Josh Peck

My work and various curiosities...

Speculative Returns in the US Residential Housing Market

Lately my primary struggle seems to be separating the wheat from the chaff for investing assets. Scarcely is there more chaff than in the US residential housing market.

As empiricists we must be vigilant against the sales pitch disguised as generally accepted wisdom. When you buy a home, the conventional wisdom is: “at least you aren’t throwing money away on rent”. That statement ignores many factors, but I’m isolating the speculative capital appreciation component of housing returns in an attempt to answer the question, “Is residential real estate a good investment for the typical individual?” Just because your home is an investment doesn’t make it a good investment.

Methodology

I simulated 1000 5-year periods that behaved roughly like the period from 1987-2016 from the S&P/Case-Shiller Home Price Indices (Percent Change) available at:

S&P/Case-Shiller 10-City Composite Home Price Index© (SPCS10RSA)

The experiment approximates the returns an average individual can expect to receive. If they happen to live in a hot market or have a reliable source of discounted real estate, fortunes will abound. Though, relying on the returns of a hot market or others' ignorance of their property values seems a poor long-term strategy.

For this example, I have selected a $475,000 home purchased entirely with cash and have treated the rent savings as a residual cash-flow of $27,600 per year, since the owner would be paying rent otherwise.

Miserable Results

What I found was worse than I anticipated. After simulating 1000 five-year periods using real housing data, the speculative returns were around 2%. When incorporating the cash-flow returns the home returned a paltry 6%. Hardly the stuff of wealth-building; especially when you consider the costs associated with owning the property.

Simulation of Expected 5-Year Returns for U.S. Residential Housing

Return Summary Statistics:
    Mean: 0.0199     Median:   0.0201
    Max:  0.0395     Min:      -0.0007
    MAD:  0.0043     Kurtosis: 0.1683

It Gets Worse

In this example, you would have to be a total slum lord (to yourself no less!) to get your lousy 6%. No maintenance, no groundskeeping, no repairs, no closing costs...

IRR Calculation for the Example

But this is absurd! There is risk inherent in housing because it is affected by so many forms of risk. Physical asset risk (will things break?), Market Risk (will the market continue to grow), Geographic Risk (will the location be desirable), Time risk (will repairs consume your time).

Top 10 Sources of Risk in Real Estate Investment Deals

Random Walk of 5-Year Housing Returns

So, What Now?

The good news is that housing does tend to keep pace with inflation. When we look at the approximately 2% per year that it returns from speculation, it seems likely that as the dollar diminishes in value through monetary policy that housing and hard assets will be a better store of value with less risk than the stock market or many other available asset classes.

That said, real estate can provide positive results from an income perspective, so it is reasonable to consider the 2% as a bonus on top of the cash-flow from operations of the property. In this analysis, it's quite reasonable to rent your primary residence, then use your capital to finance a property that you will in turn rent to others — assuming you are capable of operating the property at a profit. The benefit of this approach is further improved if you are capable of borrowing a significant portion of the capital for your investment.

In the typical case — in the US — where individuals finance 80-90% of their primary residence, it would seem that they would reap a 20% return since they are paying 10% of the cost of the home in cash, then financing the remaining 90%, since they would receive appreciation for the entire value of the property. However, this ignores the costs of borrowing, improvements, and maintenance, which can approach 5-10% per year for a net negative return of 3-7% annually before considering inflation.

Be wary and make sure you have an adequate margin of safety before considering purchasing a property under any circumstances, but especially in the case where you are financing it as your primary residence.

Check My Math

You can download a copy of the simulator on my github page:

bleechack/housing-simulator (github.com)

Example Output

{
    "mean_gain_size": 0.0069839709803921571,
    "mean_loss_size": -0.0058536540000000015,
    "num_gain": 255,
    "num_loss": 100,
    "num_obs": 359.0,
    "p_gain": 0.71030640668523681,
    "p_loss": 0.2785515320334262
}