By David Franklin
From what people read in the media and are told by their financial planners and investment managers, they arrive at the conclusion that the stock market historically outperforms the residential real estate market. Investment managers approach the comparison with a bias that fails to recognize the absolute returns in real estate.
The following is a schedule that sets out the increase in value of national residential property, based on The Economist Global Price Index, to the stock markets for the same number of years, ending in September 2013.
|Canada House Price Index||S&P TSX/Composite Index||Difference|
|15 Year Return (6.21%)||4.20%||2.01%|
|20 Year Return (5.47%)||5.57%||0.1%|
|25 Year Return (4.29%)||5.42%||1.13%|
|29 Year Return (4.61%)||5.99%||1.38%|
|US House Price Index||S&P 500 Index||Difference|
|15 Year Return (3.50%)||2.21%||1.29%|
|20 Year Return (3.49%)||6.63%||3.14%|
|25 Year Return (3.09%)||7.48%||4.39%|
|29 Year Return (3.87%)||8.05%||4.18%|
What the schedule shows is that stocks did outperform real estate until about 15 years ago. What the schedule also shows is that Canadian residential real estate increased more than US residential real estate.
|House Price Index (HPI)||Canada||US||Difference|
|15 Year Return||4.20%||3.50%||2.71%|
|20 Year Return||5.57%||3.49%||1.98%|
|25 Year Return||4.29%||3.09%||1.20%|
|29/30 Year Return||4.61%||3.87%||0.74%|
What the schedule also shows is that in most timeframes the US stock market outperformed the Canadian stock market.
|Stock market Index||Canada||US||Difference|
|15 Year Return||4.20%||2.21%||1.99%|
|20 Year Return||5.57%||6.63%||1.06%|
|25 Year Return||5.42%||7.48%||2.06%|
|29/30 Year Return||5.99%||8.05%||1.06%|
Let us now compare the returns based on the investor purchasing a single family home for cash, as that is what he is doing when he invests in the stock market. The investment property will be, in most cases, renovated, tenanted and managed by a property manager who is responsible for the renting, repairing and bookkeeping. An investor will find that he can acquire these types of properties both in Canada and the US that will provide an initial return of at least 5%. For example, if the investor paid $200,000 including closing costs, he would receive $10,000 a year after expenses. In addition to the 5% return, the investor will be able to increase rents by at least 2% a year (depending on the market and provincial legislation), especially since the Bank of Canada and Federal Reserve have an inflation target of 2% a year. By taking this into account, by present valuing the 2% rent increase will increase the overall return from 5% to 6.38%. Also, the purchase of the real estate is in markets where both the population and economy are growing and the growth is expected to continue.
Most experienced real estate investors know that they can find returns on these investments at higher rates. Naturally, as we know in markets like Toronto and Vancouver, it may be difficult to find 5% returns, as is the case in US cities such New York City, Washington D.C and San Francisco. Also, for comparison purposes, investors were getting higher returns than 5% in the 1980’s and 1990’s when interest rates were higher. For example, 100 suite apartment buildings in Toronto in the 1980’s were being purchased at an 8% return; whereas, today they are being acquired for as low as 3.5% returns.
The following schedules set out the returns with the addition of the return on investment for the residential market and also the addition of dividends based on these stock market indices. The stock market returns are then reduced by the management fees, as it is assumed that the person is not picking his own stocks and trading them. Mutual funds in Canada have fees that range from 2% to 5%, and in the US about 1%, and these fees are deducted from the return. In addition, since most mutual funds do not meet the stock market index returns, the return is reduced by another .5%. “According to recent data from Fundata.com quoted in the Financial Post, 53% of Canadian Equity funds have outperformed the S&P/TSX Composite Index in the last three years. This value drops to 34% for funds with a five-year history, and falls to a paltry 14% for funds with a 10-year history.”
A similar result also applies in the US. “Using Morningstar’s fund database, we examined the performance of more than 2,000 active US equity funds during the 15-year period from July 1, 1998 to June 28, 2013. The result: only 25.6% of the active funds currently in existence outperformed their benchmarks (nearly 75% trailed the benchmark or had an insufficient track record to compare). Many other studies over extended time periods have reached a similar conclusion, including Standard & Poor’s, which found that 69% of all domestic equity funds were either outperformed after expenses by their benchmarks over the prior five years or had been liquidated during the period from Jan. 1, 2008 to Dec. 31, 2012 (Source: S&P Indices Versus Active Funds Scorecard).” [Forbes August 28, 2013 http://www.forbes.com/sites/greggfisher/2013/08/28/in-mutual-funds-is-active-vs-passive-the-right-question/]
|Canada||HPI||Return from Income (6.38%)||S&P Index||Dividends||Less 2.5% Mgmt Fee||Difference|
|15 Year Return||6.21%||12.59%||4.20%||2.80%||4.50%||8.09%|
|20 Year Return||5.47%||11.85%||5.57%||2.80%||5.87%||5.98%|
|25 Year Return||4.29%||10.67%||5.42%||2.80%||5.72%||4.95%|
|29 Year Return||4.61%||10.99%||5.99%||2.80%||6.29%||4.70%|
|US||HPI||Return from Income (6.38%)||S&P Index||Dividends||Less 1.5% Mgmt Fee||Difference|
|15 Year Return||3.50%||8.59%||2.21%||1.79%||2.50%||6.09%|
|20 Year Return||3.49%||9.87%||6.63%||2.05%||7.18%||2.69%|
|25 Year Return||3.09%||9.47%||7.48%||2.32%||8.30%||1.17%|
|30 Year Return||3.87%||10.25%||8.05%||2.59%||9.14%||1.11%|
The schedule shows that residential investment real estate (that is tenanted) outperformed the stock market for these periods. It is the addition of the return from the investment that provided this difference. For Canadian investors who have a money manager, the difference can be reduced by 1%, as typically their fees are about 1%.
Another benefit of investing in this type of property is that if the economy slows down, rents normally do not decrease by a large percent as they are “inelastic”, so the investor may see a decline in his income, but the decrease normally will not be as large as the percentage drop in value of the stock market. In the US, the largest drop was about 13% in Seattle and a few other cities, some declined about 5% and others did not see much of a decline. So even if the value of the property declines, since the investor is investing for the long term, the value should increase, as is happening in the US and the investor will keep collecting his income, which, if the decrease happens several years after his purchase, the decline may just bring it back to the level when he first acquired the property.
Some investors who were counting on their Canadian investment in the stock market to be used for their retirement in 2008 saw their value drop by over 49% from June till March 2009. As a result, some of these people will have to continue working to earn income. By comparison, the national residential index only dropped by about 7% and also rental rates did not decrease very much in most of Canada. (The stock market drop was seven times that of the real estate decline.)
Perhaps those investors who are counting on their investments in the stock market alone to be used for their retirement, should learn about put options. A put option is a security instrument that you purchase when you want to “bet” that the market will decline and if it does you make a profit. If it does not decline or goes up, you lose the money you invested to buy the option. It is like selling short but when you short the market, if you are wrong and the market goes up, you have to pay for the increase in value which could be substantial. If these investors had purchased put options on the market, an analogy could be buying insurance to protect against a loss, they would have profited when the market declined and as a result would have loss less.
David Franklin, B.Comm, JD, has been practicing law in Ontario for over three decades, specializing in securities, mortgages, tax and real estate, and overseeing and transacting millions of dollars of transactions. Contact David at email@example.com.