Residential real estate has performed surprisingly well over the last year, not only during last February-March’s stock market plunge, but subsequently as well.
Is it unusual for this asset class to perform this well? It’s an important question that deserves being asked this month, the one-year anniversary of the pandemic-induced economic lockdown and bear market.
It’s important for another reason as well: Real estate represents one of the biggest chunks of U.S. households’ net worth, if not the biggest. It’s therefore of crucial relevance how residential real estate performs when the stock market plunges.
During the first quarter of last year, during which the S&P 500
lost more than 20%, the Case-Shiller U.S. National Home Price Index rose 1.4%. Unlike bonds, which also rose during that bear market but which have struggled ever since, the Case-Shiller Index has continued to rise. Its latest reading is 8.9% higher than where it stood at the end of last year’s first quarter.
The index’s slow-and-steady march higher over the last decade is plotted in the accompanying chart. The S&P 500’s volatility is nearly six times greater than that of the Case-Shiller index (as measured by the standard deviations of their monthly returns). To be sure, part of this greater volatility is due to how the Case-Shiller index is constructed; each month’s reading reflects a three-month moving average of the raw index values. If I were to calculate the S&P 500’s volatility using the same moving-average approach, its volatility would be “only” three times greater than that of the Case-Shiller index.
Even better, from an asset allocation perspective, is that the correlation coefficient between the Case-Shiller index and the S&P 500 is close to zero.
To find out how unusual the last decade’s experience has been, I analyzed the Case-Shiller U.S. National Home Price index as far back as monthly data are available (in the early 1950s). I measured this index’s performance in each U.S. equity bear market since then that appears in the calendar maintained by Ned Davis Research. If we ignore one bear market in which the index fell by a tiny amount (0.4%), it gained in every one of those bear markets—but one.
That one exception was a doozy, however: I’m referring, of course, to the 2007-2009 Great Recession. From its 2006 high to its 2012 low, the Case-Shiller index fell by 27%.
The $64,000 question, given this history, is whether real estate’s performance in the Great Recession is the exception rather than the rule. Robert Shiller, the Yale finance professor and Nobel laureate who is co-creator of this housing price index, believes it is.
In an interview in the wake of the financial crisis, Shiller told me that he thought real estate’s poor performance in the 2007-2009 was an anomalous event, since historically “there is surprisingly little relation” between home prices and the stock market. He therefore did not expect that “in the next bear stock market there [will] be anything unusual happening in the housing market.”
His prediction was certainly true in last year’s bear market. A recent email to Shiller to get his current thoughts was not immediately answered.
History therefore suggests that residential real estate will be a good hedge during the next equity bear market. Chances are that you nevertheless aren’t putting this lesson into practice in your retirement portfolio, however. That’s because we tend to pay inordinate attention to the recent past, a tendency known as “recency bias.” And this tendency is especially strong when that recent past is as traumatic as the 2007-2009 downturn.
Unless you believe that the world has changed in a fundamental way making the 2007-2009 experience the rule rather than the exception, however, you shouldn’t be underweighting real estate in your retirement portfolio.
If you decide to increase your allocation to real estate, your next challenge is figuring out how to do so. In most cases, of course, our real-estate investments are in our residence or other individual house, and their performance will be a function of a host of idiosyncratic factors in addition to a national price average like the Case-Shiller index.
It’s probably easier to say what not to do. For starters, note carefully that the historical results presented here reflect residential real estate. Commercial real estate is an entirely different kettle of fish, as we’ve seen over the last year as the work-from-home movement has inflicted horrible losses on that sector. Most of the publicly traded real-estate investment trusts invest heavily in commercial real estate, and the same goes for the exchange-traded funds that focus on real estate.
In fact, I couldn’t find any REITs or real estate ETFs whose returns are significantly correlated with the Case-Shiller U.S. National Home Price index. That doesn’t mean you should automatically avoid these REITs and ETFs. But you can’t justify doing so on the basis of the history presented in this column.
One way to invest directly in the residential real-estate asset class is by purchasing one of the futures contracts on the CME that are benchmarked to the Case-Shiller U.S. National Home Price index. Note carefully, however, that the market for these contracts is extremely thin. Because of this, their prices can exhibit a lot of short-term volatility having more to do with the presence or absence of bids or offers than with the performance of the Case-Shiller Index itself.
For example, at the end of last year’s first quarter, the spot contract for the Case-Shiller futures contract was trading at 232.80, and at the end of May at 233. But during April the contract fell to 210 before jumping just as quickly back to where it was before. This volatility likely was due more to the market’s illiquidity than to anything else.
Another limitation to investing in Case-Shiller futures: The longest-maturity contract is just five years out. And, given the illiquidity of the market for these futures, you bear the not-inconsiderable risk of having to roll a maturing contract into a subsequent one at unfavorable prices.
At a minimum, if you are even considering the futures market to establish your residential real-estate exposure, be sure to consult a qualified adviser.
Absent that, your best residential real-estate investment option would appear to be your home or other individual home properties. Just know that you will inevitably incur lots of idiosyncratic risk with those investments. Nevertheless, the history of the Case-Shiller index suggests that you should at least consider incurring that risk.
Notice that this discussion doesn’t take into account taxes or any of a number of other estate and financial planning considerations. As always, consult with a qualified financial adviser before making any big changes.