What Offers the Best Return on Investment? 145 Years of Real Estate vs. Stocks
A team of economists from the University of California, Davis, the University of Bonn, and the German central bank set out to answer these questions by analyzing data collected over a 145-year period of time.
The best investments to make Money: the numbers
The lead authors of the study—Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor—reported the findings of their massive study in a paper entitled “The Rate of Return on Everything, 1870-2015." In it, researchers looked at 16 advanced economies over the past 145 years to find what offers the best return on investment. They compared returns on several asset classes, including equities, residential real estate, short-term treasury bills, and longer-term treasury bonds.
To better compare apples to apples, with each asset type, they adjusted for inflation and included all returns, not just appreciation. Dividend income was included for equities, and rental income was included for residential real estate.
Their findings, in short: Residential real estate was the better investment, averaging over seven percent per annum. Equities weren’t far behind, at just under seven percent.
Then came bonds and bills, each with a far lower rate of return.
Real estate vs. stocks: average ROI
Rental income proved an important factor—roughly half of the returns on real estate investments came from rental income, while the other half came from appreciation.
Stock investments and investment property each performed differently in various countries, of course. Here’s a comparison of each of the 16 countries:
These are long-term return averages over the course of many decades. In real-time, these returns bounced up, down, sideways, and in circles.
From 1980 to 2015, the stock market, on average, performed significantly better than real estate investments. Across the 16 countries studied, stock investments earned an average annual rate of return of 10.7 percent, decisively beating the real estate market’s stolid 6.4 percent.
A few outlier countries threw off the average return on investment from the time period between 1980 and 2015. Japan saw its real estate markets collapse as its population aged. And in Germany, residential real estate has been stuck in the slow lane for decades.
Meanwhile, stock investments in Scandinavia have exploded.
But the most interesting case for real estate investing lies in its risk-reward ratio.
Rental properties: low-risk, high-return
Here's is the volatility for real estate versus stock for the past 145 years:
Real estate investing has a high barrier to entry. It’s difficult to diversify your investment portfolio. If each asset requires $20,000 in cash to purchase it, then it takes a lot of money to build a broad, diverse real estate portfolio.
Investment property is also illiquid. It can't be purchased and sold on a whim—either process typically takes months.
There's also, of course, the risk of tenants. If a tenant damages your property, or you're not receiving rents from several apartments in a multifamily, it cash flow will be damaged. But ultimately these risks are low and have an even lower impact on return on investment.
Additionally, rental properties offer a number of tax breaks and deductions including depreciation and 1031 exchanges to avoid taxes on the sale of a rental property. Investing through real estate investment trusts (REITs) may avoid corporate taxes because income paid out as dividends.
There are a number of ways to invest in real estate and maintain a diverse portfolio.
Measuring risk vs. return to find the best return on investment
How do you measure an investment’s risk against its rate of return?
There’s a way to determine the best return on investment: a literal risk-reward ratio. It’s called the Sharpe ratio after its creator, William Sharpe.
Start with an asset’s return, and subtract out the return of the going with a short-term, risk-free alternative (like U.S. Treasury bills). This provides a “risk premium”—the extra return the asset delivers over a risk-free investment.
Then divide the “risk premium” over the asset’s volatility, as measured by its annual standard deviation in value:
Risk premium / average annual standard deviation
A higher ratio indicates a better investment—greater return on investment, relative to the risk. Here’s the breakdown:
- Treasury bonds: Sharpe ratio of around 0.2
- Stock investments: Sharpe ratio 0.27.
- Residential real estate: Sharpe ratio of 0.7
The Sharpe ratio for real estate has only grown stronger over time. Since 1950, the Sharp ratio for real estate has averaged an impressive 0.8.
Another way of looking at it is return per unit of risk—here’s how stock investments have compared to real estate in each of the 16 countries studied:
Rate of return and GDP
It turns out, the best return on investment for a country isn’t tied in a 1:1 relationship with its GDP. Over time, returns on these asset classes tend to grow on average around double the speed of the country’s economy as a whole, measured by GDP.
On average, the stock market and real estate market perform several times better than GDP growth.
Why real estate investments crush bonds
A few reasons why rental real estate offers the best return on investment compared to bonds?
- Bonds expire. Bonds payout for a specific term, then stop paying. Rental properties keep paying forever.
- Rental properties tend to pay more over time.
- With every year that goes by, fixed bond payments become less valuable in real purchasing power due to inflation. But rental income and property value in the right locations rise right alongside inflation.
- Fixed mortgage payments go down over time in inflation-adjusted dollars! Then the mortgage payment disappears & rental cash flow explodes.
Should I stop investing in the stock market and just buy rental properties?
Stocks may be a roller coaster, but in the long run, the best return on investment requires a diversified portfolio. Stocks balance rental properties well. Real estate is illiquid compared to equities. You can buy and sell mutual funds, ETFs, etc. at a moment’s notice. Investment property isn’t quite so easy to get in and out of.
Stock investing also offers truly passive income. Ultimately, rental income can never be as passive as dividend income (even with property management handling general upkeep).
It’s much easier to diversify your investment portfolio with stocks, as well. You can spread $500 across thousands of companies, in every region of the world, in every industry, at every market cap. You’d be lucky to get away with only putting down $5,000 on a single rental property!