Real Estate is Exciting Now... Has it Always Been Like This?

An August 2005 New York Times article titled In the Long Run, Sleep at Home And Invest in the Stock Market (subscription required, but UBC students can get free access from LexisNexis) compared the historical returns of stocks to those of real estate. The article is a bit of a relief, as it contrasts nicely with the anecdotal tales of quick riches and impending doom scenarios that have played alternately in real estate media coverage over the last year.

The housing boom of the last five years has made many homeowners feel like very, very smart investors.

As the value of real estate has skyrocketed, owners have become enamored of the wealth their homes are creating, with many concluding that real estate is now a safer and better investment than stocks. It turns out, though, that the last five years -- when homes in some hot markets like Manhattan and Las Vegas have outperformed stocks -- has been a highly unusual period.

In fact, by a wide margin over time, stock prices have risen more quickly than home values, even on the East and West Coasts, where home values have appreciated most.

When Marti and Ray Jacobs sold the five-bedroom colonial house in Harrington Park, N.J., where they had lived since 1970, they made what looked like a typically impressive profit. They had paid $110,000 to have the house built and sold it in July for $900,000.

But the truth is that much of the gain came from simple price inflation, the same force that has made a gallon of milk more expensive today than it was three decades ago. The Jacobses also invested tens of thousands of dollars in a new master bathroom, with marble floors, a Jacuzzi bathtub and vanity cabinets.

Add it all up, and they ended up making an inflation-adjusted profit of less than 10 percent over the 35 years.

That return does not come close to the gains of the stock market over the same period. The Standard & Poor's 500-stock index has increased almost 200 percent since 1970, even after accounting for inflation.

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That does not mean real estate is a bad investment. It is often an important source of wealth for families. But its main benefit is what it has always been: you can live in the house you own.

The author discusses how availability bias has helped to persuade investors that real estate is not as risky as stocks, and also makes an important observation about leverage: it can do great things for returns in the short term, but the benefit disappears quickly as a purchaser repays a mortgage.

Eighty percent of Americans deemed real estate a safer investment than stocks in an NBC News/Wall Street Journal poll done this spring, while only 13 percent said stocks were safer.

Part of that sentiment is driven by the recent memory of the stock market collapse in 2000. Many homeowners seem to have forgotten that less than 15 years ago house prices in the Northeast and California fell, but the money they lost on technology stocks is still fresh in their minds.

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Economists caution that any comparison between real estate and stocks is tricky, because real estate is typically a leveraged investment, in which a home buyer makes a down payment equal to only a fraction of a house's value and borrows to finance the rest. While it is possible to borrow money from a brokerage firm to buy stocks, most individual investors simply buy the shares outright.

When home prices are rising, the leverage from a mortgage lifts real estate returns in the short term. Someone putting down $100,000 to buy a $500,000 home can feel as if the investment doubled when told that the house is now worth $600,000.

But the power of leverage vanishes as homeowners pay off the mortgage, as the Jacobses have. Leverage also creates more short-term risk, especially for those who have stretched to afford their house.

Perhaps most interesting is the suggestion that real estate often turns out to be a good investment for individuals because its illiquidity prevents them from being as bad at investing in this asset class as they are in others:

But economists and investment advisers say that most of the value from real estate comes not from anything that can be captured by flipping it, but from the safety net it provides in bad times. Even if the market shifts downward, "you have a roof over your head," said Jonathan Miller, a real estate appraiser in Manhattan.

Beyond the shelter it provides, the biggest advantage of real estate might be that it protects people from their worst investment instincts. Most people do not sell their house out of frustration after a few months of declining values, as they might with a stock. Instead, they are almost forced to be long-run investors who do not try to time the market.

Harlan Larson, a retired manager of car dealerships near Minneapolis, still regrets having bought Northwest Airlines stock at $25 a share a few years ago. It is now trading at less than $5.

By comparison, he views the four-bedroom home he bought for $32,500 in 1965 -- or about $200,000 in today's dollars -- as a money tree. He and his wife recently listed it for $413,000. That would translate into an annual return of 1.2 percent, taking into account inflation and the cost of two new decks and an extra room.