Wednesday, July 30, 2008

And Yet, We Are Still Investing in Real Estate

I have shown this New York Times chart to people over and over during the last few years. Yet, as time goes, I still fill compelled to share this with more people. A lot has been written about the real estate market, trying to "explain" why it was doing so well (a few years ago) and why it is doing so badly (now). But the simplicity of this chart is refreshing: it just shows how home value adjusted for inflation has varied over the last 116 years, from 1890 to 2006, when this chart was published. (For a larger view, click on the chart. This will take you to original chart on the New York Times site.)

Did you notice the hickey stick towards the end of the chart? I thought you did. When this chart was published, the market had reached its peak. Since then, home prices have gone done by about 15% on a national level. This real estate crisis is the big story, but compared to the doubling we had in the previous decade (a 100% increase), a 15% decline isn't a tragedy. Yet. Because since 2007 prices have been going down every month at a fairly constant pace, everyone is now wondering when it is going to stop.

Let's look at it this way: forget for a second that we are talking about real estate. Imagine instead that you are are in your investment advisor office, and she is telling you about this fund you didn't know about. Let's call it the RE fund:
  • She shows you above chart with the price of the RE fund over time.
  • She tells you that this fund has a long of history; that for sure it is not going to completely go away, but that (as history has proved) it might bring you fairly large gains or losses.
  • She warns you that the fund has gone up so much in the 10 years leading to 2006, not because any fundamentals have changed, but because people have been investing more and more in this fund, driving the value up.
  • She also mentions that a lot of those people buying the fund didn't have the money to do so in the first place. They have been borrowing money heavily for that purpose. Some have borrowed so much that they now can't even pay the interest on the amount they borrowed, and now have to sell.
At this point you might be running away from her office, wondering why both you and your investment advisor had to loose so much time talking about this crazy RE fund. But if you are still there, you thoughts about this fund could be summarized in 3 points:
  1. Investing in the RE fund is now highly risky. Since the mid-40s, the fund have seen two other booms: in the 70s and 80s. After each one of those booms, the value came down to the previous support level. In the last 10 years we have seen an incredible boom, which was not justified by any fundamental change; it was bubble. Since 2006 the bubble has started to deflate. Since the beginning of this year, this has been going at a rate of about 1% every month. And despite the fall, the fund has so far "only" lost 15% of it value since its peak, compared to a gain of 100% during the boom of the previous 10 years. Talk about a risky investment.
  2. This has proved, historically, to be a lousy investment. Setting aside what happened during the last 10 years, the fund stayed surprisingly in line with inflation. Since the mid-40s, it stayed in a band of 20%. Let's say you invested in the RE fund in 1950; after 50 years you would stand a gain (adjusted for inflation) of only 20%. If you had invested $1.00, 50 years later you would have $1.20. Compare this to investing in the S&P 500: with $1 invested in 1950, 50 years later you would have $70. Very lousy investment indeed.
  3. This is a fund that has a very high barrier to entry. A lot of first-time investors in the RE fund have to put almost all of their savings in it. In addition, they borrow about 5 times that amount and put all that borrowed money in the fund. Talk about lack of diversification.
Now, tell me, would you invest in the RE fund? If you had money invested in the RE fund, would you keep it there?