Mansions Aren't Such Great Investments

(Bloomberg View) -- I almost let an article about how great luxury real estate has performed sneak by without comment until I saw a dubious comparison to the stock market. Here's what caught my eye:

Adjusted for inflation, that’s a compound annual growth rate of 8.7%. The S&P 500 stock-market index averaged an inflation-adjusted annualized return of just 4.1%.

 This makes for a good teachable moment about how to analyze investments, in much the same way as the presidential election or March Madness or the saving habits of a janitor. I say this while reminding you that I am not a housing basher, unlike some. I have been positive on residential real estate for a long while.

Let's dive right in:

Don’t use outliers to prove your point: Yes, the estate of newspaper magnate William Randolph Hearst is a formidable and impressive home. But it hardly makes for a good sample to use when describing the advantages of real estate in general, or even luxury real estate in particular. Just how many 50,000-square-foot, five-acre properties in one of the most-expensive zip codes in America are there? Like Picassos and rare Ferraris, it is a one-off, not representative of residential real estate as an asset class.

Use actual transactions, not aspirational pricing: Owners of illiquid assets have to come up with credible ways to price their holdings. Wishful thinking doesn't count. The market hasn't improved enough to justify lofty asking prices for seller who hope to flip a property. Homes that don’t sell experience price declines, not increases.

Include all costs and fees: As an investor, I have spent the past few decades watching my costs go down. As a homeowner, I have spent the past few decades watching my costs go up.

As for that that Standard & Poor's 500 Index 4.1 percent annualized inflation-adjusted return. Yes, that may be accurate, but only if you omit dividends. Include them and the return jumps to 7.4 percent.  That’s pretty close to the fictional 8.7 percent return cited above.

Taxes, mortgage interest, insurance, maintenance, utilities? Although mortgage rates may be near historical lows, that probably is temporary. Meanwhile, the cost of almost everything else has gone up. Yale economist Robert Shiller pegs annual inflation-adjusted residential real estate returns, after costs, at 0.2 percent. 

 Don’t compare an outlier in one asset class to a broad index in another: Imagine if I cited Amazon.com Inc. or Apple Inc. to demonstrate the relative underperformance of bonds or commodities. You would rightly criticize me for cherry-picking.  Use median returns of different asset classes to make appropriate comparisons.

Pay attention to date ranges and exceptional factors: The article in question cites a property purchased in 1978 in Sagaponack, New York, in the tony Hamptons for $140,000 and now listed for $5.75 million. The article reports that this is a 6.61 percent annual return. But note that this is a calculation based on the asking price. That's like saying I'm calculating the return on my Apple stock based on a price of $125 a share -- which it may reach again someday -- even though it trades for $110 today. What's more, the Hamptons aren't exactly representative of anything other than the fact that in the past 40 years the financial industry was on a tear and the Hamptons became Wall Street’s summer playground.

The bottom line is that you have to live somewhere, and owning is often better than renting -- especially during the past few years, when the cost of capital has been so inexpensive. But try making the case that residential real estate, even luxury real estate, has done better than equities during the past 30 or 40 year? The data just doesn't support that conclusion.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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