Real Estate’s Curious Place

By: Dylan B. Minor PhD, MS,CFP®, ChFC, CLU, CIMA®
Doctorate in Business Economics
Chief Investment Officer

“No real estate is permanently valuable but the grave”
Mark Twain

“The first man who, having enclosed a piece of ground, bethought himself of saying This is Mine, and found people simple enough to believe him, was the real founder of civil society.”
Jean-Jacques Rousseau

Real estate is a curious kind of property. Many literal and figurative wars have been waged over particular pieces of property. Duals have been fought and lost over it. It has destroyed peoples’ financial well being, and saved it. Some people love it and some people hate it, but the fact of the matter is it is here to stay, to be owned, rented, leased, and improved upon. It is thus important to understand how real estate should be a part of one’s investment plan.

Real estate falls into a special class of assets known as a use asset. Such assets include anything of value that also has a tangible use: jewelry, art, cars, machines, and so on. Some use assets (e.g., machines and cars) can depreciate over time with their use, even drastically. Meanwhile, others—such as fine art—can later be worth more than when you first started enjoying them. Being a use asset means that real estate can (potentially) generate a return from two sources:
selling its use
appreciation in value

In addition, the owner may consume the use return (i.e., by living there) and receive any appreciation from the sale of the property. In contrast, one could own the use of a piece of real estate through a long term lease but forgo the ownership of its appreciation.

Real estate being a use asset can also create some market failures—i.e., failed sales. Use assets, such as a car, art, or a personal home, often are valued differently by the current owner than the next buyer. A home might have witnessed a child’s first steps or graduation party. Such memories are hard, if not impossible, to separate from our personal valuation of the property. Meanwhile, a potential purchaser does not generally share such memories and will thus not pay a penny extra for them. Also, a seller may really value certain aspects of a property such as its proximity to certain places, whereas a potential buyer may have a completely different valuation structure: wishing farther things to be closer and caring not if closer things were farther away. Many times, due to the idiosyncratic nature of real estate, potential sales often fail because of these matching problems. Limited price feedback along with the fact you can only generally sell (roughly) a single share of your entire real estate asset, make the problem of selling a property even more acute. In sharp contrast, consider another market like the stock market: it’s quite easy to buy and sell shares on any market day, as well as easy to know a share’s value at any given moment.

All of these characteristics of real estate can create some confusion in how to account for this asset in an overall investment plan. Should home equity be considered part of a portfolio for strategic management purposes or not? How about a commercial property or second home? And if not, how does one consider such asset in one’s investment plan? To answer these, first we turn to recent history.

The Recent History (and Future) of Residential Real Estate

Many of our clients today started buying homes in the 70’s or early 80’s and thus probably experienced dramatic returns on the value of their personal residences. As such, until 2007, many had unrealistic expectations on the future return of the value of their home. Instead, we have now witnessed many housing markets go back to what they were selling at some 10 years ago, wiping away a decade of growth, and radically altering long run historical growth rates of real estate.

For example, the median price of Santa Barbara homes and national homes, for that matter, have appreciated an average of roughly 3% per annum over the past 20 years (source: Federal Housing Finance Agency). For this same period, inflation in general was roughly 2.5% annualized. If one accounts for the fact that a typical home today has better technology and greater square footage, the value of homes have grown no more than inflation. Indeed, 50% of homes built in 2007 were roughly 2300 square feet or more, whereas 50% of homes built in 1977 were only 1600 feet or more (source: US Census Bureau). Meanwhile, gross national rents, which, of course, vary greatly region to region, have been roughly 4.5% of home value per annum. If one backs out typical property taxes and estimated maintenance of 1%-1.5% per annum, this produces a net 2-2.5% per annum income return on the value of the property. Thus, over the past 20 years, the average return on single residential property has been around 5% per annum. If one lived in her house, then the rental income portion was simply consumed as a use asset. Is this a good or bad return? In my view, this was a reasonable return for such an asset.

But what will happen to residential real estate in the future? Some put long term norms of the price of real estate to be some 3-5 times average family income. On a national basis, real estate 20 years ago was selling for roughly 4 times national income. At the height of the real estate bubble this was a little over 5 and now it stands around 4.5 times national income. Although this is not necessarily a harbinger for an additional 10% fall in the value of real estate to recalibrate back to the ratios of 20 years ago, it does suggest real estate is at least “not cheap.” Nonetheless, if including the net value of rent, the total return of 5% on a debt free single residential home represents the historical investment return. If instead, living in the home, one captures a long run average return of 3% annual growth. For comparison, we now consider Real Estate Investment Trusts (REITs).

