Towards a Realistic Return Estimate for Real Estate

<h2>Is real estate a good investment? We should know: It’s the world’s largest asset class.</h2>

* How much investment risk and return can we expect?
					* How does its risk/return profile compare to other investments?
					* How much more risky are individual assets?

Notes:

* Most of my research centers around a straight-forward question: Is real estate a good investment? We should know, it's the largest asset class in the world.

* Still, property investments are often misunderstood as being fundamentally different from more mainstream asset classes such as stocks or bonds. Simplistic advice such as "get on the housing ladder!" is typical for a view in which real estate is exceptional: returns exceed a fair compensation for risk.

* As an applied financial economist, I strive for a realistic estimates of real estate’s risks and returns, both at the market and at the asset level. To do so, I combine theory and data, traditional econometrics and innovative machine learning techniques, dusty archives and big data sensors.

* To come back to the main question: Academics, industry players, policymakers and private households— they should be familiar with real estate’s risk–return profile to make better decisions.

<h2>Economy-wide risks Bank of England Financial Stability Report (<a href="https://www.bankofengland.co.uk/financial-stability-report/2019/december-2019">2019</a>)</h2>

* “The housing market can be a key source of risk to UK financial stability. In the UK, mortgages are households’ largest financial liability and lenders’ largest loan exposure in aggregate. Housing accounts for nearly half of the total assets of UK households. [...] Historically, the rapid build-up of household debt has been a key source of risk to financial and economic stability — and not just in the UK.”

<a href="https://www.flickr.com/photos/croydonclicker/51181061000">Photo ©</a>

Notes:

* The global financial crisis of 2008/2009 has highlighted the importance of real estate for our economy and financial system once more.
					* The sheer size of the asset class dominates national accounts and household-level balance sheets alike, both in terms of assets and liabilities.
					* A large section in the Bank of England’s 2019 Financial Stability Report is devoted to real estate, modelling how the housing market can be a key source of risk to UK financial stability.

<h2>Households ...face the same challenge as sophisticated professional investors</h2>

<ul>
					<li>3 BR late Victorian terraced house in East Cambridge. Sold in August 2019.</li>
					<li>How much return can the new owners expect?</li>
					<li>How much risk do they face?</li>
				</ul>

Notes:

* Estimating the risk and return of real estate remains a real challenge. It's a challenge because it's very difficult to do and it's real because it affects not only sophisticated big investors, but also normal households.

* It's even more difficult at the asset-level. For example, this 3 bedroom late Victorian terraced house in East Cambridge was sold in 2019. If you think about this particular building, how much return can the owners expect over the coming years and how much risk do they face?

* When we bought our house, my family assumed that I would conduct a very elaborate financial analysis. It's my job, I should be able to do it. Let me confess, I did not. I made a few bold assumptions and then we made an offer.

## Academia to the rescue? Broad literature, surprisingly few answers. Data are scarce.

* **A risk premium puzzle?**
						- “Arguably the most surprising result of our study is that long-run returns on housing and equity look remarkably similar. Yet while returns are comparable, residential real estate is less volatile on a national level, opening up new and interesting risk premium puzzles.”
						 *The Rate of Return on Everything, 1870–2015* (<a href="https://academic.oup.com/qje/article/134/3/1225/5435538">Jordà et al., QJE 2019</a>)

Notes:

* And I am not the only one struggling to come up with helpful answers.
					* As a discipline, we lack good quality data.
					* Without reliable data, the academic literature remains stuck in "puzzles". A good example is a recently published QJE paper that compared the risk-return profiles of housing to stocks.
					* They, again, repeat this widely-held misconception that real estate is somehow magical: Ig offers the same returns as stocks but at a lower risk.
					* That cannot be true—and it isn't.

## Better data! “The Total Return and Risk to Residential Real Estate” (<a href="https://academic.oup.com/rfs/advance-article/doi/10.1093/rfs/hhab042/6222230">Eichholtz, Korevaar, Lindenthal, Tallec, RFS 2021</a>)
				* Asset-level total return: Rents, costs, taxes, prices for residential RE in Paris (1809–1943) and Amsterdam (1900–1979)

Notes:

* In a recent paper, Piet Eichholtz, Matthijs Korevaar, Ronan Tallec and I show that this puzzle completely disappears with better data.

* We collected 170K rent and price observations for Paris and Amsterdam and were able to calculate total returns at the property level. This is the first study that offers asset-level total return data for more than just a few years.

* Two things stand out from this paper: First, risk is a lot higher than previously thought. That means that the risk-adjusted returns of real estate are no positive outliers but comparable to stock returns.

* Second, almost all of the return comes from rents. Rents are really making or breaking property returns in the long run.