A Rational Approach to Fitting Real Estate into Your Financial Life

How homeownership and investing fit together

May 20, 2024

white and brown house near green grass field under white clouds and blue sky during daytime — Photo by Ronnie George on Unsplash

Confesstime.

Stocks are not the asset class with the highest risk-adjusted returns. That honor belongs to real estate—or so it seems.

That was the finding of a 2017 paper titled “The Rate of Return on Everything, 1870–2015,” written by researchers from the Federal Reserve Bank of San Francisco1. Over the 130-year sample, they found the global stock market provided real returns of 6.89% per year compared to 7.05% for global real estate. Not only did real estate provide better returns, it did so with significantly less volatility.

Global real estate has provided superior returns, and the ride has been significantly less bumpy.

That makes real estate sound like a slam-dunk investment, but the reality becomes complicated when you start to look at the important caveats of the findings of the Federal Reserve paper.

Let’s dive into those complications and caveats and explore how real estate fits into a portfolio.

Homeownership vs. real estate investing

The first and most important complication we must address when discussing investing in real estate is “What does investing in real estate mean to you?”

There are two very different ways people invest in real estate.

Owning a home
Buying investment properties

Homeownership as an investment

The most important caveat you need to know is that 7.05% annual return for real estate does not apply to owner-occupied housing.

There are two ways to make money in real estate.

Collecting rent.
The value of the property increases.

You don't collect rent when you own a home and live in it, and roughly half of that 7.05% return disappears. The house you live in is not a better investment than stocks; let’s get that out of the way.

Here are a few other points that make owning a home a less attractive investment compared to investing in stocks through index funds.

Owning a home is the ultimate idiosyncratic risk

In the past, I’ve discussed the concept of idiosyncratic risk, which, in the context of picking stocks, is a risk that is unique to an individual company. Owning a home is as idiosyncratic as an investment can get.

Buying a home means buying a single unit of:

A broad asset class; real estate.
A subsector of real estate; single-family homes.
Single-family home in a particular country.
Single-family home in a particular state or province within that country.
Single-family home in a particular city within that state or province.
Single-family home in a particular neighborhood within that city.
Single-family home on a particular street within that neighborhood.

In real estate, they say the most important factor is “location, location, location,” which is 100% accurate.

Every real estate market is unique. The factors that impact the value of a home in Detroit, Michigan, are radically different than what impacts the value of a home in London, England.

Homes are riskier than you think

Before the financial crisis, nearly everyone believed that it was a fact of life that house prices in America would always go up every year. While the events of 2008-2009 disproved that belief, houses are still considered a safe investment.

That belief is backed up by the research from the Federal Reserve, which found the standard deviation of global real state returns was roughly half the standard deviation for global stocks.

What we can take from that is that owning a home will have less price volatility than a 100% equity portfolio. But remember, putting 100% of your money in stocks is very aggressive and risky. Housing being less risky than a 100% stock portfolio does not make it “safe.”

Government bonds are “safe,” but buying a house involves risk.

The question is, how much risk?

That question was answered in a 2017 paper titled “The Home as a Risky Asset,” written by David Blanchett published in the Journal of Personal Finance2. Blanchett found that owning a home was equally as risky as a 60/40 portfolio of stocks and government bonds.

He also concluded that the realized returns of homeowners are often less than inflation when you account for maintenance costs, taxes, and transaction fees. This is especially true for homeowners who move a lot.

A paid-off house provides risk-free income

I don’t want to give you the idea that owning a home is a bad idea. You shouldn’t count on your home to be your primary means of accumulating wealth. But there are a lot of benefits to owning a home.

If you bought your home using a mortgage, it creates forced savings. Every time you make a mortgage payment, a portion of that payment goes towards paying down the principal of the loan—Which makes you a little bit richer.

Nearly every developed country in the world provides major tax incentives to homeowners. For example, Americans can deduct a portion of their mortgage interest against their income. Canadians don’t have to pay any capital gains taxes when they sell their primary residence. These tax incentives make homeownership an effective vehicle in which to accumulate personal wealth.

The largest benefit of homeownership is very subtle but very powerful.

Homeownership acts as a form of rent control.

If you have a fixed-rate mortgage, your housing costs on a year-to-year basis will be relatively flat. You are not subject to the landlord jacking up your rent when market conditions allow them to do so. If you can continue increasing your income throughout your career, having a fixed-rate mortgage means that your housing costs as a percentage of your income will drop on a year-over-year basis.

As housing costs as a percentage of your income drops, that frees up more money that you can invest in index funds and build passive wealth.

Once the mortgage is paid off, your housing costs drop to the level of your property taxes and local maintenance costs.

A paid-off mortgage is like receiving tax-free income from a bond. If your mortgage payment was $1,500, paying off that mortgage is no different than receiving $1,500 per month in tax-free and risk-free income. That not only frees up more money for you to invest, but all else being equal, a paid-off mortgage increases your capacity to be more aggressive in your investment portfolio.

Rental properties as an investment

Buying a house and renting it out is a completely different investment than buying a house to live in yourself.

Rental properties are the investment that has historically provided a 7.05% annual real return. So, does that mean you should sell your index funds and go buy rental properties?

No.

If you are self-managing your real estate portfolio, you don’t have a passive investment; you have a business. Your return on investment with rental properties is directly linked to your skill at finding deals, finding tenants, and managing the property. Rental properties can be incredible wealth-building assets, but only if you are a skilled real estate investor. If you make terrible decisions, you could lose your shirt in real estate.

For some people investing in real estate will lead to financial freedom. For others, it could lead to financial ruin.

Compare that to investing in a globally diversified index fund; you invest and do nothing. Getting paid to do nothing that’s how you build passive wealth. They will never make a reality show about index investors like they do with real estate, but the boring, rational approach works.

There is another very big caveat you need to be aware of with the annual returns of real estate. That 7.05% annual return does not account for property taxes. A rule of thumb is that property taxes are roughly 1% of the value of a property. Including property taxes drops the net return on real estate to 6.05%, which is less than stocks.

Another important caveat is that to capture that ̶7̶.̶0̶5̶% 6.05% real return, an investor would have needed to have invested in all 16 countries that the Federal Reserve researchers included in their study.

Given the price of a single property and the high transaction fees involved in buying real estate, it would be nearly impossible for individual investors to build a globally diversified portfolio of rental properties across 16 countries. In contrast, the rational investor can buy a single index fund that tracks the global stock market with a few clicks.

Finally, real estate as an investment has another drawback; lack of liquidity.

If you own a rental property worth $500,000, you can’t decide to sell $100,000 worth of the property. It’s an all-or-nothing proposition. If you decided to sell the entire property, it would take weeks or months and cost thousands of dollars. If you have $500,000 in index funds, you can quickly sell $100,000 in a matter of seconds at a minimal cost.

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