A comparison of market risk between real estate and stock market investments.

[gwasser]

When investing in 1973 in non-leveraged real estate, a $1.00 investment would have appreciated to $17.23 in 2010 based on Calgary`s average single family house price. Was that same dollar invested in the stocks of the Dow Jones, it would have brought in $12.63. This does not include rental income or dividends. Of course there was volatility along the way. If the same comparison was done in 2005, your stocks would have been worth $12.60 and the real estate $9.39. As often pointed out at REIN, no investment does go up in a straight line. Also, Calgary real estate appreciates faster than many other parts of Canada. In Calgary, real estate appreciates at a compounded rate of about 8% while Canada`s average real estate compounds at 6% or so. Though the rate of appreciation is higher, cap rates in Calgary are lower than Canada`s average. A 1-2% difference in compounded appreciation may not seem significant, but over the same 37 year period, $1 invested in Canadian real estate would have appreciated to only $8.64.

A lot of real estate investors feel real estate is less volatile than stock market investments. But when one compares year end stock market and real estate prices, this is not the case. Check out the graph in the figure below. Stocks trade on a daily basis and with price movements reported nearly instantaneous; while real estate prices are only reported on a monthly bases by local real estate boards. So it may seem that the stock market is more volatile, but as the graph shows, that is not necessarily the case on a year-over-year basis.

http://http://3.bp.blogspot.com/_nY...+estate+price+volatility+-+not+leveraged..jpg
Figure 1 - comparison of investment performance as the value invested of $1 in real estate compared with shares in the Dow Jones.

Price volatility is often referred to as risk, because if one is forced to sell in a down market, an investor is likely to sell at a loss. So the real issue is, whether one can hold on to an investment through good and bad times, until the investor chooses to sell the investment at a profit. That is, why buying at the right price but also selling at the right price are so important – both determine in the end how profitable the investment was.

So, if volatility constitutes risk because it may cause a forced sale at a market low, then when using leverage that risk is significantly increased, because a significant amount of the investor`s control regarding when to sell is handed over to the lender. The latter can be demanding repayment of the loan from the investor at any inappropriate time (a down market) and thus forces the investor to sell, possiblye at a loss – a loss that is magnified by the degree of leverage used. The higher the leverage is the higher potential is for loss. To get a better idea about how much higher the risk incurred is, have a look at the figure below, where the value of $1.00 invested without leverage in the real estate market or stock market is compared to a real estate investment levered at a LTV (loan to value ratio) of 80%.

I tried to copy in the figures several times - the Editor allowed figure 1 but I can`t get figures 2 and 3 posted. If you would like to see them, please, visit my blog (http://www.canadiandiversifiedinvestor.com/). Sorry for the inconvenience.

Figure 2- Investment performance of $1 invested in real estate or shares in the Dow Jones compared with an 80% LTV real estate investment. Note equity in the leveraged investment turned negative in 1985 and a new $1 investment was made after a 7 year period of bankruptcy and credit record repair.
The increased volatility of the leveraged investment is sufficiently extreme that the non-leveraged investments seem to increase smoothly. Also, the equity invested in the 80% LTV investment was wiped out in 1985. It was assumed in this simulation, that the investor went bankrupt and needed the subsequent 7 years to repair his/her credit record and to raise new equity ($1.00) before the investor was able to re-enter the real estate market to make a new 80% LTV investment.

In Figure 3, the same investment comparisons are shown but now in terms of year-over-year investment value change and expressed as a percentage of the amount invested in the year before.

I tried to copy in the figures several times - the Editor allowed figure 1 but I can`t get figures 2 and 3 posted. If you would like to see them, please, visit my blog (http://www.canadiandiversifiedinvestor.com/). Sorry for the inconvenience.

Figure 3- comparison of investment performance of $1 invested of $1 in real estate or shares in the Dow Jones with a 80% LTV real estate investment expressed in terms of the percentage of annual change.

My conclusion is that in terms of performance, non-leveraged stock market and real estate investments are comparable in terms of risk and return over the long term. However, their performance is not well correlated because Calgary real estate outperforms the Dow Jones over certain periods while at other times the Dow Jones out performs Calgary real estate. This supports the idea of investment diversification. The use of leverage adds significant real estate investment risk and increases the potential reward (returns). This risk is often mitigated by aiming for positive cash flow obtained from rental or other real estate activities. One must however ask oneself, based on the above result, whether long term stock market investments could not be enhanced in performance as well using leverage, where the risk related to volatility is offset by funds generated from dividend income and better liquidity.

 

[brentdavies]

Toronto and Vancounver have had huge run ups prior to the Calgary price explosion prior to 2006. Is Calgary`s huge gain due in part to the huge gap in prices between Vancounver and Toronto. Call it the rubber band effect, or Alberta was just stuck in the mud in the 1990`s.

Great post.

