Housing is recovering from its worst decline since the Great Depression, and institutional investors are leading the way back into the arena—investing in U.S. housing in a fashion and to a degree never before seen. Perhaps you are considering a reallocation away from stocks to housing. Is now the time to shift? Let’s review the facts.

A New Trend
Single-family home prices in Atlanta were up 10% in December from a year earlier. Other major cities have experienced similar price increases. Nevertheless, national home prices are still 29% below their 2006 peak, according to Yahoo! Finance. One major factor underlying recent robust price increases has been the Fed’s efforts to drive interest rates as close to zero as possible. As a consequence, traditional bond portfolios no longer provide adequate yields to meet the minimal income needs of virtually any investors (institutional or retail).

The desperate search for income by the more forward-thinking investors has led to a powerful new trend, according to The Wall Street Journal—that of large institutions seeking income by purchasing single-family dwellings and subsequently renting them (generating a higher income stream).

For example, the U.S. Masters Residential Property Fund, a real-estate investment trust that has raised $276 million, is betting on the U.S. housing recovery by buying houses at discount prices. The business of buying and renting houses has morphed over the past two years into one of the hottest investments on Wall Street.

“Dozens of pension investors and private-equity firms, such as Blackstone Group LP and Colony Capital LLC, are clamoring to buy homes in beaten-up markets,” writes Robbie Whelan in the Journal, in a story called “Foreign Buyers Hop on Rental Trend.” “In January, investment bank Keefe, Bruyette & Woods estimated that institutional investors had raised between $6 billion and $9 billion to buy U.S. houses and convert them into rentals.

“In December … Silver Bay Realty Trust Corp. became the first U.S.-based single-family rental company to go public as a REIT,” he continues.

These behaviors have the potential to feed on themselves, delivering an extended rally in housing prices. The current housing inventory-to-sales ratio (the supply/demand ratio for housing) is the tightest it has been since the beginning of 2005, according to Ned Davis Research in Atlanta. This ratio could serve as a strong driver for future house price appreciation.

Housing Versus Stocks
The Karl Case/Robert Shiller housing price data is the most widely respected and used long-term housing data series for domestic single-family dwellings—with high-quality data extending back to December 31, 1889. Figure 1 provides a comparison of the returns between U.S. housing and U.S. stocks after the adjustment for inflation (real returns).

With great clarity and robustness, these data demonstrate that equities typically deliver far higher returns than housing. Unless the investor has an unusual and rare ability to pick the right period favoring housing, he or she is likely to be disadvantaged.

Just how skilled would an investor have to be in order to do better in housing than domestic equities? Figure 2 shows the all-time best time periods for housing in two- to 12-year increments, over the last 123 years, next to the S&P 500.

Observe that even when one identifies the absolute best-performing time windows for housing, equities still performed better! The only exception to this rule was the unusual and exceptional housing environment that ended in early 2006: The after-inflation return to housing for the nine years ended December 31, 2005, was 7.01%, and it was only 5.08% for U.S. stocks.

Housing’s Low Returns
So why are housing’s returns lower than equities’? Recall that when one invests in stocks, one buys a portion of a corporation’s earnings and the future growth of those earnings. When one invests in housing (a single-family dwelling), he or she acquires a remarkably different asset.

Actually, it’s the acquisition of two quite different assets. First is the structure itself. This is a continuously depreciating asset that declines in value every year as it deteriorates—its annual rate of return is always negative. The only exception to this rule is when the cost of “carpentry” rises faster than the general Consumer Price Index.

The second component is the land on which the structure rests. Land is in fixed supply, and in any economy with a growing population, its relative price has a strong propensity to appreciate. It has been estimated by researchers at the Federal Reserve and the University of Wisconsin that, on average, the typical American house has about 50% of its value locked up in the land and the remaining 50% in the structure itself (obviously, there are wide variations from this 50/50 rule by geographic region).

Given that the structure has an inherent negative return and the land a positive return driven mostly by favorable population growth, it is natural to expect a low return to housing—which is well demonstrated by the data. In general, those investors who expect housing to offer higher returns than its historic long-run average of less than 1% are heavily biased by the exceptional time period ending in 2006.

The Case For Housing
Given these observations, a decision today to reallocate away from domestic equities and toward housing would need to be based on either a well-founded belief that stocks were about to decline in value or that we were entering an extended period during which the forces driving housing prices upward were as strong as those in the decade preceding early-2006. The first outcome is possible, the second implausible.

But an important distinction should be drawn. The returns are different for people who own single-family dwellings to live in and those who purchase and then operate houses as rental units.  The latter are involved in the difficult, back-breaking work of identifying an attractively priced local house, acquiring it at a good price, converting it into a rental and managing the unending day-to-day tasks of the successful landlord. This would be a significant operational business, and it holds, at least, the potential for more attractive returns—and perhaps even more so in the environment ahead.

Rob Brown, Ph.D., CFA, is the Chief Investment Strategist at United Capital Financial Advisers LLC. E-mail rob.brown@unitedcp.com.