Real Estate in the Context of the Jorda-Schularick-Taylor Database and Publication

Real Estate
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Dear fellow Mustachians

First post from a long-time lurker here. My intention with this thread is to stimulate a discussion about real estate in the context of the Jorda-Schularick-Taylor database and the associated landmark publication “The Rate of Return on Everything, 1870-2015”.

In short, the researchers put together historical return data on the four asset classes stocks, real estate, corporate bonds and government bills for 18 industrialised countries. One of the main findings is that real estate historically performed as well as stocks (7.06% and 6.88% real annual returns, respectively).

To go into the details a bit further, the numbers given above are arithmetic means of the overall pooled data. When considering geometric means (which I believe is more appropriate due to the multiplicative nature of the underlying compound interest phenomenon), real estate even outperformed stocks by a large margin: 6.62% as opposed to 4.66%. This stark difference is due to the much larger variability of stock returns. You can find the relevant numbers in table II on page 1241 of the publication.

Now this is not the end of the story. The cool thing is that you can download the data they used under the link given above. That’s what I did, and after some data wrangling in R, I came up with the following:

country_aggregates
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When you average across countries and weight the real returns data by historical GDP (to mimick a globally diversified portfolio), stocks and real estate perform equally well with 6.6% real annual returns each. However, the upside to real estate is that the variability in historical returns has been much lower (much smaller drawdowns in particular).

Now this raises some interesting questions: Should we consider giving more weight to real estate in our portfolios? If so, how much and through which instruments? Is the study trustworthy?

For me, when I first saw the study and did the data analysis, I was about to make my portfolio 50% real estate. But now that I want to pull the trigger, I’m starting to doubt, which is why I’m putting this up for discussion. I still tend to make a large fraction of my portfolio real estate, probably through a global real estate ETF. And yes, I’m aware that I’m punished by tax in Switzerland due to the higher fraction of returns made up by rental yield which is taxed as income. I’m willing to accept that drawback for better diversification and much lower variability.

What do you guys think? Curious to read your answers.

Cheers,
Natural Ascetic

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chart

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Well, the data you show come from a relatively short historical episode with unique market conditions. Hence your sample is not only small, but also biased.

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While the global real estate ETF will not ask you to fix things in its apartment, this is priced in - dividend yields and appreciation are lower to reflect the fact that you’re paying company management do deal with tenants.

You also cannot lever it up four to one, like you can with primary residential real estate.

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Also how much of that ETF is commercial property? Lots of offices places didn’t really recover post COVID.

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While the global real estate ETF will not ask you to fix things in its apartment, this is priced in - dividend yields and appreciation are lower to reflect the fact that you’re paying company management do deal with tenants.

That’s accounted for in the study. They use net rental yields (see footnote 13 on page 1239).

You also cannot lever it up four to one, like you can with primary residential real estate.

True. If I understand you correctly, you mean buying a house yourself. If so, the tradeoff would be leverage against diversification, which can both make sense depending on the personal situation. In my case, I would opt for diversification as I’m not planning to buy a house anytime soon.

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Also how much of that ETF is commercial property? Lots of offices places didn’t really recover post COVID.

Good point. In all the real estate ETFs I looked at, a significant percentage of the fund is offices / stores / other non-residential.

But that drop has already taken place, and likely won’t repeat as home office will stay around. So on the one hand, possibly there are still a lot of unused office buildings in those ETFs / REITs which will not be profitable in the future. On the other hand, that may well be reflected already in the price of those ETFs and one could now buy at the low point after the drop :slight_smile:

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Absolutely. 17 years (since 2006) though may be a short episode „historically“ speaking - but I certainly wouldn’t consider it a short episode in a human‘s lifetime.

Also note that a Real Estate would not have failed you once but twice: in both recent performance and higher volatility (drawdown).

I guess what I’m missing is a compelling argument if, why and when real estate prices prices / income returns to the mean - or catch up to equity by outperforming the latter.