 

[Nir]

Hi Godfired, A basic rule in economics is: in an efficient market/equilibrium --> expected profit increases with effort and risk.
investing in RE requires more work than stocks. therefore I am not surprised it is expected to make more money for you.
you copied great graphs but surprisingly concluded "non-leveraged stock market and real estate investments are comparable in terms of risk and return over the long term." just look again at the first graph you were able to paste. RE performed significantly better b/c as we know in reality RE LTV >> 0. Thanks.

 

[Rickson9]

Interesting post. If an investor were investing in an entire market (ie DOW or Calgary RE) then diversification would appear to be important. Otherwise, concentration of capital into the best understood asset would be preferred. IMHO.

 

[gwasser]

QUOTE (investmart @ May 22 2010, 09:13 PM) Hi Godfired, A basic rule in economics is: in an efficient market/equilibrium --> expected profit increases with effort and risk.
investing in RE requires more work than stocks. therefore I am not surprised it is expected to make more money for you.
you copied great graphs but surprisingly concluded "non-leveraged stock market and real estate investments are comparable in terms of risk and return over the long term." just look again at the first graph you were able to paste. RE performed significantly better b/c as we know in reality RE LTV >> 0. Thanks.

First of all, I was not fired by God.

You misunderstand my point. Of course you get a higher ROI on your return with leverage, but if you would have invested $1 with 80% LTV in 1973 then (not counting mortgage pay down and positive cash flow) you would have gone broke in 1984-1985 (fig. 2 and 3). Also, the value of your investment (i.e. your equity value) would have been extremely volatile - a lot more than the stock market (or real estate without leverage). In fact, the volatility shoots through the roof - higher risk is higher return.

Figure 1 - based on year-end prices makes me also wonder whether leverage would be appropriate for stock market investing. Yes, I know about 1929, but the speculative leverage bubble in real estate that burst in 2008 caused a lot of damage too in the U.S. and Europe. In terms of investment money it may have caused just as much damage as 1929. If it were not for our much improved social safety net and the lessons that people like Carney, Bernanke and others learned from the Great Depression, we may have been now in Another Great Depression.

Not shown in my posting is the fact that if you used 65% LTV for your real estate investments, you would also have experienced a lot of investment volatility, but you would not have gone `broke` in 1985. For me, this confirms that the prudent level of LTV is 65% not 80%.

Your point regarding a better ROI on real estate investing as compensation for your work, I have already written on that extensively in earlier posts and you are right. But then you should also consider that when you invest in the stock market you will have (especially prior to your retirement) the time to take on a full time job for which you get compensated as well. So should you ad your salary to your ROI from stocks and bonds?

I am learning about investing more every day and I hope to do so for the rest of my life. I also like real estate investing it has many attractive attributes but that does not mean you have to look at it through rose coloured glasses and exclude other forms of investments! A true investor looks at all numbers not just at the ones he or she just likes. It is about putting your money to work not about putting you to work!

 

[gwasser]

QUOTE (Rickson9 @ May 23 2010, 01:08 AM) Interesting post. If an investor were investing in an entire market (ie DOW or Calgary RE) then diversification would appear to be important. Otherwise, concentration of capital into the best understood asset would be preferred. IMHO.


You are right. But why limit yourself?

Would it not have been better if you were a millionaire before you were thirty?

This is Figure 2



This is figure 3. Don`t know why it worked today.

 

[gwasser]

Now it does not let me edit my previous post to tell you that you have to double click on the icons. So it didn`t quite work after all.

 

[gwasser]

QUOTE (brentdavies @ May 22 2010, 03:18 PM) Toronto and Vancounver have had huge run ups prior to the Calgary price explosion prior to 2006. Is Calgary`s huge gain due in part to the huge gap in prices between Vancounver and Toronto. Call it the rubber band effect, or Alberta was just stuck in the mud in the 1990`s.

Great post.

I think you`re right. In the mid-80s we were experiencing a lot of unemployment and misery in the oil-patch. Not just because of the NEP but also because of the low commodity prices that helped the U.S. to boom especially because it kept inflation and interest rates low creating room for the High Tech Boom.

In the early 2000 we finally recovered in commodities spurred on by China and Peak Oil (or something similar). Hence the explosion in real estate prices in Alberta (Don`s Tiger Wood Years).

 

[Rickson9]

QUOTE (gwasser @ May 24 2010, 12:22 PM) You are right. But why limit yourself?
Would it not have been better if you were a millionaire before you were thirty?

Limits are important. And if money was the most important thing in my life I would agree.

 

[bizaro86]

QUOTE (Rickson9 @ May 24 2010, 10:57 AM) Limits are important. And if money was the most important thing in my life I would agree.

I like this. Knowing my own limits is probably the most important thing I (or any of us) can do in our investing career, and to stop investing from taking over life.

This is a good thread, the diversity of opinion is enlightening.

Michael