Note this is a “vintage/classic” story that was featured in my old school, hard-copy, paper newsletter from the summer of 2007. It is reprinted (in its original form) and still holds true today.
Real estate has gotten a lot of attention lately. On the positive side, real estate benefited from the high returns over the last few years. More recently, the notice has soured due to the sub-prime loan collapse, and the softening of the overall real estate market.
Most investors hold real estate via two common ways. The first, and most obvious, way is through their personal real estate holdings. A second way, which most investors may not always consider, is that they own real estate indirectly through their equities. Many companies, particularly large ones, have their own real estate portfolio. Since you already own these companies as part of your portfolio, this provides additional exposure to this asset class. When you combine these two ways of owning real estate, most people have a significant exposure to real estate.
Despite this, many people choose to invest in real estate directly via investment properties or through real estate investment trusts (REITs). REITs are the stocks of companies that manage diversified portfolios of commercial buildings (like a mutual fund of real estate). Most research suggests that real estate has a strong performance history as an asset class. From 1926 to today, real estate has enjoyed an 11% historical rate of return. Compare that to a 10% return for US large stocks and 12% for US small stocks (Francis and Ibbotson). While that return figure is attractive, it is misleading because it is not easy (particularly before REITs) to own the entire asset class and realize that long-term return.
Other studies argue that real estate’s returns are much worse. Yale finance and economics professor, Robert Shiller, is the author of Irrational Exuberance. Looking back to 1890, he contends that real estate has produced truly outstanding returns only twice: after World War II, when returning troops were starting their families, and from 1998 to 2005, a period he thinks is a bubble. Housing’s rate of return, he argues, has to trend back to the mean of about 3% a year – barely above the inflation rate.
One of my favorite financial and economic academics, Charles Ellis, PhD, also has an opinion regarding real estate. In Winning the Loser’s Game (2002), he writes regarding residential properties, “Over the past 25 years home prices have risen less than the consumer price index and have returned less than Treasury bills.” A couple other very long-term studies (one over the last 300 years and another covers the past 700 years) show that real estate appreciates at the rate of inflation.
One of the disadvantages of real estate include it’s lack of liquidity. Investing in REITs is one way to work around this flaw if you are mindful that, as an asset class, REITs don’t behave much like property. They can drop like rocks in a well. In their worst year, they lost 17.5%. And they’ve never returned as much as they have in recent years, after benefiting from investors’ enthusiasm for both real estate and stock markets.
A second disadvantage is that it is difficult to determine the correlation of real estate to other asset classes in your portfolio. Some studies suggest that small cap stocks (which have a similar, long-term rate of return) are a better diversifier.
So do you need to run out and add real estate to your portfolio? Unless real estate is your passion, you might be better off putting your money into more diversified holdings. When you combine your real estate holdings in your homes and the real estate owned by your equities, you might already have adequate exposure to this asset class.