How Do Stock Market Returns Compare to Real Estate Returns?

 Stock market

Despite some arguments that your home isn not an investment, to the average American a home has many characteristics of one. It tends to appreciate in value, there is an active market for buying and selling, and it can be relied upon for future cash flow (typically through renting or a reverse mortgage).

Given the overall value of this asset, for most Americans a home represents their largest investment. The second largest? Well, I hope it’s the stock and bond investments in their 401(k) or other retirement account, though it surely pales in comparison when you consider the trillions of dollars of “home wealth” held by many U.S. families!

If you’ve ever considered how the returns of these two markets compare, perhaps this brief comparison of stock market returns and real estate returns will be helpful.

There are many sides to this argument and I’m not covering every base here (such as the tax advantages of each) but seeing how this is a question I’m asked regularly, I thought it would be helpful to at least compare and discuss the overall returns of each and share some other insights.

The Historical Growth of the U.S. Stock Market

Due to the active nature of the stock market, it’s fairly straightforward to determine its past performance, since fair market prices are almost always available in real time. According to Professor Aswath Damodaran of NYU, from 1926 to 2016 the stock market has grown an average of 9.53% annually.

It’s important to remember, though, that this is before costs. As I’ve written before, investment fees can really do some damage to your overall investment growth if you’re not careful. Consider, for example, if you paid 2% per year to have your portfolio managed by a professional. Earning 7.53% rather than 9.53% over time would result in much less accumulated wealth.

Fortunately, for those willing to invest themselves, an index fund--a mutual fund matching the U.S. stock market’s performance--can be bought for a fraction of a percent.

The Historical Growth of the U.S. Housing Market

How about the housing market’s performance over time? According to economist Robert Shiller, the long-term return of real estate have been fairly modest compared to stock market returns. He breaks it into two pieces: land values and home values.

Over the century from 1915 to 2015, though, the real value of American farmland (deflated by the Consumer Price Index) increased only...1.1 percent a year.

What about home prices? Surely home values have appreciated more than this! Shiller continues.

[deflated] home prices rose even more slowly over the same period — a total increase of 1.8 times, which comes to an average of only 0.6 percent a year.

Note that Shiller is using “deflated” numbers, or numbers that don’t take inflation into account. If you were to assume inflation averaged 2.5% per year over that same period, then the average annual increase for both real estate components would be 4.2% (1.1% + 0.6% + 2.5%).

To make matters worse, we should remember that--like stock market returns mentioned previously--none of these average returns take costs into account. A researcher at Morningstar points out that one problem is the House Price Index--the index that tracks home prices over time--is tied to the resale value of homes. This wouldn’t be a problem if homes were just bought and resold again, but there’s capital improvements to consider.

So, if I were buy a home and try to flip it, put all this money into it, you don’t see those expenses in terms of the actual resale value. There’s also things like insurance, ongoing maintenance, real estate taxes that really kind of drive that down. So, I think that when you factor in all the costs of owning a home, the realized return is often less than inflation or possibly even negative.

In investing, costs matter. When considering investment options one should always understand the costs of investing rather than simply looking at the overall returns (before fees).

Uncertainty and Built Up Demand in the Housing Market

Unfortunately though, all we can do is look at historical prices, not future ones. I know many homeownership advocates who believe the paradigm of homeownership in the 21st century is drastically different than it was in the 20th.

Financial author Morgan Housel also recently made the case for the continued rise of home ownership (and the subsequent rise in values) by pointing out that a growing base of young, future homebuyers simply aren’t in the market to buy a home...yet.

Millennials delaying homeownership doesn’t mean there’s less need for housing investment. It means the housing market is like a grocery store checkout where the customer stopped putting food on the conveyer belt for a moment. The clerk sees less food coming his way, but there’s still the same amount of food in the cart waiting to be scanned.

Frankly, It’s an Unfair Comparison

Finally, there are arguments that comparing the returns of the stock market and the real estate market is unfair.

Stock investments in your 401(k) are very liquid, meaning they can be bought and sold quickly--literally in the half blink of an eye--with extremely low costs. Stock prices can be known in real-time, meaning buyers know what they’ll pay and sellers know what they’ll receive.

Real estate prices, on the other hand, are much trickier to determine. Homes are purchased individually, one by one, without a comparably active market like stocks. One could look at a home as not just buying a share of stock or a mutual fund, but buying an entire business, which is much more difficult to properly calculate the price of. As a result, costs tend to go up as realtors are selected, appraisers are hired, and assessments are made.

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Over the past century, average U.S. stock market returns have been shown to handily beat the average returns of the U.S housing market. Much of this discrepancy is explained by the costs of upgrading and maintaining real estate property over time. Still, many experts suspect that, over the short-term at least, there is still room for housing prices to continue to climb as pent up demand is released. Nevertheless, the liquidity, comparably low costs, and better overall returns of the stock market makes it hard to beat in the long run.