Is Real Estate a Good Investment?
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Residential real estate is a unique and complex asset. Housing and rental prices fluctuate, property dwellings depreciate, ownership can involve paying taxes, insurance, utilities and loan interest, and properties are generally illiquid and costly to trade. Before deciding whether to buy or sell an investment property, it's important to understand how real estate generates investment returns and how those returns compare to other assets. Note that the decision to buy a home as your primary residence involves an entirely different calculus that relies on your lifetime balance sheet. In what follows, I utilize decades of data from the US housing, stock and bond markets to help you evaluate whether real estate is a good long-term investment for your situation.
(In this article I refer strictly to residential real estate—e.g., single and multi-family homes, condos and apartments.)
Real estate can provide rental income and price appreciation
Investing in real estate involves buying real property and renting it to someone else.[1] How much you can expect to collect in rent each year is the first component of the total return to real estate. Expressed as a percentage of the property’s value, this is called the rental dividend:
Rental Dividend (%) = Annual Rent ($) / Property Value ($)
In addition to rent, property values may fluctuate over time. How much you can expect the market value (or price) of the property to change each year is the second component of the total return. Expressed as a percentage of the property’s value, this is called the capital gain or loss:
Capital Gain or Loss (%) = Annual Price Change ($) / Property Value ($)
Adding these two components together gives us the total return to real estate:
Total Return (%) = Rental Dividend (%) + Capital Gain or Loss (%)
Figure 1 shows total annual inflation-adjusted returns to US real estate (black line) since 1954, showing both the rental dividend (yellow area) and capital gain or loss (blue area) components, respectively. (Note that capital gains are stacked on top of the rental dividend, while capital losses are folded over the rental dividend.)
Sources: Robert Shiller, US Bureau of Labor Statistics, US Dept. of Housing and Urban Development (see Appendix)
Similar to real estate, buying equity in publicly traded companies can generate both a dividend and capital gain or loss. US Treasury bonds, on the other hand, make interest payments akin to a fixed dividend and generate no capital gains or losses if held to maturity. Figure 2 shows total annual inflation-adjusted returns to 10-year US Treasury bonds (red line) and US stocks in the S&P 500 index (black line) since 1954, showing both the stock dividend (yellow area) and capital gain or loss (blue area) components, respectively.
Source: Robert Shiller
These figures illustrate that 1) average total returns and the variability of those returns (i.e., the standard deviation) have both been considerably lower for real estate and bonds than for stocks, and 2) that dividends have made up the vast majority of total returns to real estate and relatively little to stocks. (See Figure 3 in Appendix for details.) Clearly, investing in real estate has been more like investing in bonds than in stocks. This elicits an important question: What historical mix of stocks and bonds would have generated an equivalent rate of return and level of risk to that of real estate? To answer this question, we must first account for any ongoing expenses associated with real estate investing.
Real estate can be expensive to operate
Unlike investing in stocks and bonds, real estate requires significant operating expenses—not to mention time commitments and transaction costs. Such expenses typically amount to a stable percentage of the property’s value or dwelling’s replacement cost (i.e., the cost to replace the entire structure). For example, utilities and maintenance can be 3-4% and homeowner’s insurance 0.25-0.50% of the dwelling’s replacement cost, and property taxes about 1% of the property’s value. Assuming the dwelling amounts to half the property’s value, as is true in many major metro areas, total operating expenses amount to about 3% of the property’s value.[2] If you take on debt to finance the purchase of property you’ll have additional interest expenses, likely amounting to an extra 1% of the property’s value.[3]
Accounting for these ongoing expenses gives us the net total return to investing in real estate as a percentage of the property’s value:
Net Total Return (%) = (Rental Dividend + Capital Gain or Loss) – (Operating Expenses + Loan Interest)
Real estate is like a conservative mix of stocks and bonds
Assuming annual operating expenses of 3% and no loan interest, average net total returns to real estate after-inflation are just 2.8% since 1954, much lower than total stock returns (8.5%) and only slightly higher than bond returns (2.2%). Average variability of returns to real estate are 4.4% since 1954, much lower than stocks (16.1%) and only slightly higher than bonds (2.1%). (See Figure 3 in Appendix.) Clearly, investing in real estate has been more like investing in bonds than in stocks, especially after expenses!
