What is the True Rate of Return on Real Estate?

Posted by on March 25, 2008 in Real Estate

I am going to fully admit my bias up-front: I do not consider residential real estate a good investment. The costs of residential home ownership or upkeep of residential real estate investments are too great relative to other forms of investments (commercial real estate or residential on scale are different ballgame since the rules are different). Real estate should be considered shelter and no more. However, when real estate prices eventually find their true valuation, what type of return can only expect from real estate?

It depends on who you asked (to be as impartial as possible, despite my bias, I tried to find the high and low end)

  • Fidelity Research Institute (funded by the mutual fund giant) found from 1963 to 2006 the average appreciation in real estate was 5.9% with great regional variances. Keep in mind who funded the research but a great piece on how we have moved from viewing our homes as a an asset of last resort to leveraging the door knobs off.
  • The S&P/Case-Shiller Home Price Index found the that the value of residential real estate grew by 9.31% in the U.S. from the period of 1998-2007 (the survey period excludes the real estate crashes of the 80′s and 90′s). The study excludes new housing and any pricing out of the ordinary in a region (i.e. someone massively overbidding or a fire sale relative to other prices).
  • Jack Francis and Roger Ibbotson published an academic paper called “Empirical Risk-Return Analysis of Real Estate Investments in the U.S., 1972-1999” updated in 2004. The researchers found real estate values grew at 8.6% annually during this period (sorry, I couldn’t find the paper, I am relying on Money.com as a source).
  • The University of British Columbia Sauder School of Business summarizes nominal and real growth rate (growth after inflation) for real estate in selected Canadian cities from the period of 1985-2003. Real return growth rates varied from 1.65% to 3.89% implying real estate growth at mid to high single digits factoring in inflation.

With the exception of the last study, all the real estate growth/appreciation rates do not factor in inflation. However, assuming inflation runs at 2-5% annually, real estate returns historically are inflation protectors with a few percentage points of gain built in. All the studies find that real estate tends to return between 5%-9% but, once you subtract inflation from the return, real estate has t-bill like returns (on a pre-tax basis).

The perception that real estate is a good investment appears to derive from the fact inflation is not stripped out of the return and prices keep going up because of inflation and not necessarily a great return.

By comparison, Jeremy Siegel, in his book Stocks for the Long Run, found that the historical nominal rate of return on stock was 11.2% from the period of 1946-2006. After inflation, the return is 6.9%. All the studies cited above (with the exception of the Shiller index) show that stock had greater returns than real estate over the period studied (and the Shiller index finds REITS, which are stock, to be more profitable than real estate).

Having said that, I don’t believe the real estate market has collapsed completely (remember that the media reports on exceptions rather than the rule and ignores the 90% silent majority). Certain areas will maintain their value and certain types of housing will always be desirable. This chart is often used to discredit real estate investing altogether- careful how it is applied since it lacks any context (although I agree with Millionaire Mommy Next Door’s argument that, in some circumstances, it is better to rent than own). Real estate has its place; just don’t expect it to return double-digits over the long term. Four Pillars blogs about whether real estate investing is profitable from a slight different angle at Twice Paid.


11 Comments on What is the True Rate of Return on Real Estate?

By Traciatim on March 25, 2008 at 10:54 am

“All the studies find that real estate tends to return between 5%-9% but, once you subtract inflation from the return, real estate has t-bill like returns.”

I think that statement is false. Once you subtract inflation T-Bills have no return, and Real Estate does. Plus the gains on the T-Bills are taxed, the gain on your residence is not.

Another thing to note is that you need a place to live no matter what. What percentage of home shoppers that choose to rent are really investing the difference? I doubt very much unless you count investing in nice meals on the town as investing.

I agree with you that your home is not an investment, however it IS an inflation protector and value holder. Much like metals and commodities, sometimes they spike and sometimes they lag, but over the long haul the money you put in will be the money you take out adjusted for inflation.

In most cities, other than the run-away real estate price cities, you could buy a home for 100K with a mortgage for 6% over 25 years making a payment of about 640, add in taxes, some maintenance, and heat, city sewage/water, and you’re near 1200 bucks. You can probably rent the same or similar property for about 1200 bucks too.

Here is the trouble, Lets assume your rent, house, and costs increase all at 3% to match the inflation rate. Your income is 50K because you buy houses that are two times your income.

I realize this argument is a little moot since primarily your residence is a personal choice and not as much a financial one but I’m running through the math anyway.

At the start:
You make 50K
You pay 1200 to a house, or 28.8% of income.
You pay 1200 to rent, or 28.8% of income.

In 10 years:
Your salary will have increased to $67195.
Your Mortgage is still 640, expenses went from 560 to 752, to total $1392 (24.9%)
Your Rent would be $1612 (28.8% of income)

In 25 years:
Your salary will have increased to $104688
Your Mortgage is now 0, expenses are $1172 (13.4%)
Your Rent would be $2512 (28.8%)

So now, since of course for my story they moved at 40 and are now 65 each person is going to live of CPP/OAS/GIS and whatever government handouts since they forgot to plan for the future the whole time living life rather than looking at finances. Which do you think will have a much easier time living a ‘normal’ lifestyle?

