Raging Bulls: Edifices vs. Equities

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Housing prices and stock prices are hot topics, and both have been in raging bull markets over the last year. But who has been the heavyweight champion over time? Like many things in investing, the answer depends on the time frame and assumptions. So, let’s begin by introducing our competitors and the rules of the match.

Edifices

To keep things simple for the real estate investment, and because of data availability, I have assumed the purchase of semi-detached, 3 bedroom houses in Vancouver and Victoria to represent residential real estate.

Equities

I have used the total return on Canadian stocks (S&P TSX) and a balanced stock portfolio. The balanced stock portfolio is 40% Canadian stocks (S&P TSX), 30% U.S. stocks (S&P 500), and 30% international developed market stocks (EAFE). All returns have been converted to Canadian dollars. I assumed the investments in stocks were done through ETFs. The average historical investment cost was 0.08% for Canadian stocks and 0.07% for balanced equity.

Rules Of the Match

Since every investor has a different tax situation, income and capital gains taxes were not factored into returns.

Bout 1: Lightweights vs Middleweights

Chart 1 shows the price returns (lightweights) for the Vancouver and Victoria real estate investments versus the total returns (middleweights) of Canadian and balanced stocks. The time period is the 20 years ended March 2021. We assume a starting investment of $250,000. This was the average of the price of a Vancouver and Victoria semi-detached house in March 2001.

It is no wonder that we hear so much about real estate gains. Over the last 20 years Vancouver real estate came out on top, with $250,000 growing to $1.1M, a 7.7% annualized return. Canadian stocks were a contender, growing to $1M or an annualized return of 7.3%. Victoria real estate and balanced stocks were close, growing to around $0.9M and annualized returns just under 7%.

Chart 1

Bulking-Up

Bout 1 was unfair, as we only looked at the price return of the real estate. Let’s get the competitors evenly matched by estimating the total return on Vancouver and Victoria real estate investments versus the total return on equities. To do that I used additional data and assumptions.

  • No debt to finance the purchase of the investments
  • The real estate value at the beginning of an investment period was based on the median or average price from CMHC data for a semi-detached home, and the starting monthly rent was based on CMHC data for 3 Bedroom+
  • The purchase prices and rents at the beginning of each period were as follows:
    • 20 years beginning March 2001: Vancouver $285,000 and rent $930; Victoria $214,000 and rent $894
    • 10 years beginning March 2011: Vancouver $675,000 and rent $1,300; Victoria $524,000 and rent $1,368
    • 5 years beginning March 2016: Vancouver $815,000 and rent $1,450; Victoria $578,000 and rent $1,496
  • The real estate price changes were based off the Teranet–National Bank House Price indices
  • The average annual rent increase was based off historical inflation and B.C.’s historical maximum allowable rent increases, which resulted in 3.5% for the 20-year period and 3.1% for the 10 and 5 year periods
  • Monthly maintenance costs of 15% of rent
  • Historical annual property tax for Vancouver and Victoria from B.C. government and City of Vancouver data
  • Annual home insurance based off representative historical rates
  • Closing costs based on B.C. property transfer tax and estimated costs for appraisals, inspections, and legal costs

Bout 2: Middleweights

The resulting bulked-up internal rate of returns (IRR) for the edifices are shown in Chart 2. The returns for equities were already total returns, so the 20 year numbers are unchanged from Chart 1. Chart 2 also shows how the time period of 5, 10 or 20 years changes the IRRs.

Chart 2 Annualized Returns

Looking at the IRRs for the last 20 years on this new total return basis, we see that total return on Vancouver real estate is the leader at 9.4%. This is up from the 7.7% price return in Chart 1. The big change compared to Chart 1 is that the total return for Victoria real estate has surged past Canadian equities. It increased to 9.1% from its price return of 6.8%. The bulked-up return for real estate is a result of the net rental income earned.

The results are much different over the other time periods. Over the last 10 years balanced stocks moved from the laggard position over the last 20 years to the clear leader with a return of 10.1%. Over the last 5 years balanced stocks remained the leader with a return of 11.3%, followed by Victoria real estate at 10.4%. Vancouver real estate went from the leader over the last 20 years to the laggard over the last five years with a return of 7.2%.

Bout 3: Heavyweights

Now it is time to get closer to a real-life investing situation. In Bout 2 I assumed that no debt was used to purchase the investments, which is unrealistic for real estate. For Bout 3 I put in place a mortgage for part of the real estate purchase. However, to have a fair match I also assumed the stocks were bought with some debt (a margin loan). Since the maximum borrowing amount for a margin loan is 50% of the value of the stocks, I also assumed a 50% mortgage for the real estate.

The other data and assumptions to calculate the IRRs were:

  • Variable rate mortgages for the real estate with a 25 year amortization period
  • An average historical discount to the monthly Prime Rate of -0.65%, based on Bank of Canada data, for the variable rate mortgages
  • The monthly Prime Rate history from the Bank of Canada
  • Margin loans for stocks were based on the monthly Prime lending rate
  • An average historical premium to the monthly Prime Rate for margin loans of +0.75%
  • Margin loans were structured with a 25-year amortization period to get the same loan principal paydown schedule as the real estate mortgages

Chart 3 Annualized Returns

With leverage everything changed to the upside. Over the last 20 years Vancouver and Victoria real estate dominated with returns over 11% compared to stocks at around 8%. Over the last 10 years balanced stocks were once again the clear winner, with real estate taking second and third place. The last 5 years were exceptionally strong for edifices and equities with all returns in the 20% range. The returns for balanced equities and Victoria real estate were a draw at 23.7%, with Canadian stocks a bit lower and Vancouver real estate a little further behind.

And The Winner Is…

The IRRs in Chart 3 are the most relevant as they are the closest to real world returns. Yes, you can borrow up to 80% of the value of an investment property to boost returns further. For example, 80% debt financing would have increased the annualized return of real estate over stocks by another 3% over 20 years, 6% over 10 years, and 18% over 5 years. But you can’t borrow that much against stocks, so for an apples-to-apples comparison leverage needed to be 50%.

Based on the numbers alone from the 20 year period in Chart 3, the champion has been edifices in the form of Vancouver and Victoria residential real estate. But you can see how sensitive the returns have been to the time period, as balanced equities dominated over 10 years and tied for first over 5 years.

Post Bout Wrap Up

When analyzing edifices and equities for an investment portfolio, you know that returns are not the only thing to look at. Factors such as risk, diversification, liquidity, time horizon, and taxes are important too, especially in the case of real estate holdings. Our edifice examples assumed the purchase of a single property. This introduces a lot of property specific risk that could have occurred, but that can be eliminated by holding a diversified portfolio of properties.

It is also important to point out that one common driver behind the raging bull markets in edifices, and equities for that matter, has been the continual fall of interest rates over the last 20 years. Looking forward, falling rates are unlikely to be a tailwind as there are forces pressuring rates higher. First, economic growth is recovering from the Covid shock and restrictions. Second, a massive amount of debt has been and continues to be issued to finance government spending around the globe.

While we are unlikely to earn returns like those over the last decade or two, edifices and equities are both important parts of a diversified investment portfolio. There is no one size fits all allocation though. The weighting of each must be customized to reflect your own personal situation, goals, and preferences.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.