Real estate may be a better — and safer — investment than I thought. This is my conclusion after reading a comprehensive study published this month titled, “The Total Risk Premium Puzzle.”
To revisit our previous understanding, it has been widely accepted that equities yield real returns much higher than those of government securities. By most estimates that gap is about 6.5 percentage points; while government bonds might offer an average return of about 1 percent a year, for example, equities return about 7.5 percent a year (the precise figures depend on the data sample). Equities, however, are much riskier, and so there is a trade-off between risk and return. So far, so good.
The returns to real estate are harder to measure, both over time and across countries. One difficulty is measuring the “imputed rent” return — that is, if you buy a house you also get the pleasure of living there and don’t have to pay rent elsewhere. But many analysts doubted whether the return to U.S. housing was robust over, say, the 1890-1990 period.
The authors of the aforementioned study — Òscar Jordà, Moritz Schularick and Alan M. Taylor — have constructed a new database for the U.S. and 15 other advanced economies, ranging from 1870 through the present. Their striking finding is that housing returns are about equal to equity returns, and furthermore housing as an investment is significantly less risky than equities.
In their full sample, equities average a 6.7 percent return per annum, and housing 6.9 percent. For the U.S. alone, equities return 8.5 percent and housing 6.1 percent, the latter figure being lower but still quite respectable. The standard deviation of housing returns, one measure of risk, is less than half of that for equities, whether for the cross-country data or for the U.S. alone. Another measure of risk, the covariance of housing returns with private consumption levels, also shows real estate to be a safer investment than equities, again on average.
One obvious implication is that many people should consider investing more in housing. The authors show that the transaction costs of dealing in real estate probably do not erase the gains to be made from investing in real estate, at least for the typical homebuyer.
Furthermore, due to globalization, returns on equities are increasingly correlated across countries, which makes diversification harder to achieve. That is less true with real estate markets, which depend more on local conditions. So buying real estate in different countries, if you are in a financial position to do so, is a good way to diversify, in some ways better than equities.