Insights

In our previous article, we discussed the tendency of equity market returns[1] to mean-revert with periods of high returns followed by lower returns and vice versa. The previous article explained this observed behavior. As we stated, “The key is to understand the source of “investment” returns. Two factors affect the overall investment returns—one, underlying returns on capital of the businesses, and two, changes in valuation multiples.”

This month’s letter takes the example of real estate to explain the expected investment return equation further. The unlevered return from real estate is comprised of two factors. One, the net rental yield. Note that this factor is synonymous with the underlying return on capital of businesses. And two, changes in the property’s market value after adjusting for appropriate inflation.

Since 1911[2], housing property in the US has yielded a gross [3] inflation-adjusted annualized return of 6.0%. The first chart shows the total real returns from US housing since 1911. Gross rental income on US housing has averaged at 5.1% per annum, with a 0.9% annualized return from real price appreciation.

After an extended period of above-average increases in prices, it is only reasonable that there will be a general belief that prices will continue to rise at those high rates. The period between 1995 to 2006 was just that kind of a period that gave rise to the Great Financial Crisis (GFC). As is seen in the second chart above, this price appreciation has left US National housing prices well above their trend levels.

When evaluating any asset including equities, the key is to understand the sources of the returns from that asset. Owners of equities can truly only earn the cash flows generated by the businesses that underlie their investments. When investors are willing to pay a high price for the privilege to acquire an interest in those cash flows, the underlying expected returns on their investments decline. Furthermore, as and when the second component of the total investment return equation reverses itself, it results in significant losses.

1 The holding period used for the purposes of that analysis was twelve years.

2 Data source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. | OECD, Housing prices | S&P/Case-Shiller Home Price Indices and CPI, Fred.

3 We have used the total rent for calculating total returns. These rents are gross of expenses and taxes against the property.