Taking a Realistic Look at Real Estate

A few naysayers like Yale's economist and real estate expert Robert Shiller have been warning about the real estate bubble for some time now. Many investors have learned that investing in real estate is no more a sure thing than buying emerging market stocks on margin. That makes now a good time to take a realistic look at real estate as an investment and compare it to its best alternative, stocks.

Historical Returns

The first question to ask about any investment is what range of returns can be expected from it over time. Most people—especially those who live or invested in hot real estate markets such as California, Florida, and New York City—will be shocked to hear that, over the long run, real estate has provided an inflation-adjusted return of about 0% per year compared to an average annual inflation-adjusted return of about 7% for stocks. According to Shiller's numbers, there have been only two pronounced boom periods in real estate: the first after World War II and the second from 1998 to 2005.

Of course, in real estate location is everything, and talking about national averages is not meaningful the same way as talking about the S&P 500 is for stock investments. Nonetheless, in real estate identifying areas that will boom next before prices go up is as difficult as picking the next winning sector in the stock market. In both, most investors get sucked in too late.

Beyond a record of providing much higher returns, the stock market has another advantage. To earn the historically higher return of the stock market, you do not have to identify the next hot sector; you can just buy a broad-based index fund.

The second question to ask about any investment is how risky is it. In this respect, real estate comes out ahead provided you do not buy into a red-hot area at near-peak price. In general, real estate is not just less risky, it also feels less risky because in a down market the falling price of your real estate investment does not haunt you the same way the falling price of your stock investments does.

The Good and the Bad

Real estate also offers well-known leverage and tax advantages. You can buy real estate with a 20% or even a 5% down payment. Of course, leverage is a double-edged sword, and your investment in any highly leveraged investment can be wiped out by even a small downturn. Leverage makes real estate investment riskier than the underlying property. Nonetheless, in the case of real estate, if you keep making your mortgage and tax payments and keep up the property, you can ride out a downturn. On stocks bought even with a much lower 50% margin, you are more likely to get forced out of the market in a downturn because of the significantly higher volatility of stocks.

Similarly, a real estate investment offers certain well-known attractive tax benefits. On the other hand, stock investments are much more liquid, have much lower transaction costs, and can be diversified more easily. And they take a lot less knowledge and investigation if you are willing to use index funds and be a long-term investor.

Despite the few advantages and myths of real estate as an investment, it is not a sure and easy road to riches. Real estate is a good part of a diversified portfolio and you should have a certain amount of real estate investment in the form of your home and probably one or more good real estate investment trust (REIT) mutual funds. Above all, do not get into over-leveraged real estate positions in a speculative market with unrealistic expectations.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.