In fact, since 1954, investing in real estate has generated an equivalent return to a portfolio comprised of just 10% stocks and 90% bonds. Since 2003, a time in which total returns to real estate and stocks have improved while bond rates have fallen, investing in real estate has generated an equivalent net return to a portfolio of 30% stocks and 70% bonds. Moreover, across both time periods, real estate has been relatively riskier (with a higher standard deviation of returns) than the stated mix of stocks and bonds! In other words, given the choice between investing in real estate vs a conservative mix of stocks and bonds producing an equivalent return, you’d always have preferred the latter.[4]
Buyer Beware
Investing in real estate involves collecting rent from tenants and capturing any price appreciation the property may generate. It also involves costs, including maintenance, taxes, insurance, utilities and loan interest—not to mention the value of your time. After expenses and inflation, investing in real property has generated a historical return of about 3%, roughly equivalent to investing in a conservative mix of stocks and bonds. Although investing in real estate can provide certain tax advantages, these are mostly an illusion worth ignoring, especially if you’re not in the highest income tax bracket.[5] Ultimately, investing in a conservative mix of stocks and bonds has consistently outperformed real estate at a lower level of risk. Although no one can predict future returns, history tells a compelling story that residential real estate may not be a particularly good long-term investment.
FOOTNOTES
[1] Note that if you buy a property and live in it yourself, it is for the most part NOT an investment. This is because you’re technically spending the “imputed” rent that you receive from the property on actually living in the home, rather than investing those dollars elsewhere. You do however retain any capital gains on the property’s value, which can be captured if and when you sell the property.
[2] Sources: Bernstein, The Investor’s Manifesto, 2012 (pg 36). Eisfeldt & Demers, Total Returns to Single Family Rentals, 2021 (pg 29).
[3] This assumes a fixed 3% mortgage interest rate, 30-year term loan, 20% down payment, and a nominal growth rate for the property’s value of 4.37% (matching the historical national average). Note that a higher mortgage rate, smaller down payment, longer mortgage term, and/or lesser price appreciation the larger the interest payments will be as a percentage of the property’s value.
[4] Investing in a mix of 23% stocks and 77% bonds since 1954 would have produced a higher return than real estate (3.6% vs 2.8%) at an equivalent level of risk (4.4% standard deviation). Investing in a mix of 46% stocks and 54% bonds since 2003 would have produced a higher return than real estate (4.5% vs 3.3%) at an equivalent level of risk (6.7% standard deviation). Theory tells us to never select a mix of investments that you expect to produce a lower return for a given level of risk, or a higher level of risk for a given level of return.
[5] Owning real estate can provide certain tax-advantages, including tax deductions for depreciation and operating expenses, capital gains exclusions, tax-free exchanges, stepped-up cost basis, etc. However, on average, such tax advantages are ultimately capitalized into market prices, making them more an illusion than a true financial game-changer. In the absolute best-case scenario where the investor is in the highest income tax bracket, all operating expenses are 100% tax deductible, the IRS depreciation deduction makes 100% of rental income tax deductible (very unlikely!) and capital gains are never realized, after-tax inflation-adjusted historical returns to real estate are about 4% compared to 6% for stocks. Using more reasonable assumptions, after-tax returns have been closer to 3% and 7%, respectively.
APPENDIX
Sources: Robert Shiller, US Bureau of Labor Statistics, US Dept. of Housing and Urban Development (see Appendix)
Additional Data-Related Notes
I could not find any publicly available data documenting long-run historical rental dividends to US residential real estate, nor could I easily create my own estimate using home and rental price data. To create my own monthly time series, I first created a price-to-rent index going back to 1953 using Robert Shiller’s nominal US home price index and the US Bureau of Labor Statistics US rental price index (monthly home price data is not available before 1953). Since I needed a price-to-rent ratio not an index to estimate the rental dividend, I calibrated the price-to-rent index using the median US home sales price in 2020 from the US Bureau of Labor Statistics and the median US rental price in 2020 from the US Department of Housing and Urban Development. Specifically, I estimated the rental dividend for 2020 by dividing the median rental price for 1-4 bedroom homes by the median home sales price. This provided a point estimate for the rental dividend (i.e., rent-to-price ratio) which I then divided by the price-to-rent index to create a monthly time series for the rental dividend going back to 1953. To confirm the accuracy of my time series data, I compared it to a 2021 analysis by the Federal Reserve and a 2021 academic article by Eisfeldt and Demers.