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Have real estate returns been overstated?

A new study suggests that the annual growth rate in net total returns from property investments is closer to zero
Have real estate returns been overstated?
  • Previous studies have been too general in analysing rental income and transaction data
  • Holding costs have been overlooked, which can mean the risk to returns is underestimated 
  • Commercial property has outperformed residential in recent decades

Property has long held a special allure for investors. Part of the attraction lies in the theory that placing cash in bricks and mortar offers stable, long-term income that is tied to inflation. Yet what if real estate does not generate the returns that have previously been assumed? That is the conclusion reached in a new study led by HEC Paris professor Christophe Spaenjers.

In a newly released paper The Rate of Return on Real Estate: Long-Run Micro-Level Evidence, Professor Spaenjers and his two co-authors analysed the real estate investments held in the endowments of two Cambridge and two Oxford colleges, from 1901 to 1983. The holdings include commercial and agricultural real estate, and residential property let at open market rents. The findings implied annualised real total returns, net of costs, ranging from approximately 2.3 per cent for residential to 4.5 per cent for agricultural real estate. Not only were capital gains lower over the long term, but the rate of growth in those income returns was also close to zero for all property types: +0.3 per cent for agricultural, -0.3 per cent for commercial, and -1.0 per cent for residential real estate.

That is substantially below the returns suggested by previous studies, including 2019 research that estimated an average real net return to housing of 6.6 per cent a year, similar to those generated by equities. 

So why the discrepancy? The answer seems to be in the granularity of the data analysed. Previous studies have focused on the growth in average or aggregate contractual rental income in the market, rather than income actually realised from the property holdings of institutional investors, the authors of the research argue. This distinction is important because “market-wide income may increase as new, higher-quality properties are added to the existing stock, while the income for any previously-constructed property may not evolve in the same way”, the authors of the study assert. What’s more, where income data are available for property samples, transaction prices are not typically observed for the same properties. As a result, researchers often combine income and price data from different sources to estimate yields and total returns. 

The study attempts to navigate these challenges by analysing transaction prices, rental income, and costs for the same sample of individual properties – those owned by King’s College and Trinity College in Cambridge and Christ Church and New College in Oxford. Historically, these colleges have invested in agricultural and commercial real estate, as well as housing.  

During the latter decades of the period studied, commercial property outperformed residential property. Residential returns may in fact have previously been overstated. Most data have tended to capture contractual rental income, which can be significantly higher than realised income due to rent arrears and temporary voids, and therefore leads to overstated rental yields. What’s more, the ratio of contractual rents to market rents may also be highest at the time of establishing the contract, which is typically when they are observed for most academic studies. The difference in performance between commercial and residential income returns is also partly attributed to a lower holding costs associated with the former, which has an annual average expense-to-income ratio of just over 19 per cent, compared with 32 per cent for residential. In existing academic research, maintenance costs are not always taken into account, it argues. Yet ignoring holding costs can therefore lead to a substantial underestimation of the riskiness of real estate investments.  

The study has some natural challenges in terms of lessons for UK investors today. Chief among them is that it focuses on investments only up to 1983 – the dynamics of the commercial property market have changed dramatically since then, particularly with the structural decline in retail and rise of logistics warehouses. It is also unclear to what extent asset management activity was undertaken by the four Oxbridge colleges. It is unlikely to reflect the large-scale redevelopment work performed by many UK-listed commercial landlords, which allows them to re-let space at sometimes substantially higher rents than previously agreed. Nor do we know exactly which areas of the commercial property market those colleges are exposed to – logistics and retail rental and asset values are moving in starkly different directions. 

Yet one lesson that does hold true is over diversification: "Ownership of one property is more hazardous than owning a portfolio of dozens or hundreds of properties”. It is a benefit borne out by many UK real estate investment trusts since the onset of the pandemic, where the impact of weakening retail rents has been eased by more resilient corners of the property market.   

The Rate of Return on Real Estate: Long-Run Micro-Level Evidence is available to read in full via The Review of Financial Studies.