Don't Buy More Real Estate

The Wall Street Journal had an article today saying "Why Investors Should Consider Real Estate."  That's good advice for one or two of you.  The rest should burn the paper.

First, here are the basic facts about real estate and stocks:  Real estate returns have been almost as high as stock market returns over the long run.  The variance of real estate returns is roughly equal to the variance of stock market returns.  (Real estate may appear more stable, but that's a false impression, due only to real estate's lack of liquidity.  If you could trade the corner retail center on a stock market, it's price would fluctuate as much as any stock price.)  Real estate returns are loosely correlated with the stock market, but far from perfectly correlated.  The implication is that an efficient portfolio should have some of both.  Because of the lower average returns to real estate, it should have a lower allocation to a portfolio.

The numbers are open to discussion, based on the time periods over which the returns, variances and co-variances are estimated.  I urge real estate on people whose holdings are less than 20 percent of total assets; and discourage real estate from being as much of half of assets.  So 20 to 45% of your assets in real estate is OK.  Small deviations from ideal are not too bad.

Now let's look at actual holdings, turning to the Federal Reserve's Survey of Consumer Finances.  Sixty-nine percent of all families own their own home.  Only 21 percent of families own stock.  For the middle quintile (percentiles ranging from 40th to 60th), the median stock holding of families that own stock is $12,000.  The median primary residence value for families who own their home is $135,000.  (These are 2004 data; they seem low to me, but they include plenty of older housing in the Midwest and south.)  So the median holdings are vastly overweighted toward real estate.

Moving to the highest income quintile, stock holdings are quite a bit larger.  Fifty-five percent of top-quintile families own stock, and among the stock-holders, median value of stocks is $57,000.  But 95 percent of these families own their own home, with a median value of $450,000.  If we just consider the home and stocks, the top quintile is hugely overweighted in real estate.   In addition, 37 percent of the top quintile own other residential property, and 21 percent own non-residential property.  The median values for these holdings are $268,300 for other residential, and $189,000 for non-residential.

If you are anywhere close to typical, you have WAY TOO MUCH REAL ESTATE.

Note that we don't care how much equity you have in your home.  Your net worth is influenced by the total asset you own.  For instance, suppose that you own a $400,000 home with a $300,000 mortgage, leaving $100,000 in equity.  If home prices in your neighborhood go up by 10%, tell me how much your net worth rises:  10% of $400,000 or 10% of $100,000?

So who should be buying more real estate?  If you really love stocks, and have been loading up on stocks to the neglect of real estate, OK, consider it.  But if you own a $500,000 home and no other real estate, I'd like you to have $2,000,000 in stocks before you buy any more real estate.  If you have a $500,000 home and a $300,000 beach house, then don't add more real estate until you're well over $3,000,000 in stocks.

For the one or two of you who need real estate, here's how to do it.  I assume that you are not inclined to be a do-it-yourself landlord.  (If you had that inclination, you already would own too much real estate.)  REITs are easy to invest in, but their returns are not taxed at the low rate of dividends and capital gains.  If you have an IRA, load up on REITs within the IRA.  Everything coming out of the IRA will be taxed at your regular rate; no benefit for capital gains and dividends that are earned inside the IRA, so you might as well have your high-tax-rate income there.  Don't worry about the IRA being diversified, so long as your total holdings are diversified.  If you can't get all the real estate you want in your IRA, see if you can add a REIT mutual fund to your 401(k).  If you have a 401(k) from a former employer, you can roll it into your IRA to get more investment choices.

Comments

[Ruben A]

In the returns you projected, did you actually take into account the fact that most real estate is purchased with leverage? You can't leverage stocks the way you can real estate. Will the bank lend you 80% of the value of a stock so you can purchase it as an investment? And there is a much greater ability to control real estate than there is with stock. If a stock doesn't perform, you can sell it, or buy more of other stuff to diversify. But you certainly can't change the way the company does business in the stock you own. All the contrary with real estate.

Also, your article only addresses one type of ownership in real estate, and that is the type used as a residence. If you are to compare real estate with stocks as an investment, you can't simply eliminate investment properties into your equation. You can own and control real estate investments, but renters pay your bills for it.

Regardless whether a person goes real estate or stocks, they will always need to do the leg work in order for them to make a return, otherwise, the only ones making the money will be the stock and real estate brokers.