Groundbreaking New Study (called "The Rate of Return of Everything") Finds Long-term Returns of Real Estate Walloped Bonds and Treasuries...and did About the Same as Stocks.
Updated: Mar 2
A new study of all major asset classes (going back to the 19th century) finds that long run returns from un-leveraged residential real estate have trounced bonds and treasuries, and were about the same as stocks. And this didn't include the after-tax benefits of real-estate (which are substantial versus equities). Data-driven investors may be adopting a tectonic shift in strategy. Original post: January 9, 2019. Updated afterwards.
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Virtually every traditional financial planner will tell you that the public markets are the undisputed king of long-term investments (and meaning stocks along with a mix of bonds). Sure, you might dabble in some other things (if you consider it "throw away" money). But you don’t want to deviate too far from the time-tested way. Keep the overwhelming amount of your money in stocks and bonds (at least 90%+) and minimize others as much as possible. But is this actually data-driven advice? Interestingly enough, before this month, arguably, no one actually knew. That’s because no comprehensive long-term study had ever been done on the major asset classes. The data is spread out into so many different places, it was too much of a pain to assemble.
Well, this month, several intrepid researchers revealed that they’ve spent the last several years doing what no one else was willing to do...taking on this problem. They released their paper (“The Rate of Return on Everything, 1870-2015”) through the Federal Reserve Bank of San Francisco. And the result is a bombshell that has major implications for investors.
“The Rate of Return on Everything”
Their study analyzed the returns of the major investment classes: equity (stocks), bonds, treasury bills and housing (real estate). And it analyzes returns from 1870 through 2015, which is the most comprehensive look that’s ever been done.
Here’s what they found:
First housing trounced bonds and treasuries (and by 100%+).
And both real estate and the stocks performed admirably well over that time. The stock market returned a very impressive 7% real return (“real” means final return after inflation). And real estate did even better at a little over 8% (and edged it out).
Even more interesting was how residential real estate beat stocks. Normally higher performance requires higher risk. But residential real estate actually did better while being less volatile and risky.
This is the financial equivalent of having your cake and eating it too. And it was a lot of cake. In the U.S. real estate was half as volatile as equities:
Okay...But What Have You Done for Me Lately?
However, the authors argue that there's a potential hitch with looking too far back in time.
The modern era of finance (starting after World War II) is a completely different animal from the late 19th century. Back then, you could become one of the richest people on the planet by investing in steel and railroads. Today that same investment might not even keep up with inflation.
So maybe things have changed since then? So they dug into this issue and found this:
Interestingly, the modern era hasn't changed things a whole lot. Housing still walloped stocks and bonds (and by even more than before). And stocks and housing still both performed very well (and about the same). And in the modern era-only, equities edged out housing by a small amount (about a percent).
A deeper look at this is in the year-by-year decadal moving average:
So even though stocks edged out real-estate overall, there were also many years where the decadal average favored real-estate (and so "#1" status would depend a little on timing/luck).
IMPORTANT: this is only a pre-tax comparison at this point. Real-estate has much better tax treatment than equities, and post-tax returns matters most to investors. This is talked about in the section after the next one.
Why so Temperamental, Mr. Market?
Why did stocks get more volatile in the modern era? The study says there are two main factors.
First, capital gains produced a larger part of the return on stocks than they did on housing. And capital gains are the riskiest and most volatile part of an investment. (Stock dividends and real estate income are less volatile).
The second thing that happened is that stock market correlation changed after World War II. Before that, a drop in the Hong Kong stock market wouldn’t make much of a difference to your stock in the US or the UK. Today everything is interconnected, so when one goes down they all tend to go down with it.
What’s very interesting for real estate investors is that the study found that this hasn’t happened on the housing side. So if you have an air B&B rental property in Madrid, it’s remained pretty insulated from a residential property in say, Houston. Real estate is a lot less liquid and less easily exchangeable than stock, which gives it an advantage in this situation.
The Tax Man Cometh (for your stock profits)
One downside is that this study (like pretty much all) didn’t look at post-tax income. That's because it's complicated to do (and differs from country to country and also person to person). But it's the final return, so is also what ultimately most matters to every investor.
In the U.S. equities/stocks currently have modest tax benefits. Their capital gains are taxed less than ordinary income from salaries. But real estate has much more generous tax benefits. First sale profits are capital gains (like stocks). Then there’s temporary shielding of income via depreciation (which equities don't have). And then the really big one is the ability to avoid paying taxes permanently with a 1031-exchange daisy chain, which is called “defer, defer and die”.
See more in "How to invest in real-estate without paying a penny of tax (legally)" This is exceptionally favorable tax treatment for real-estate and there’s no equivalent to this in public markets.
So if post-tax treatment had been factored into the above study/graph, it's difficult for me to see how real-estate wouldn’t come on top in virtually every single year.
What does this mean?
This study is groundbreaking and debunks numerous myths. And I believe that data-driven financial advisors and studious investors will be changing a lot of their strategies. Here are the key takeaways, from my point of view.
The traditional advice, that most investors should be 90% in public markets (stocks/bonds) and 10% maximum in "other stuff", is not data-driven.
In my opinion blindly following it is unnecessarily increasing my risk, lower my diversification and reducing my total returns.
Real estate investors may wish to consider diversifying into overseas properties to minimize their volatility, decrease that risk, and improve overall portfolio performance.
Important Limitations
Before you’re tempted to dump your entire stock portfolio and put it all in a value-added multifamily real estate fund, it’s crucial to understand two important things about the study.
First, they only looked at one narrow section of real estate: residential properties. Most diversified real estate portfolios also have commercial properties (office, retail, apartments, hotels, self storage, etc.). This study says nothing about that. So we can’t yet assume that the long-term performance and risk characteristics of one will be the same as the other. (I just hope we won’t have to wait another 145 years for that report!)
Second, their performance numbers were based on the real estate being purchased with cash and without any leverage/loans. I personally have a residential rental portfolio like this, and feel it’s an excellent risk-adjusted return. But most crowdfunding and syndication investments are leveraged. This increases the return when things go well, but also increases the risk of loss when things don’t. That will most definitely change at least the risk-adjusted performance. So a person perhaps can’t extrapolate one from the other. Again, we’ll have to hope another report will take a more definitive look at this.
Third, the study calculated transaction costs based on a holding period of 10 years on the residential properties. And they based that on the average time a person lives in their house. However, the average crowdfunded/syndication investment runs only 5 years. And 5 years gives less time to ride out volatility (so that could be higher in the longer term). On the other hand, the study does confirm the strategies of investors who choose long-term real estate investments (typically 10 years). And the same is true for buy-and-hold strategies, which should also perform similarly well.
Other items: The Really Big Picture
Many (including me) have complained about how interest rates have dropped so low. When the return of a safe investment gets too low, it drives lots of people into riskier investments. This causes prices to go up, which causes asset bubbles. And when they burst, this can cause a bad down cycle. All of us are patiently waiting for “things to get back to normal” in the next 3 to 5 years.
But the study found something very surprising and interesting. Once inflation is taken into account, today’s safe rate of return falls in line with the historical average of 1 to 3%. It just seems really low because the time frame we’re comparing it to (1980s through early 2000s) were a weird historical aberration. The authors put it this way:
“Viewed from a long-run perspective, it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today. The puzzle may well be why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
This is a shocking finding. If it’s true, we’re unlikely to see the safe real-rate go up anytime soon. Or to put it in another way: the crazy “quest for yield” and all its unpleasant side effects are something we may have to put up with for a long time. And any investors waiting for CDs and treasury bills to return a decent amount over inflation very soon, perhaps shouldn’t be holding their breath.
