3 min read.Updated: 19 Aug 2019, 10:23 PM ISTTadit Kundu
Housing is a better investment choice than equities even though house prices are susceptible to credit cycles, a database of asset returns since 1870 suggests
When you meet a financial planner, one advice that you are most likely to receive is to stay away from real estate and instead invest in financial assets (stocks and bonds), which are likely to fetch you better returns over the long run.
Such advice is based on a body of research which suggests that equities typically outperform most asset classes across markets. But a new path-breaking study of historical asset prices has put a stake through that body of research.
The study builds on a new database of asset prices — Jordà-Schularick-Taylor Macrohistory Database funded by the Institute for New Economic Thinking (INET) — and asserts that “residential real estate, not equity, has been the best long-run investment over the course of modern history". Their study finds that while returns on housing and equities have been similar in the long-run, housing has been much less volatile. Hence, risk-adjusted returns from housing has been better over the long run.
Returns here include both price changes and the rental income or dividend earned on investment. Adjusting the total returns for volatility, housing outperforms equities in all the sixteen advanced economies studied by the researchers. The appropriate measure to compare returns from housing investment and equities is the Sharpe ratio, which simply means the excess return earned over the risk-free rate, divided by volatility.
However, this does not mean that house prices never fall. Housing sector is also prone to slumps, which often coincide with overall slowdown in lending in the economy. The database prepared by economists Óscar Jordá, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan M. Taylor, some of whom are affiliated with US and German central banks suggests that housing price movements have a strong correlation with overall credit growth in the economy.
Whenever the credit taps in an economy are loosened, eventually a lot of the money ends up in real estate, boosting house prices. Conversely, periods of slowing credit growth often lead to decline in house prices.
Economists at the Bank for International Settlements (BIS) have often drawn attention to this phenomenon as part of their hypothesis on the working of the financial cycle, or the financial cycle drag (FCD) hypothesis, which states that credit booms in any economy tend to fund relatively low-productivity sectors such as real estate. This creates a debt overhang, without adequately increasing productivity or potential output in the economy. Eventually, when the credit boom fades away, it might lead to a protracted economic slowdown. According to BIS economists, when business cycles coincide with financial cycles – i.e. credit booms and credit busts – recessions could be deeper and longer.
The new database unfortunately does not include data on India, for which reliable long-run data on house prices is hard to come by. The limited house price data available from around 2010 onwards suggests that housing price movements have been less volatile than equities. Unsurprisingly, residential real estate remains a very popular avenue for households to invest their wealth. More than ninety percent of the wealth of Indian households’ is tied up in land or in buildings, according to a 2016 research paper by Ishan Anand and Anjana Thampi.
However, house price growth in major Indian cities has remained muted for the last few years, coming off sharply from the rapid rise witnessed during the credit boom of the 2010-2012 period. As in other countries, the rise and wane of the credit cycle also seems to drive the rise and fall of house prices in the country.