, negotiate leases, collect rents, and so on. You can hire a property manager, but there go some of your returns. Now multiply that by who knows how much if you go global. This is beyond impractical.
As we also know as evidence-based investors, you’re not expected to receive extra compensation (beyond risk-free returns) for taking on the concentrated risk of owning a single asset. Since you’re better off being diversified across the whole asset class, you’re essentially taking on extra risks with little expectation that your return will be any better for it. I’m not saying you can’t do well by buying individual properties. Cleary, many have. But if you do, it’ll be far more a matter of random luck than deliberate planning.
I know, I know. Some of you are probably thinking you’ve got what it takes to do better than those average, ho-hum REITs. For you, I’ve included an illustration in my accompanying video of what you might reasonably expect from investing in a rental property in our Ottawa real estate market, based on realistic expected return assumptions. If that’s still not enough, you can follow that up with an 18-page white paper, “Housing: The Best Investment in History (On Paper),” in which I’ve taken an even deeper dive.
Again, 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 sometimes, the bigger they are, the harder they fall. With this brief blog, my longer video and/or an immersion into my white paper, I hope I’ve convinced you it should be far more cost effective and statistically reliable to gain the factor exposure that real estate offers through a factor-loaded portfolio of stocks, bonds and, potentially, REITs. This factor exposure can be accomplished cost effectively using low-cost index funds.
After that, if you’ve got some discretionary “fun money” and a fondness for fixing toilets, be my guest: Pick up a rental unit or two to manage in your spare time.
Why else is real estate one of your favourite investments? Let me know, and then be sure to subscribe to my ongoing Comment Sense Investing series. Whether it’s about property in our provinces. or castles in the sky, I’ll be sure to keep the thoughtful commentary heading your way.
