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One reason real estate is such a compelling investment is due to leverage. By mortgaging a property, investors put very little of their own equity into a property. Over the long term, as property values rise, small gains in total value provide a large investment return on the investor's equity. However, there's a price to pay for this leverage: the risk that even a small drop in value wipes out the investor's equity. Investing with leverage is risky business, as many home owners and investors have recently discovered.
However, for those investors who are in for the long-term, and can weather the down cycles, real estate offers a terrific investment. The reason is that property values, mortgage rates, and rents are relatively stable, and their combined volatilities tend to reduce overall volatilitiy of the combined return on investment.
We calculate return on investment as a combination of growth in asset value (property appreciation) and net rental income. We use historical rates of return on investment and its volatility to calculate the Sharpe Ratio, one quantification of risk-adjusted returns. Sharpe Ratios of private residential real estate investments are much higher than the Sharpe Ratio of the stock market.
The effect of mortgages, or leverage, is to increase both the volatility as well as the returns on an investment. By dialing up the leverage, we can match the risk on our investment in real estate to the risk normally found in our investments in the stock market. At that equivalent level of risk, the returns in real estate could be as much as 50% higher then the stock market.
There are a number of reasons why real estate has better risk-adjusted returns:
- The Federal government favors home ownership, and facilitates home ownership with policies that facilitate borrowing, stabilize the cost of borrowing, and support stable home values. These policies include monetary policy and tax policies for example.
- Houses have inherent utility, so there is always demand for housing, and both our population and economy are growing, so demand for more and better housing is continuous over the long term.
- Housing is "sticky": it's hard to sell houses quickly, compared, for example, to equities traded on electronic exchanges. That means that changes in value tend to be much less volatile because housing prices don't respond quickly to news events and policy changes.
- The actual "market makers" who are the "buyers of last resort" for single family properties are typically private investors. Unlike highly regulated exchanges and financial processes which provide transparency into, and quick response to, asset values, the private investor market offers little transparency and little or no fungibility between markets. In other words, pricing is set locally and privately, so national events have less of a systemic impact on real estate values. For example, a change in treasury rates has an immediate impact on the pricing of bonds or stocks, but a less immediate and less defined impact on the decision of individual investor contemplating the purchase of a new property.
