Is Real Estate Best For Building Wealth?
When asked in a Bankrate study in July, “What is the best way to invest money you wouldn’t need for 10 years or more,” 28% of millennials picked real estate and 23% chose cash. Only 17% favored stocks.
This is the wrong way to build wealth.
I’m not saying that real estate per se is a bad investment. Certainly owning your own home is a great way to put down roots in a community in which you want to live. But when it comes to investing your savings for growth, it’s critically important to understand not just the return expectation for each asset class but the risk expectation as well. If you think real estate gives you the best returns with the lowest risk, you would be mistaken.
A study by the London Business School (cited by Taylor Tepper at Bankrate) found that housing returned only 1.3% per year (on average) above inflation from 1900 to 2011. Stocks, on the other hand, performed more than four times better. Elizabeth Sohmer, an analyst at Bernstein Private Wealth Management, reported that from 1975 through mid-2017, according to the Case-Shiller National Home Price Index, housing prices rose an average of 4.9% each year. The S&P 500 increased by 12.0% over that same period. More recently, from 2010 through the middle of 2017, stock returns still blew away housing returns by more than 9% annually. Even in the Bay Area, despite the tremendous run-up in home prices over the last seven years, real estate returns have failed to outpace the growth in stocks.
What about the risk (or volatility) of owning real estate? Illiquidity, one of the factors that adds to the volatility of an asset class such as real estate, at the same time masks it. The media cannot report the change in the price of your rental property on a daily basis because without a buyer there is no way to determine it. So while you hear about the stock market soaring or plunging on a regular basis in the media, the lack of reporting on real estate makes it appear to be a quiet and low-risk asset class. It isn’t. Take San Francisco housing prices for example. From 2000 through 2005 they grew by a whopping 12.7% each year (on average). A $500K house purchased at the start of the decade would have grown in value to $907K in just five years. But from 2005 through 2009, that $907K house would have dropped in value to $642K, a -6.7% average annual decline. The data firm of Crandall, Pierce & Co. further identified three other periods (from 1969-71, 1978-81, and from 1989-92) where housing prices nationally plunged by more than 15%. So much for low volatility.
The biggest argument I’ve heard extolling the benefit of investing in real estate is the leverage that you can get from borrowing money for the purchase. Putting 50% down and borrowing the rest (via a mortgage) will double the returns you can get. Very true. But what people forget is that when prices are falling, that same leverage multiplies the losses by the same amount. Let’s not forget 2008, with millions of homeowners finding themselves with mortgage balances higher than their homes were worth. Using leverage for wealth building does not help you manage risk, it exacerbates it.
In short, investing in a small amount of real estate as part of a diversified portfolio including stocks, bonds, and other asset classes in order to grow your savings in a targeted, risk-managed manner is an excellent approach. Putting all your savings into real estate, or even half, is not. Millennials, take heed!