Stocks VS Real Estate: Bubbles Or Investments?

June 19, 2017

Stocks VS Real Estate: Bubbles Or Investments?

  • It could be argued that both stocks and real estate are in a bubble. However, the game is the same, finding a quality stock or piece of real estate at a low price is crucial for long term returns.
  • Low interest rates have inflated asset values and net household wealth, and a return to the average would be detrimental for the economy. It’s unlikely this would be allowed, but there will be volatility.
  • In the case of higher inflation, a 30-year fixed-mortgage real estate investment doesn’t look bad at all.

Introduction

I was struck when I read a while ago that the Obamas purchased a home in DC for $8.1 million.

I wasn’t struck by the purchase price as the former president will probably make more than that from speeches in a year, but what struck me was that the same house was previously sold for $5.3 million in 2014. Thus in less than three years, the house appreciated 52%. Also worth mentioning is the fact that the house first sold for $50,000 in 1928.

Zillow estimates the monthly rent to be $22,000, or $264,000 per year, or 3.2% of the purchase price per year. The Obamas stated that as they planned to live in DC for another two years, it was logical to buy.

I must say that I don’t agree on this one with the Obamas because the 3.2% rent cost is below the 30-year fixed mortgage rate. And as the Obamas plan to live there for only two years, if interest rates increase, the $8.1 million they paid for the house will look like a bubble price.

Why am I talking about real estate here on Investiv Daily when this is where we usually talk about stocks? Firstly, an investor should be less interested in the investment class and more interested in the risk reward puzzle. Secondly, by looking at other asset prices we can see whether all asset prices are in a bubble or not. Thirdly, it’s always good to compare real estate and stocks because there are always periods in time when real estate is simply too attractive to miss.

With proper use of leverage—which is easier to get, less risky, and less expensive than using margin for stocks—an intelligent real estate investor can achieve high returns. However, don’t get your hopes up as real estate prices may not look like they’re in a bubble now due to low interest rates, but it will look like they were in a huge bubble if interest rates continue to increase significantly.

Real Estate vs. Stocks

The typical opinion is that real estate is the safest investment as real estate can only go up. By looking at the period from 1975 to 2007, such a hypothesis would be absolutely correct.


Figure 1: U.S. real estate price index from 1975 to 2007. Source: FRED.

However since then, real estate prices have been more volatile than stocks. Thus, Obama’s purchase could result in a significant loss for the family when they try to sell the home a few years from now.


Figure 2: U.S. real estate vs. the Dow Jones industrial index since 2007. Source: FRED.

So if real estate is as risky as stocks, where should one invest now? My simple answer is that at this point in time, one shouldn’t invest in either of these asset classes.

This is a heavy statement, but as you can see in the above figure, both stocks and real estate have gone up significantly since 2009 and 2012, respectively. In the meantime, corporate earnings haven’t improved at all and rent income has just increased alongside inflation.


Figure 3: Rent increases closely follow inflation. Source: FRED.

A wider perspective shows that household wealth has increased significantly faster than GDP as interest rates have been in constant decline over the last 35 years.


Figure 4: Net household wealth, GPD, and 10-year Treasury yield. Source: FRED.

By calculating the ratio of household wealth to GDP, we can see whether asset values are inflated due to low interest rates or if net wealth has been growing thanks to economic progress.


Figure 5: Net household wealth to GDP ratio has been increasing since the 1970s. Source: Author’s calculations, data from FRED.

The conclusion is simple. The higher interest rates are, the lower the value of asset classes like stocks, bonds, and real estate will be. Now, if interest rates increase to where they were twenty years ago before the dotcom bubble, real estate bubble, and the current monetary easing/central bank bubble, the ratio of wealth to GDP could quickly return to an historical average of 3.5. This would mean that stocks, real estate, and bonds would drop 25% on aggregate from current levels.

Conclusion

As such a drop would have a terrible impact on the economy, I don’t see central banks allowing for higher interest rates, even if they’re currently cheering for higher interest rates. This means that in the long term, asset values will be kept relatively high because there is no other option as lower asset values would lead into a new Great Recession. Despite this, we should expect lots of volatility in the next decade. It’s also possible for it to be called the lost decade, where asset values don’t appreciate at all which would be similar to what happened in the 1970s.

Now, back to the debate on real estate vs. stocks. Both are excellent investment vehicles and always will be. The big difference between the two is that real estate is management intensive, meaning that you will have to do some painting and change a toilet seat here and there. On the other hand, with stocks, you don’t have to leave your office or home.

In the end, it all boils down to the quality of the real estate or stocks you purchase and the price you pay. If you overpay for stocks or real estate, your returns will be miserable. However, if you manage to find bargains in both asset classes, then the investment is a no brainer.

An interesting option for those who are interested in looking for real estate diversification and are willing to do the work, look for a fixed rate 30-year mortgage and a high-yield, secure, easy to rent out, low maintenance cost piece of real estate. I’m not a specialist on real estate, but I find the risk reward of such a scheme extremely attractive because in case of higher inflation, your mortgage costs will be fixed while real estate values and rent should remain stable due to inflation even if there is a recession. In such an environment, stocks would be crushed as earnings would fall and expected returns would increase.

P.S. Avoid REITs

I don’t consider REITs an investment in real estate, but as an investment in a leveraged real estate derivative. REITs are corporations with a constant expansion mindset no matter the price or logic behind the expansion, as long as the current return is higher than their debt cost.

Additionally, when things go well, the valuations of good REITs are astronomical, and thus don’t serve the purpose of protection in case of inflation as their debt always has to be refinanced and their investments are risky as they chase the highest marginal return. Don’t be fooled by an REIT with a good past performance as that performance is mostly influenced by lower interest rates.

By Sven Carlin Investiv Daily Real Estate Stocks Share: