Risk Latte - Is Real Estate just for Consumption or is it an Investment?

Is Real Estate just for Consumption or is it an Investment?

Aditya Rana
September 12, 2010

The idea of real estate as a consumption good goes back to Adam Smith, and is modern day adherents include thoughtful managers such as David Swensen, who runs the Yale endowment fund. The real returns on US real estate, over the last century, has been negligible (see chart below). Zero! Zilch! Meanwhile stocks have returned about 6% and bonds about 2-3%.

The only periods during which real estate has yielded positive real returns, are bubble periods. And invariably, these gains (and more!) are eventually given back. Real estate is definitely an effective hedge against inflation, but so are other asset classes like commodities, gold, some stocks sectors, timber, farmland, etc.

There are ample anecdotal stories about how much money has been made on real estate over several years, but perhaps the only universal law of finance – the principle of “reversion to mean” implies that these returns are highly unlikely to be repeated in the future. Just ask the Japanese, the Americans, and the Europeans (except the British for the moment) – and this list will eventually expand to include the Australians, Chinese, Hong Kong Chinese, Singaporeans, and Indians

Various people over history have made fortunes in real estate , but on a closer look a common factor in all these stories is likely to be: they have been insiders and usually in partnership with the government which has a strong vested interest in promoting continuous appreciation in real estate values (it boost tax revenues and has a positive direct and indirect impact on GDP) through limiting supply, zoning laws and most importantly promoting leverage through the mortgage market and artificially cheap financing rates. But this process cannot continue indefinitely and invariably ends badly for most unless you are the privileged few who will get bailed out by the government!

There is a time to buy real estate (even as an investment), but at the end or beginning of the bubble cycle, and being disciplined about the exit strategy!



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