A common staple of finance websites and literature is a comparison between different investing options. Stocks? Bonds? Real Estate? Where should you put your money?

The answer, of course, will depend on your resources, your risk appetite, and your goals. But for investors who still have a fair amount of runway ahead of them before they hit retirement, most comparisons fail to highlight the true benefits of investing in real estate. 

The bottom line:

Over the long run, the stock market has yielded great returns. From 1987 to the present the S&P 500 has appreciated at an average rate of almost 10% per annum, and the NASDAQ has averaged over 11%. Over the same period the average home price in America has increased at around 5.6 percent. 

This is the comparison upon which many analysts focus. One dollar invested in real estate in 1987 would be worth around $2.84 today. That same dollar would be worth $5.74 or $7.31 were it invested in the S&P 500 or the NASDAQ, respectively. But this is the whole picture

Volatility: Real Estate Bubbles vs. the Stock Market

We’ll get to leverage in a moment – that’s where these conversations inevitably lead. But the first thing to consider is volatility. 

Yeah - we know that stocks yielded an average of 10% to 11% over the past twenty years or so, but how did we get from point A to point B? Investors will remember the period from 1999 to 2002 which were rough years for the sock market. From its peak in August of 2000 to the bottom in September of 2002 the S&P 500 lost over 40 percent of its value. Over roughly the same period the NASDAQ declined by a whopping 75 percent. Eventually the market managed to shake off these doldrums, but this was a tough period for investors. 

Real estate has hit some hard road bumps too. It’s interesting to compare the severity of regional real estate downturns with the stock market collapses listed above. Global Insight periodically releases a study of market valuations in which they list, among other things, a summary of major past price corrections. The most severe being associated with the oil bust in the ’80s; fellow Texans will remember this period.

• Lafayette LA, declined by 35% over 15 quarters
• Odessa TX, declined by 28% over 18 quarters
• Abilene TX, declined by 28% over 11 quarters

All three of these markets were significantly overvalued before they fell. The lesson here being: what goes up must come down, and investors who live in regions characterized by overvalued markets have reason to be concerned. 

If you live in certain parts of Florida, California, and other overheated regions of the country, this means you.   But for the rest of you: note that the three historical cases above are the worst of the worst. There never in recent history has been a major national correction in real estate prices, and most regions have experienced continuous growth in property values for decades. Watch out for regional markets that have been spiked into a speculative frenzy - but overall, volatility in housing prices is low.

It doesn’t make sense to talk about leverage without first talking about volatility. You can use leverage to turbo-charge the returns on about any investment, but high volatility usually makes leverage prohibitively risky. 

Not so with real estate.

Aside from a handful of regional exceptions notwithstanding, real estate prices historically have marched steadily upwards at a steady 5.6 percent per annum. Factoring in leverage this return ratchets up to over 13% per annum; considerably better than stock market returns at lower volatility. 

What is leverage?

Simply put: a dollar invested in stocks buys you one dollar’s worth of stock. But that’s not the way we buy real estate. A typical investor might put $20,000 down to buy a $100,000 home. So instead of getting one dollar’s worth of house for your one dollar investment you’re getting control over five dollars worth of house. 

That’s 5:1 leverage. One buck from you, and four bucks from the bank. 

That $5 invested in the housing market in 1987 would be worth around $14.18 today. Assuming that you hadn’t paid down any of the mortgage your $1 investment would be worth $10.18. Compare that against the $5.74 that your S&P 500 investment would be worth or the $7.31 that your NASDAQ would have netted. 

The upside...

I’ve made some simplifications, but overall they’re conservative ones:

• Dividends and rental cashflow. I left ‘em both out of the analysis. But any property that you’ve had for twenty years will be raking it in cashflow-wise, whereas corporate dividends these days are pretty skinny. Advantage: Real Estate.
• Paying down the mortgage. Back in the late '80s interest rates were hovering around 10% (gasp!). At this rate a standard fixed 30 year mortgage would have paid off around 30% of its principal balance over twenty years. That’s another advantage that I haven’t included in the comparison. Advantage: Real Estate

Timing can be important and in some regions now isn't the best time to be jumping into the market, but over the long term it's hard to argue that real estate doesn't have a place in your portfolio.