Real Estate Investment Trusts

REITs are public companies that specialize in buying, selling, and managing real estate. They typically specialize in different niches and can invest in everything from residential multi-units to commercial buildings, from medical buildings, shopping malls, student housing, and even self storage properties. Generally, their investments produce substantial income and REITs are required by law to distribute the vast majority of any income created. As far as market size, one can infer from the FTSE Developed Real Estate Index that the current REIT market is close to a $1 trillion dollars. For comparison, according to the Wilshire Total Stock Market index, the total US stock market is worth about $12 trillion.

Currently, the REIT index fund the Dow Jones US Real Estate index has a current yield of roughly 4% per annum. That is, net of expenses, the REIT companies comprising this index are providing roughly 4% of annual income. For comparison, the largest US companies, as represented by the S&P500, are currently providing an average of roughly 2% per annum in dividends. But what about total return?

Over the past 20 years, as measured by the FTSE REIT index, REITs have averaged over 11% per annum, whereas the S&P500 has averaged close to 8.5% per annum—these returns include both dividends and price appreciation. However, while the S&P500 historical return is, in my view, a reasonable long term return expectation, the past REIT return is not. In my opinion, its past return was inflated by the confluence of plummeting interest rates and sky rocketing property values. Instead, with the income for REITs, based on their historical average of 4% (source: Cohen & Steers) shows an 8% per annum total long run return for REITs. Please keep in mind that past performance is no guarantee of future returns.

As always, at Omega, we utilize many other assets classes beyond US stocks and incorporate them into a strategic portfolio based on how they balance out the other portfolio asset classes through their sensitivity to different kinds of economic factors. As such, we have recently begun to increase our exposure to real estate through REITs. Why REITs over direct real estate? First, we never use direct real estate as part of a portfolio because of its illiquidity. REITs, in contrast, are publicly traded on regulated exchanges and so it is very easy to both obtain a market quote to determine its current value and to dispose of it in a low cost manner. In contrast, direct real estate can take months to sell and at much higher selling costs compared to REITs. Second, unless a direct real estate investment is over $10,000,000, it is difficult to obtain adequate diversification, both regionally and to the type of property (e.g., apartments versus a retail mall property). Third, REITs are available in small denominations, making them available to those with real estate portfolios under $10,000,000, and also allowing for effective rebalancing. For proper risk management, strategic rebalancing and tactical tilts are important. However, if one’s real estate exposure is a direct holding, apart from pulling a couple doors off the home and selling them on EBay, it may be hard to shave just a portion of the property value off and invest that into say more hedge funds. Contrarily, it can be a challenge to add a slice of money back into a direct real estate holding via adding say additional doors or nicer doors. Lastly, one can have access to a portfolio of REITs that is professionally managed at just a fraction of the cost if instead holding direct real estate (whether one is themselves the property manager or they hire a professional manager).

Direct Real Estate and Portfolios

So what place does direct real estate have in a portfolio? At Omega, direct real estate, including your home, enters in to your overall investment plan based on your estate planning strategies. It also indirectly enters into your investment management plan. When you own a property, you can either receive rental income or benefit from not having to pay rent, leading to less overall annual income needed. Therefore, ceteris paribus, less of an income need can lead to a bit more of an aggressive portfolio mix. Alternatively, it can also mean you do not need as high of an investment return to meet your financial goals, and thus for your situation, you actually will take on less risk. The course of either of these depends on your own unique situation. In this spirit, if you would like to learn more about how to incorporate real estate and other non traditional asset classes into a portfolio, or would like to learn more about our proprietary financial management process Optimized Wealth IntegrationTM, please feel free to write or call.

Omega Financial Group is a Registered Investment Adviser. This brochure is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Omega Financial Group and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Omega Financial Group unless a client service agreement is in place.

Since no one manager/investment program is suitable for all types of investors, this information is provided for informational purposes only. We need to review your investment objectives, risk tolerance and liquidity needs before we introduce suitable managers/investment programs to you.

Omega Financial Group does not provide tax or legal advice. There may be tax implications associated with buying and selling real estate which should addressed with your tax advisor.
The indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index.

Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions.

The FTSE Developed Real Estate Index is designed to represent general trends in eligible real estate equities worldwide. Relevant real estate activities are defined as the ownership, disposure and development of income-producing real estate. The index measures the performance of REITs listed in developed markets outside the U.S.
The Wilshire Total Stock Market Index is a market capitalization-weighted index composed of more than 6,700 publicly-traded companies. This is one of the broadest indexes and is designed to track the overall performance of the American stock markets.

The Dow Jones Wilshire U.S. Real Estate Investment Trusts Index measures the performance of publicly traded real estate securities, excluding the U.S., with readily available prices. The Index is the ex US Real Estate Investment Trusts component of the Dow Jones Wilshire Global REIT Index and is comprised of REITs and REIT-like securities.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.

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