Location, location, location or correlation, correlation, correlation?
Real Estate Basics
Consider two different profiles of a client: a young professional and a retiree, both in need of a home. While searching for a new home they each hear the clichĆ©s ālocation, location, locationā and āreal estate is always a good investmentā from friends, family, and their real estate agent.
In this post I research deeper into whether this is really the case or if either of these cliches should be forgotten. I use S&P 500Ā®Ā data from multpl.com and housing data from Zillow, spanning the years 2000ā2020, for analysis & interpretation. Our two clients, the young professional (āClient Yā) and retiree (āClient Rā), can provide some insight that your friends, family, and real estate agent may be missing.
The term real estate carries a broad definition. To most people it means your primary residence, but it can include investments like rental properties, commercial real estate projects (like retail, office, and industrial buildings), and pooled real estate investments that are publicly traded. REITs, or real estate investment trusts, were created in the 1960s and today are often owned by investors inside of IRAs and brokerage accounts. In this post we are going to focus only on housing markets because the primary residence is often one of the largest assets we see on a clientās balance sheet. The value of real estate in the U.S. housing market has been increasing rapidly following the onset of the COVID pandemic, but even prior to that we could see that home prices generally go up.
The graph above shows the average sale price of homes sold in the U.S. The shaded areas highlight the periods of recessions. (Side note: see that recessions were more frequent in the 70s and less frequent in the modern era!) What you cannot see from the graph are some of the statistics that I computed on the raw data:
- The average annual price increase for homes sold in the U.S. is about 5.72 percent. In other words, each year the median home value increases by roughly 5.72 percent in the U.S., making housing real estate a very attractive investment.
- The maximum one-year increase in home values occurred from 2020 to 2021, jumping 18.09 percent in that one-year period!
- The minimum one-year increase in home values occurred from 1969 to 1970, an average loss of 9.24 percent.
- In general, the average of home values in the U.S. appreciates annually. Since 1963 we have only seen losses in average home values 10 times.
A Case Study in Home Ownership
With that information in mind, letās get back to our example with Client Y and Client R. Client Y has a smaller portfolio ($100,000), but they work in a high-paying job in the investment banking industry. Client Y wants to have a home large enough to let their family grow and gets approved for a large mortgage on a large house in New Jersey, which is valued at $750,000.
The potential returns of the $750,000 home, an average of 5.74 percent over long periods of time without respect to location, will exceed the portfolio returns for years to come. And even though their net worth is reduced by the mortgage balance, the returns on Client Yās home are leveraged due to the mortgage. This makes the choice of the home location that much more important to Client Y, but there is no such thing as the āaverageā home. If Client Y will pick a real home in a real city, Client Y should seek a home that is non-correlated or negatively correlated to the S&P 500Ā®, given their job in the investment industry.
I plotted out a selection of the full-sample, twenty-two-year correlations between the S&P 500Ā® and four-bedroom homes for metropolitan areas in the U.S. (Figure 1). We can see immediately that there is a wide range of correlations across the U.S. despite the similarity in property type. The correlation between the S&P 500Ā® and the average U.S. four-bedroom home is 0.09, meaning on average the U.S. housing market moves slightly with the S&P 500Ā®.
In a work-from-home world, there could be opportunities for city life in Greenville, SC, or Asheville, NC, for Client Y. These locations, as shown in Figure 1, have a close to 0 or slightly negative correlation to the S&P 500Ā®. For a financial professional looking to diversify from their professionās ups and downs, these locations could be a good place to start.
Not everyone has the flexibility of choosing exactly where their home will be. Given that reality as a constraint, it often is easier to change the non-real-estate holdings to help hedge or diversify the overall portfolio. Consider Client R, our example retiree client. Client Rās 401(k) plan and IRA have had longer to grow and compound, so their portfolio is larger ($750,000). Client R desires to live near their working adult children and young grandchildren. If this requires living in regions like Vineland, NJ; Seattle, WA; or San Diego, CA, holding a higher amount of intermediate-term Treasury bonds (which have a negative correlation to the S&P 500Ā®) could help a retiree add diversification since their home is positively correlated to the market. On the other hand, if Client R instead has their heart set on retiring in a community like Alpena, MI, a higher equity allocation might be warranted because that house on average will be negatively correlated with the S&P 500Ā®. These types of decisions should be made with an advisor that works to understand your goals and objectives while connecting them back to your investments.
Does the old adage of location, location, location hold up? In my opinion it is more like correlation, correlation, correlation. When investing in real estate alongside more traditional portfolio assets like stocks and bonds, keep in mind what your investment horizon and your goals are. Even if the primary goal of the purchase is to attain stable shelter in a house you love, remember that the property is also a financial asset; it is likely one of your largest positions in your portfolio! Not all real estate is a good investment, but investing in real estate can be an important part of your financial resilience. Are you taking into consideration the value of your home, its correlation to your portfolio, or your income stream? Talk with Cardinal Retirement Planning today to get started.
Anessa Custovic, PhD
