A house is often badged as the one secure long-term investment, particularly in times of short-term volatility. But the exact opposite can be argued.
Retail investors across the globe are obsessed with real estate investments, but there is a lack of data related to home ownership generating misconceptions. When the financial markets are driven by data why do we jump to property purchases?
Just after the Second World War we had the strongest GDP growth. Between 1961 and 1970 growth was 5.5%, this is compared to the 3.8% average between 1961 and 2015. This was the consequence of a boom in investments and consumer confidence. The markets benefitted from this for decades and it marked a new cycle of leverage in the global economy which is still growing today.
The effect on financial assets and real estate was profound. From 1950 to 2009 an investment in US stocks gained 7% real return, with most of the gains in the 80s and 90s related to the wave of savers that benefited from economic growth in the previous decades who were willing to invest in the stock market. Real estate also benefited from the wealth creation of the previous decades. In the UK the real return on real estate investments had almost tripled by 2007 from an initial investment in 1975. The baby boomers grew up in an environment where real estate was not only a home, but also an investment with comparable returns to the stock market.
An investor knows that past performance does not indicate future returns, but it is not uncommon to hear that ‘real estate prices cannot go down’. Nobel laureate, Bob Shiller, commented that since homes are relatively infrequent purchases, people tend to remember the purchase price and they are surprised by the difference between then and now, but most of that difference comes from inflation. The 30% crash in property prices in real terms in the US between 2006 and 2012 serves as an example of the risk in property investments.
When you consider agency fees, stamp duty and the numerous other costs involved in the buying and selling of houses the returns are lower compared to the stock market. Liquidity and the imperfect price process make a real estate investment valuation complicated, perhaps too complicated for the average retail investor or even estate agent. Many owners fail to sell their home as they stick to the price they have in mind and buyers have issues with bureaucracy; creating liquidity issues for both parties and potentially a loss of income.
Infrequent transactions create expectations of projected returns that are often unrealistic once the sellers “face” the buyer market, thus dragging down real return. There are always exceptions, London property prices have benefited from the role of the capital as a financial centre, with a nominal return of 523% from January 1995 to February 2016. It is perceived that buyers in London have low buying power, but given the difficult time in emerging economies (big buyers in the London market) and the low level of profit in the banks (lower compensation for bankers) it is hard to see who is going to be the marginal buyer given the current unaffordability for most of the population.
Diversification is often disregarded when retail investors buy properties. Some might argue the first home is not a real investment, it has more to do with personal ambition. However, when we buy and sell our first home we start thinking in the same way as investors: Is that a good price? Is that area going to appreciate in the future? So in practice we end up in a loop of infrequent trading generating behavioural biases potentially damaging our perspective on investments.
Buying a first home is an investment; we commit our probability of wealth creation to a single investment hoping to make the right choice. But, as Shiller argues, the capital markets could be a better option for investing, not only because of the return potential, but also because being wrong with a real estate investment has more financial implications due to the level of debt created by a mortgage. Diversification in investments is important to navigate financial and economic cycles. Concentrating your wealth in property ignores all other asset classes.
Renting can be a viable option if any spare cash is invested efficiently. The common misconception is that renting costs are comparable to mortgage repayments. The reality is that we commit an amount of cash upfront to buy the flat which is going to drag the gain from cash that was previously invested.
A wise investor should be aware that investing in real estate is difficult, undiversified and is often unable to beat the returns of the capital markets.
