The real deal on real estate | Ben Esget

By Ben Esget
Contributing Writer 

For some time I have thought of real estate as having a cult-like following.

People talking about real estate seem to share commonalities with those looking for the mothership—reason goes out the window. Lately it seems that everyone sees real estate as the investment of choice, which offers the highest rate of return and greater safety.

To prove my point, I took one of our younger employees out to lunch and asked him to give me his views on real estate, unprompted. He told me he viewed real estate as a consistently low-risk investment that has generated reasonable returns.

I asked him what he expected real estate to return annualized over the next 40 years, and he replied 10-15 percent unleveraged. He did say, however, he was cautious because of the crash. Even savvy investors seem to believe that 8-9 percent is very reasonable.

But the truth will set you free.

According to data from the National Association of Realtors, real estate has been one of the worst performing asset classes (unlevered) for the last 37 years. From 1974 to today, home prices nationally have appreciated at 4.6 percent, annualized. A diverse range of assets have substantially outperformed real estate over the same time frame. (Click on the chart below)

Those numbers do not tell the whole story on real estate.

During the period above, the average home increased in size from about 1,200 square feet to 2,000 square feet, which brings the unleveraged return on a home to about the rate of inflation. Real estate returns generally include the rents received, as well as leverage, and are offset by real estate taxes, maintenance and property management.

To recreate a typical rental scenario, I ran the numbers through my spreadsheet and came up with historical rates of return of roughly 5.8 percent, all factors included. Coincidently, this is the exact rate of return from the average publicly traded REIT over that period.

This 5.8 percent makes sense logically, as well. Unleveraged real estate returns in the longrun should be capped at the cost of inflation. The CPI consists of roughly 40 percent housing costs. If housing were to appreciate faster than inflation for a length of time, it would become a much larger component of household income, and the CPI would either be adjusted to reflect that or people would just quit using the CPI as a gage of inflation.

The gap would eventually become large enough that the housing price index would become a better indicator of the cost of living than the CPI.

While 5.8 percent is a reasonable return, it still is not impressive enough to spur a cult-like following. I believe the reason that investors are enamored with real estate is something known as the recency bias, a well-established logical flaw in investors’ brains that overweighs the recent past in our predictions of the future.

Since 2000, the returns of real estate have been well above the long-term average of 5.8 percent—roughly 7.8 percent by our calculations. During this time most other asset classes have performed terribly.

During 2011 and 2012, real estate has been the best performing asset class according to Vanguard. (Click Graph 1 below; green is the NASDAQ, red is the S&P 500 and the blue is the Fidelity Real Estate Fund)

Going back further (Click Graph 2 below) you see a much more realistic view of real estate returns.

It is my belief that the cult of real estate is being held up by the Federal Reserve’s ridiculously low rate policy. Instead of letting real estate decline to a supply and demand balancing point, the Fed has held the cost of capital so low that it has made highly levered assets much more attractive than they would be otherwise.

While real estate has had healthy returns for investors, I believe that today’s real estate investor should be prepared for large regressions to the mean in terms of performance and probably a long period of dismal returns as monetary easing policies eventually come to an end. During this time, I also fully expect the number of real estate agents to regress to the mean as the cult finally dies.

We reviewed the FHFA housing data for Whatcom County from the period of 1979 through 2012 and discovered appreciation in home prices have not kept pace with the national average. During this period, Whatcom County home prices only rose by 3 percent, a full 35 percent lower than the national average.

There are two ways you can look at this data. You could say that our area lags the rest of the nation because it has lower job prospects and slower wage growth. Or, you could say that Whatcom County has lagged the rest of the country for so long that it is undervalued relative to the rest of the nation and should start catching up.

I can make reasonable arguments for both positions.

Wages definitely are much lower here than many other parts of the country and relative to wages, real estate already seems very expensive. On the other hand, technology is making telecommuting more viable, and many people choose Whatcom County as a place to live for its beauty and community.

As the telecommuting trend picks up speed, wages may not be as contingent on local employment and the area may quickly become “cheap,” relative to other areas with similar amenities.

Whatever future returns Whatcom County real estate might offer, this area will surely continue to provide non-quantitative dividends through its natural beauty and rich community.

Ben Esget is the president of WealthMark LLC, an investment firm in Bellingham. His columns appear on every other Wednesday. Esget also runs the finance blog, in an effort to level the playing field between Wall Street and Main Street. Contact him at 360-734-1323 or

Author’s note: The information in this column should not be construed as investment advice. Everyone’s goals and investment portfolios are unique. Please contact a financial advisor or an accountant for your particular needs.

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