Safe as Houses - What return should you expect from houses?

While at Business School I took classes from Real Estate "experts" which can be summarized by:
(a) There are some really cool ways to avoid taxes with real estate
(b) Don't invest in any properties overseas, unless its with your cousin who lives there, ideally with mafia ties (cause you'll end up paying tourist prices, and management would be a nightmare)

We used clever charts calculating returns. As usual, we used historical prices to calculate future prices which is nature's way of creating bubbles. I'm not going to revisit the tired topic of the mortgage mess in the country but here is a simple question. What investment return should you really expect from real estate investments every year? 15%? 5% ? 1%?

Efficient market theory suggests that all investments converge to the same return over time, since money will flow to the higher yielding investment until this is true. REIT (Real Estate Investment Trusts) out-performed the stock market since their recent inception, present debacle excepted. So how has real estate performed over the long haul.

Robert Shiller is perhaps one of the most widely read experts in this field, but his conclusions pretty much match up with common sense. The simple rule of thumb is that people cannot spend more than they have on housing, at least not for long. Their monthly income vs. monthly housing costs is a ratio that has been quite constant over time.

This is true for all countries, all centuries. Monthly housing payments (be they mortgages or rent) will typically vary from quarter to half of someones salary. In Huston they will be closer to quater and in San Francisco they will be closer to half, the higher rate is often blamed on artificial control of supply through zoning laws and local city ordinances. Perhaps I am stating the obvious but there are just a few factors involved in the average U.S. house price:

(1) The average income of an house buying family, closely related to GDP per family
(2) The mortgage interest rate.
(3) The "extras" in a monthly house cost such as local taxes and monthly apartment dues.

So, if none of these three factors have changed, and the price of houses go up, surely you are in a housing bubble. If the mortgage interest rate is temporarily low and is the only factor that has changed, then the price increase will only last as long as the mortgage rate is low. If suddenly mothers start going back into the workforce and taking up more professional work, then the median family income goes up, and hence house prices will go up. It seems as this bird has flown already, since the percentage of women in the workforce is not growing significantly anymore in most urban areas.

Shiller has deduced that over the last 100 years, median house prices have risen just slightly more than inflation each year. I would expect it tracks median family income.

My guess is that the only places that have had genuine long term increases in house prices that beat the average are places that have seen a demographic shift, e.g. from lower middle class incomes to upper middle class such as the upper west side in Manhattan over the last three decades. In other words, you can get genuinely rich in real estate investments, bubbles aside, when you can predict when a neighborhood is going to dump a chunk of its current residents and bring in richer ones.

I almost feel that this is too obvious but perhaps people are getting too wrapped up with supply and demand.

No matter how scarce the supply, people can only pay from what they earn. Even if you choke supply artificially buyers will not be able to pay much more than half of their income on housing and still have a life. So utimately, the average house price in the U.S. is married to the average family income in the U.S. Additionally, the average rent paid is also married to the average family income.


Stating what must be common knowlege by now, the recent bubble was magnified by the banks giving loans to people who historically wouldn't qualify. They did this because of the new process of mortgage securitization, which means that mortgages were broken up into shares and sold to many customers leaving the banks to take a nice commission and have little or no stake in the success of the mortgage. The customers were typically not informed that the quality of loans were going drastically down year on year so they kept buying them. With so many generous new mortgages, house prices were able to lose touch with income, but obviously not for long.

When the dust settles how much return should you expect if you buy an investment property for cash?

If you assume house prices are fairly valued right now, (a big assumption) mortgage rates can't go much lower, so the average house price will trend the average family income. This is unlikely to exceed 3%-4% (so in real terms with inflation at 3% the actual gain is 0% to 1%). Rent minus expenses will possibly give you another 3% to 5% annually, although the taxman may take at least a third of this. So an all cash purchase of an "average" investment property to rent out should give you something like 6% to 9% annually before taxes.

If you borrow the money to buy the house your return is about 2% above the mortgage rate which you could consider your risk premium.