I wrote earlier this year that New Year’s resolutions tend to fail because goals are set which ignore the realities of the market. Many commentators have also wondered how perfectly intelligent people can buy into Ponzi schemes promoting unrealistic returns. Therein lies the problem. Most average investors have no conception of what an “average” return on stocks or real estate should be. As a result, there is no internal metric to determine risk/reward and a statement such as “you can return 12% in stocks” are thrown about causally without some context to determine whether this statement is realistic are not.

What then are realistic expectations of return on stocks and real estate?

STOCKS

Jeremy Siegel notes that total nominal return (return before inflation) for stocks from the period of 1802-2006 was 8.3%. What we witnessed from 1985-2006, where nominal return was 12.4%, was a historical anomaly. To use an often-quoted phrase of 2010, the “new normal” should be a reversion to historical mean.

However, one never uses the past to predict the near future. To realistically predict future expectation of growth, one uses the Gordon Equation which is (dividend yield + dividend growth rate). The S & P 500 dividend yield was 2.0% in 2009. It has been predicted that the S & P 500 dividend growth rate will be 6.1% in 2010 (according to Business Week, the historical dividend growth rate is 5.56%) . In other words, the “experts” predict expected equity return of 8.1% which falls within the historical range.

Practically speaking, and let’s assume high single digit growth does come true, subtracting inflation and transaction costs, a realistic real return for most retail investors should be in the range of 5-7% if one tracked a broad based index; aim for this sweet spot and one has a reasonable expectation of return without subjecting oneself to above average risk.

Any investment that is advertised to yield greater than this  range requires a greater risk tolerance on the investor. Thus, anyone pitching an investor a product returning 10-15% this year is not lying but is implicitly asking the investor to undertake a large amount of risk. The question is not whether the 10-15% return is realistic but whether one has the stomach to suffer loss in the event the manager reaches too far to attempt to produce such return.

Remember one of the key rules of investing: never invest any money you cannot afford to lose.

REAL ESTATE

Admittedly, since all real estate is local, the following is a broad based review and not an indication of local conditions.

Appreciation

To quote William Bernstein:

“..the best data on house price suggests that after taking inflation into account, the answer [to how much a house appreciates] is slim to none. These data focuses on historical data from three nations.  Real house prices (TMW- in other words after inflation return) in the United States did not rise at all between 1890-1990…Thus, at most you will receive a 3 per cent real (1 per cent price increase plus 2 percent net ‘dividend’) return on your home …”

The study Bernstein cites on real returns from 1890-1990 is a 2006 piece by Robert Shiller. Shiller, as many of you know, was one of the more famous economists who called the housing bubble before it burst.

Income  from real estate

The standard way to measure return on real estate is to determine the capitalization rate or cap rate. A cap rate measures expected asset level return. It is calculated by: annual net operating income/cost.  For example, a rental property nets $10,000 of rental income on a $100,000 purchase. Thus, the cap rate is 10%. There are downsides to using cap rate to determine return but it is generally viewed as a standardized measure of income production from real estate.

It is difficult to determine cap rates for smaller rental properties or non-institutional real estate investors. Collection of data would be difficult given the hundreds of thousands of real estate investors who would have to give honest feedback to someone.  However, data is much more readily available for institutional based commercial real estate. To this end, the National Council of Real Estate Investment Fiduciaries states that historical commercial real estate cap rates is approximately 7.6%.

Cap rates for most retail real estate investors may be lower than 7.6%. Most commercial leases work on what is known as a triple net basis. In plain English, the tenant has to pay for all of its proportionate costs of the leased premise including taxes, operating costs/maintenance and insurance. Most commercial leases  grant the landlord the right to adjust these costs retroactively if their estimates were off.

Smaller real estate investors, especially operating in rent control regulatory regimes, are granted no such right to full recovery (not to mention the opportunity costs of tending to the property which commercial landlords hire managers to carry out). Accordingly, small scale real estate investing may have a cap rate lower than 7.6% analogous to stock return being eroded by transaction costs.

If we assume that there is some slippage between institutional and non-institutional real estate investors, one is left with a cap rate within the range of 5-7%.

WHAT DOES THIS MEAN TO YOU?

The above suggests that “magic beans” promising returns of double digits over the medium to long term is accompanied with higher than average risk tolerance. If one cannot stomach such risk, then Jack- he of a long investing horizon and no assets to lose- may be better off buying the beans instead.

What strikes me about the data is how unrealistic investors became about expectations of return over the last 10-15 years. A real return of 4-6% in the stock market or in real estate investing is nothing to sneeze at (consider that most non-managerial salaried employees receive raises of 3-5% in good times which is really a 1-2% raise after inflation; this tends to suggest prudent investing yield greater year over year return than human capital). Perhaps there is nothing wrong with the stock market or real estate market. There may be, instead, something wrong with our expectations.

It is interesting to note that nominal return on stocks and real estate are similar; if you add in the 1% appreciation plus the 7.6% cap rate, you end up at 8.6% nominal real estate return vs. 8.3% nominal return on stocks.

What it suggests is that, in a vacuum, opportunity costs between the two assets classes is not material different. However, what Bernstein overlooks is that real estate appreciation, small as it is on a global basis, is tax-free in many jurisdictions as it pertains to the principal residence.

There may be a greater tax effect on stock sales depending on what jurisdiction you live in (some jurisdictions outside North America have no capital gains tax on stock sales).  Stock investing is a “passive” compared to real estate investing. This raises the question of whether the government tax policy on real estate is a recognition that sweat equity has been contributed which should be rewarded with better tax incentives.

To go back to my initial point, the above are average expectations of return based on historical data. There are obviously local effects and greater or lesser than average returns in short-term transactions. But again, the question is not whether one wants higher returns- we all do- but  does one have the risk tolerance to pursue such returns?