Historical Real Returns for Stocks vs. Houses

Source: Social Security Advisory Board; Irrational Exuberance by Robert Shiller

Home prices always go up, so housing must be a good investment, right? Not exactly. Although it seems that home valuations have increased considerably over the last 100 years or so, real returns on housing have not.

According to Robert Shiller, the well known Yale economist who predicted the stock collapse in 2000, the real return on housing between 1890 and 2004 was a very modest 0.4% a year.

Stocks have fared much better. A recent study by the Social Security Advisory Board found that the real return on stocks has averaged nearly 7% per year over the last 200 years.

Source: Stocks for the Long Run by Jeremy Siegel

Adjusted for inflation, real returns on stocks have had not only a higher average rate of return than housing, they have also been unbelievably consistent over the past 200 years. Between 1800 and 1870 real returns averaged 7%. The rate of return dropped slightly to 6.6% through 1925, and rose again to 6.9% through 2004.

Real Returns vs. Gross Returns

There are tons of stories floating around about savvy investors who made big bucks during the recent housing boom. If you have read any of them, you are probably wondering how stocks could be a better investment than housing when houses have been providing record rates of returns in the last ten years.

The answer is simple: real returns over long periods are different than gross returns enhanced by external boosts made over short periods.

Real returns are the money that is made after inflation -- the true gain made from investments. In the long term, real returns are the only returns that are of any importance.

Although it is true that some people made significant gross returns over the last few years because of the change in housing valuations, these returns were not based on the sound fundamentals associated with housing, but were instead a product of lax lending standards, low interest rates, and real estate speculation.

These three factors are no longer in play, which is why the enhanced gross returns we have seen most recently will most definitely be short-lived.

Lenders and borrowers alike are starting to feel the effects of loose lending. Standards have tightened and home loan denial rates have increased considerably as a result. Interest rates have also risen since the boom.

These changes are significant because they mean less people are able to get a loan to buy a home. This decreases the demand for product (homes) and puts pressure on the market. Couple that with the swing in real estate speculation--people are finally realizing that housing isn't the best get rich quick scheme in the world--and you have a market that is forced to return to normal.

Normal means that long term home prices will fall to more realistic levels and then essentially stay flat after being adjusted for inflation. This turns housing from a 'can't miss investment' to a 'can't win investment'.

A Look at Short Term Returns

Source: Winans International

In the last 20 years, stocks beat real estate hands down. New home prices gained 268%--a mere fraction of the Dow's gain.

Ironically, the last two decades have been the most profitable period for real estate investors on record. If housing couldn't beat stocks during this period, the former doesn't stand a chance over the latter in any period.

It is also worth noting that many of the people who made money with housing over the last couple of years did so with the extreme use of leverage. In other words, they relied on debt to make a gain.

While this can work out in special cases, it can also work to an investor's disadvantage. When home prices go down--they are dropping now and will continue to drop--homebuyers stand to lose all they invested and then some.

This cannot happen with the stock market. There is almost no chance of losing 100 percent of your investment, and there is no feasible way to lose more than you invested.

Bottom line: If you are more interested in the short term versus the long term, or if you are fixated on gross returns, you can look at the graph above, consider the dangers of extreme leverage in a slow market, and still feel good about investing in stocks versus housing.