Sunday, May 11, 2008

Housing Prices Over Past 20 years

Above is a scatter plot of annualized excess geometric average returns (above the Fed Funds) against annualized standard deviation in returns, for housing prices using the Case-Shiller index. The index has monthly observations back to 1987, for 17 municipalities (some start in 1991), for low, medium, and high-priced sectors. Thus, every observation is for a sector/city, over the 20 year sample.

As you can see, the average annual return is about 0.5%. That's the annual excess returns. After expenses, which for houses include property taxes of about 1-2%, plus broker fees (about 6% to sell), I think its safe to say the returns are indistinguishable from zero. Residential real estate has generally been thought to be a superior investment over the past 20 years, but I think this is mainly due to selective anecdotal inference.

There does seem to be a small volatility premium, in that the more volatile series had slightly higher returns. The volatility was low, consistent with intuition, and higher vol does seem to go with higher return.

Here we see a housing price index from Case-Shiller, and a housing price index that subtracts the opportunity cost, as reflected by the Fed Funds rate, labeled the Tot Ret Index. The main reason why our intuition about home prices is much rosier than reality, is that the returns that seem so certain, includes a long stretch in the nineties where the cumulative return was minuscule while Fed Funds averaged about 5% annually. A benchmark is essential, because, like an equity fund manager making money in 1999, if you ignore the opportunity cost, many investments look like great, when in fact they were not.

But what is truly amazing is that we see the improbable event that are all to common for financial time series. Prices have fallen about 20% cumulatively over the past year and a half(these are excess returns). Thus, from a standard deviation perspective, it was one of those five-sigma events (annualized vol was about 4%). Fat tails are part of almost every financial time series.


Nathanael said...

I am curious if considering the alternative to owning is renting (rather than funding a money market account), if the rent/own question might be a more practical consideration or benchmark for the typical home owner.

From this perspective, one would look at the PV of series rent cash outflows, and compare to the PV of mortgage + other ownership cost outflows + Sales proceeds inflows, and choose the one with the greater expected PV.

I suspect that the perception of of home ownership as a great investment is based on the fact that it is not just an investment, it is money that would need to be spent regardless of if it was considered an investment or a pure living expense. The fact that there is any return at all could make it a good deal.

Alexander said...

I don't believe the anecdotal evidence comes from specific cases, rather than the general phenomenon of financing home-buying via large borrowings. The return on equity is pretty outstanding when it is five times the Fed Funds (rather than equal the Fed Funds).

The hoopla around housing is really more about the general public's ignorance of leverage.

Anonymous said...

Resi property is a wonderful investment (trade) for many reasons including leverage, value add abilities, mispricings and negotiation skills, some of the negatives are the liquidity and transaction costs.

I have seen two multi-century studies, I understand the conclusion was that property tracks inflation over this time (survivor bias to consider as well), the conclusion from me being, well ok.. but there would have been many fortunes (measured in purchasing power) made on these properties over that time none the less :)

Enjoying your blog.


J. said...

Seems to me you are comparing

(a) the Case-Shiller home price index, which tracks resale value of residential real estate, single family houses,

against the benchmark (opportunity cost of the money), in this case,

(b) Fed Funds rate, which is the interest rate usually overnight.

Allow me to formulate my comment in Hungarian: You compare (a) Töke (Capital) vs (b) kamat (Interest). Töke is known to engender kamat (otherwise known as rent), so kamat is comparable to one's favorite kamat benchmark but never to Töke.

Be kind when correcting my confusion (aka senility).

Anonymous said...

A typical real estate story around here is: Bought 10 years ago for $200,000. Put $20,000 down. Now the home is worth around $350,000 and about $100k is owed. So, $20k turned into $250k while the mortgage payment was less then renting due to the tax treatment of home interest.
Seems rational.

Eric Falkenstein said...

I thought you could only deduct interest on your primary residence? I suppose if you can make it zero carry with renters, real estate might work.

Anonymous said...

In Australia you can deduct the interest on investment properties, but not your own home, a strange situation that gives a govt sponsored boost to property investors. It's been a wonderful investment since federation here more often than not and especially so in the last few decades.


Anonymous said...

There are a lot of distortions to the incentives for home ownership, and the size of the home owned ... due to the deductability of interest on the primary residence. Often, after taxes it is cheaper to own than to rent. In 2 of the homes I've owned, my (untaxed) capital gains when I sold were greater then the sum of all my mortgage and property tax payments during ownership. Not a bad deal.
But that's not going to happen on my current home. In order for that to be true, the average price increase has to exceed the (interest + property taxes). That's something like 7% a year. Not going to happen.

Anonymous said...

why geometric return? doesn't that imply the money you gain is reinvested? that would seem to be an unrealistic assumption.