One of them could sell their home for 200K, move to Honduras/Panama/Mexico (or whatever choice retirement country at the time), and relax until death in good weather. The other one has to stay renting because they have no assets.

By Traciatim on March 25, 2008 at 10:58 am

Actually, the renter will probably have to move, since CPP/OAS will only provide about half their income in retirement . . . So they will have to get something that’s around 1200 bucks, but in 25 years that same 1200 bucks will surely not get a rental place anywhere near what they are used to living in. Probably instead of renting a home, you’re going to be in a run down apartment somewhere . . .

By admin on March 25, 2008 at 11:19 am

Traciatim- thanks for the thorough comments. A more accurate description is real estate returns t-bill pre-tax and I will make that change accordingly. Thanks for pointing that out. I don’t substantially disagree with you about houses being inflation protectors (as stated in the post). My larger point though is that houses are substantially inflation protectors and that’s about it. If one is investing in a home thinking it will go up 10% plus year over year, statistically speaking, this would be a false assumption over a long study period.

To address your point though, in certain markets, real estate appreciation substantially outstrips the increase in rentals. In such a case, the prudent approach would be to rent rather than buy since this indicates a bubble market may be forming (especially where the increase in prices far outstrip the increase in the costs of rent). Whether people do this or not is another question…

By Canadian Capitalist on March 25, 2008 at 11:25 am

Thicken: I disagree with your analysis because it ignores a major component of real estate returns – viz. the rental income or the imputed rental income for a owner-occupied home.

That said, it is not clear to me what the total return on real estate is. Some books claim “equity-like” returns and David Swensen in “Unconventional Success” says that real estate ranks higher than bonds but lower than equities in the risk-reward spectrum.

By Hannah on March 25, 2008 at 1:06 pm

I think it also depends at how you plan on using your Real Estate: if you’re just going to be living in it then yes, you’re not going to see much appreciation over time compared to other forms of investment, but if you’re using your property as an investment, then things are different.

Buying a property and renting it for profit actually does give a good ROR. If you keep a positive cash flow, then your mortgage is paid for and any remainder is passive income. Any appreciation in the value of the land should be secondary.

Compare it to the people who purchase stocks with the intention of getting dividends. I agree that Real Estate isn’t always the best investment, but ROR for investment properties is higher than you make it seem when you consider income.

By admin on March 25, 2008 at 6:35 pm

I agree with both CC and Hannah in principal re: rental income. But I previously cited a study where less than 45% of property owners reported a profit. If you invest in real estate on a commercial or wholesale purpose than I am more willing to agree that there will be profits from rental income.

By FinancialJungle on March 26, 2008 at 4:26 am

End point bias can drastically alter the compounded appreciation of real estate. Vancouverites, who bought homes at the market top in 1980, had to wait 26 years just to recover their inflation-adjusted principal back. The lucky ones who bought 5 years ago have already doubled their money. That’s why the cited studies are all over the map because they’re measured in different periods.

A real estate investor once told me “you make money on the day you buy.” Buying a house is like buying stocks. The more attractive the entry price is, the better the return. I know many people don’t treat their home as an investment which is fine, but this is just another form of mental accounting. Every extra dollar paid in your home is one dollar less in your retirement investment account. You may not label your home as your investment, but it should be handled like one; buy the best home you can find at your price point.

To Traciatim, the rent versus buy formula is just garbage-in-garbage-out. My rent-to-value ratio is 4.7%. On the other hand, a 5-year fixed is 5.79%. Throw in 1.21% for property taxes, condo fees and insurance to round the expenses to 7%. This excludes the principal portion of the mortgage payment. Obviously, I’m better off renting and investing the 2.3% difference. This is similar to what Millionaire Mommy Next Door is doing, although in a more humble scale.

By Four Pillars on March 26, 2008 at 7:12 am

Thanks for the great post and link!


By Home Owner on May 13, 2008 at 7:51 pm

You also have to take into consideration that mortgage interest and property and school taxes are deductible. Rent is not at all. After years of renting with no equity, no investment, no tax deductions, buying a house was the best decision I ever made in terms of lifestyle and especially financially. What Suze Orman says is true. Unless renting affords you convenience that you need, a house is too much work, or you live in a place, like a city, where a large percentage of people rent, buying property (house, condo, co-op) is THE way to go!

By Home Owner on May 13, 2008 at 7:56 pm

I also wanted to respond to what was said about mortgage payments staying fixed and rent going up. For the many years I rented, it went up significantly every year. If I was retired and on a fixed or somewhat reduced income, it would have been hard if not impossible to keep up with the rent. At some point, if the rent went up too rapidly, I may have had to move out anyway to something less expensive. That probably would have meant a smaller apartment or one in an area that wasn’t as nice as I was living in. Now, I’m building equity and paying down a mortgage that is fixed and will eventually be paid off. Plus, the house offers so much more than my apartment did.

By Ask the Readers: Is Your Home an Investment? | Million Dollar Journey on March 30, 2009 at 7:34 am

[...] providing that you purchase at a decent price with affordable payments.  Real estate has proven to beat inflation over the long term by a couple percentage points, thus a long term inflation hedge.  However, it isn’t a [...]

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