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Ok, to address that, I looked at the data in some more detail. Specifically, I looked at the time series of a hypothetical portfolio with the returns given by the time series above (bottom two panels, gdp weighted). For every year, I computed the duration until the last year when the portfolio had a lower or equal value. That is the latest possible time until break even. The results are as follows:

Duration_until_last_lower
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So periods of 10+ years without net gain seem to occur also in stocks, and actually more frequently than in real estate.

Regarding your last point, I think nobody knows. My whole point with this historical exercise is to come up with a best guess of what returns we can expect in the future based on past observations. Of course, if the expectations will prove true is a different matter.

Something else that got me thinking is the current Chinese real estate crisis. But that would be a topic for a different thread I guess.

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You also cannot lever it up four to one, like you can with primary residential real estate.

Another thought on leverage. Aren’t the REITs that are included in those RE ETFs leveraged themselves? So the ETF would implicitly also be leveraged. Not sure on this though…

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I think it would be good to have REITs for diversification, but I would be wary about adding as much as 50%! I think the key concern for me is how well they manage their balance sheet and debt, including how low their interest rate is and how long they fixed it for. I would have hoped that a well run REIT would have fixed very long rates in as they were so low and at the same time built in sufficient rental escalators to protect against inflation. I think REITs could be a decent investment but that it also requires a fair bit of research to get comfortable on them.

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With several hundred different REITs in my ETF, and the largest one making up 6%, I am confident that those risks are sufficiently diversified away. Similar concerns apply to stocks, and nobody worries about them in their stock ETFs.

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Though it is still quite a highly concentrated high sector risk - though I guess that is what you are going after. You expect RE to outperform so overweighting it and also taking the risk that the sector under-performs.

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I‘m not sure if I can share that. Why should real estate be more concentrated than stocks?

Also, I‘m not looking for outperformance. According to the historical data, real estate performs equally well as stocks, while being less volatile. So the goal is stability and diversification.

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I mean concentrated in that you have made it 50% of the portfolio.

When I think of Real Estate, I think of it as a sector. So if you look at the GICS sector rating of, say, the MSCI US Broad Market Index, you get something like:

Screenshot_2023-09-19_23-01-56
Screenshot_2023-09-19_23-01-56958×696 68 KB

Which shows Real Estate is under 3% sector weighting. You have 17x that weighting! Which is why I said it is very highly concentrated (meaning RE sector overweight).

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REITs taking a beating today. I dipped a toe in the water and started to accumulate some.

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Was setting money on FIRE on REITs this week. More going in today.

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Personally, I believe in RE investing and that it should form a substantial part of any portfolio - even for growth focused investors. HOWEVER, with any investment the key is to use a sensible MEAN of investing, and this is where I see a question-mark.

The problem with any risk based investment is that you could either face a dilution or a squeeze-out scenario. In a market where a large share of the market capitalization was publicly listed, there is less risk it materialized. Simply buy the market and you don’t care if one company screws over another one as then simply one share goes down and the other goes up. But with RE where most of the market cap was held privatly, these risks can materialize.

Hence, it is important to buy real estate schemes that are well funded; otherwise you may end up in the situation like e.g. Vonovia this year where they shareholders experience indirect dillution as they need to take up very high yielding debt… and where shareholders are squeezed out as Vonovia was forced to fire-sell at fairly low prices. Investors can’t even benefit from these fire-sale as all other listed RE Players are in the same situation; so the only way to mitigate/benefit from this was if you became a private RE investor.

Long story short: Theoretically, RE is a great idea but I don’t realy believe in REIT. Swiss RE Funds are a bit a different story and I can warmly welcome them to any investor.

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Was setting money on FIRE on REITs this week. More going in today.

Glad to hear you found my arguments convincing :wink: History will vindicate me.

I put in a (for me) substantial sum myself. Not 50% yet though.

I’ll reply to your other post shortly.

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what’s your target allocation as of now? what vehicles do you go for?

I still aim for 50% stocks, 50% real estate. Right now I’m at about 28.5% RE. Not sure yet how I’m gonna do the transition exactly. Details pending.

Right now I use this ETF. I can see arguments for and against this and other ETFs, with the choice depending on what you value. For me, this one makes sense.

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