What’s a better investment, stocks or real estate? And, while we’re asking this grandiose question, what’s a safer investment?
You probably have an opinion already as to the answer to both of these questions. It’s good to have opinions about important questions. And these certainly are important questions – they directly affect how you grow your wealth.
But opinions are never as useful as facts.
A team of economists from the University of California, Davis, the University of Bonn, and the German central bank, set out to answer these questions by analyzing a stunning amount of data.
Answer it they did. Ready for 145 years of economic data, summarized over the next five minutes for you?
The Rate of Return on Everything
The lead authors of the study – Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor – reported the findings of their massive study in a paper entitled The Rate of Return on Everything, 1870-2015. In it, researchers looked at 16 advanced economies over the past 145 years. Specifically, they compared returns on equities, residential real estate, short-term treasury bills, and longer-term treasury bonds.
With each asset type, they adjusted for inflation and included all returns, not just appreciation. Dividend income was included for equities, and rental income was included for residential real estate.
Their findings, in short: Residential real estate had the best returns, averaging over 7 percent per annum. Equities weren’t far behind, at just under 7 percent.
Then came bonds and bills, with far lower returns (surprising to no one).
Equities vs. Real Estate
Rental income proved an important factor – roughly half of the returns on real estate came from rents, while the other half came from appreciation.
Equities and real estate each performed differently in various countries, of course. Here’s a comparison of each of the 16 countries when considering equities versus real estate:
Keep in mind, these are long-term averages over the course of many decades. In real time, these returns bounced up, down, sideways, and in circles.
Here’s a curious little chestnut for you: from 1980-2015, equities have, on average, performed significantly better than real estate. Across the 16 countries studied, equities earned an average annual return of 10.7 percent, decisively beating real estate’s stolid 6.4 percent.
Should we all sell our rentals and buy stocks?
Of course not. But the reasons are multiple and a bit nuanced.
First, a few outlier countries threw off the average returns from 1980-2015. Japan saw its real estate markets collapse as its population aged and started declining. In Germany, real estate has been stuck in the slow lane for decades.
Meanwhile, equities in Scandinavia have exploded.
But the most interesting case for real estate lies in its risk-reward ratio.
Of Risk and Volatility
Let’s do a quick stereotype check-in, shall we?
Treasury bonds are low-risk, low-return. I don’t think anyone’s prepared to challenge that stereotype – after all, stereotypes exist for a reason, right?
Equities are high risk, high return. This one gets a little more interesting, but a quick look at how stock markets have gyrated for the last century – up 29 percent one year and down 18 percent the next – should disabuse anyone of the notion that equities don’t come with high volatility and risk.
And that brings us to an economic assumption that dates back to, well, the beginning of economic theory. Economists have long held as a given that risk and returns are highly correlated, and that “the invisible hand” of the market will ensure that remains the case.
Why? Because if an asset were low-risk, high-return, everyone and their mother would fling so much money at it that the returns would dry up faster than Lindsay Lohan’s acting career.
Except that assumption hasn’t held true for residential rental properties.
Rental Properties: Low Risk, High Returns
Throughout modern history, residential real estate has actually boasted extremely high returns with low risk. Take a look at volatility for equities versus real estate for the past 145 years:
Brighter economics minds than mine are scratching their heads as to why that is. But since I can’t resist offering a (you guessed it!) opinion, here are a few thoughts as to why.
First, real estate is expensive. Until the past ten years, with the advent of crowdfunding, you couldn’t invest your extra $100 a month in it like you could do with stocks.
Even if you leverage to the hilt and borrow the maximum mortgage allowed, that still usually puts you at 20 percent down, plus thousands of dollars in closing costs. Which says nothing of credit requirements, income requirements, and/or lenders’ requirements for investing experience.
In other words, real estate investing has a high barrier to entry.
It’s also difficult to diversify for those very same reasons. If each asset requires $20,000 in cash to purchase it, then it takes a lot of money to build a broad, diverse portfolio.
Real estate is also notoriously illiquid. You can’t buy it and sell it on a whim – it typically takes months to do either one.
But hey, that’s also precisely why it’s so much more stable than equities.