About Me

My photo
Senior Vice-President for Research and Innovation, Professor of Theoretical Physics, Michigan State University

Friday, June 13, 2008

Equities vs real estate

Which is the better long term investment, equities or real estate? The conventional (but not necessarily correct!) wisdom for a long time has been real estate, although this may be changing with the current housing bust. Note here I mean property as an investment, not as a primary residence, which has different considerations such as saved rent, etc.

Something that complicates the discussion is that typical investors are much more familiar with the use of leverage (e.g., 10% down) in buying a house than in buying stocks. The discussion below does a good job of clarifying. I'm not sure you can buy a long-dated 5 year index call at 80% strike for 28%, but that's probably the right ball park. Note the writer is in the UK.

Related posts here (see first figure below), here (second figure below) and here.

Re: the property v equities argument

Property has naturally outperformed in the last 7 years as its a much easier asset class for an individual to leverage. So its no surprise that through the final phases of the credit bubble its done much better as much broader class of people can borrow against it.

However, over a much longer time period the relative returns havet been much different. Each has had their relative booms and busts (.com bubble, property bubble etc)

The question now is which will do better as we go from a decade of excessive leveraging to a long period of de-leveraging.

Its hard to argue for property in that context, especially as its "earnings yield" is maybe 4.5% at best after all costs, while that of the average equity is more like 8% now

You can leverage an equity investment just as much as property without the hassle of finding a tenant, the stamp costs, the illiquidity etc etc

Assume a 5 year investment horizon. Imagine you had 100k of equity that you wanted to leverage 5 times into a LT investment

A) Buy a property. Borrowing 80% of purchase price, Investing 20% of your own equity and 8% for stamp. Equating to 28% cash investment upfront all-in


B) Buy a 5year call option to buy the Eurostoxx @ 80% of where it is now. This will cost 28% as well

Economically you have the exact same exposure to leverage...if the value of either asset is 50% higher in 5 years you come out with 5.35x your original outlay (ie 150% / 28%)


Advantage of the property investment;

1- You dont see the value of the investment every day, you just optimistically assume its going higher!

Advantage of the equity Option;

1- Your maximum loss is the 28%. [If the property falls > 28% and u sell u lose > 28%]
2- Its more liquid, you can sell anytime of the day Mon-Fri
3- You dont have to find a tenant or risk cashflow issues if it becomes hard to rent or int rates suddenly spike.

The first figure below, which covers 1980-2005 (i.e.,extending almost to the peak of the real estate bubble; see second figure below), shows that equity returns have exceeded real estate returns even in the hottest markets.


Stock Market said...

I really appreciate your post and you explain each and every point very well.Thanks for sharing this information.And I’ll love to read your next post too.
Stock Market

Jesica m said...

Thiese topics and article are so information based.This is so interesting blog. You are best listing
knowledge provide at this site. I am very excited read this nice article.
George offers Property
opportunities and teaching Commercial to Residential

Blog Archive