“Real Estate Prices have gone nuts! The prices are insane!”
Real estate prices are a major topic everywhere you go. Home prices have skyrocketed in recent years, becoming out of reach for most young people. The price-to-income ratio in Los Angeles and San Francisco is now approximately 10, which means that if you work ten years, earn the average salary of a person living in one of those cities, and save all of it, you would be able to buy a house at the end of the period.
You don’t really need to wait ten years, though, as you can always leverage your capital with a mortgage, but that is also becoming not so attainable unless you want to enslave yourself to the bank. By the way, did you know that mortgage is a synonym for enslave?
The rival of the indices
I have tried to determine if this enslavement is really worth it. The best index we have for real estate prices in the U.S is the Case-Schiller Index. Its methodology is not so intuitive, so we will not discuss it, but here is a link for those who can’t give up. I know them. I am one of them.
The only thing you should really know about Case-Schiller is that the index calculates changes in real estate prices in the top metropolitan areas in the U.S. Among them you could find all the usual suspects, which I might discuss in future posts, but the issue of this post is only the San Francisco metropolitan area.
San Francisco prices have increased dramatically in the last few years. This city is a major technology hub, drawing freaks and geeks from everywhere around the globe. As the economy and especially the technology industry recovered from the recession, property prices spiked, so it seems that buying a home a few years ago could have been a great financial decision. Imagine, though, that instead of buying a house in San Francisco you decided to rent and invest the extra money saved in some San Francisco-based companies (mostly tech companies). Year after year, by investing in Google, Apple, Facebook, and others, your return would have been higher than the real estate return (according to the Case-Schiller index).
It’s easy to pick these companies in retrospect, right? So let’s choose a more credible index to compare with it. Intuitively, the NASDAQ index comes to mind. The NASDAQ is composed of some major tech companies, including Google, Apple, and Facebook, which probably makes it likely to have a correlation with the San Francisco economy and thus with the San Francisco real estate business. Accordingly, I compared the returns of both indices in the last decade.
Tam tam tam…The results:
In 2016, the Case-Schiller (CS) in San Francisco went up by 5.7%, and the NASDAQ went up by 21.7%. The scenario in 2015 was quite different, as the CS rose by 10%, but the NASDAQ finished the year with a slightly negative return.
In 2014, the NASDAQ was on top—12.9% to 9.4%, while in 2013 it was 30.6% to 22.6%, and in 2012 the CS enjoyed a bigger yield of 14.4% to 11.7%.
So, for the period 2012–2016, the indices were pretty close, with several wins for the NASDAQ and some upsets for the CS. What’s particularly interesting, though, is what happened before 2012.
In 2007 and 2008, both indices went down—2007 was the first bad year for the CS in the San Francisco metro area for a long time: -10.8%, while the NASDAQ was -3%. In 2008, both indices plummeted—the CS by 31.2% and the NASDAQ by 38%, but look what happened in the critical years between 2009 and 2011, the NASDAQ gained each year: 45%, 26%, and 4%, respectively. The CS? Oh, boy—just 5%, 0%, and -5%!—generally flat during the same period that the NASDAQ had significant gains.
We need to remember the notable equation Risk Equals Reward. It seems that the NASDAQ is more volatile than the CS, which was expected, but the CS is still a very risky index, with a flying-high standard deviation. Considering the last decade, it seems that the risk of the CS is not always “worth” the reward, at least if the reward is disguised as a mortgage.
If $100 had been invested in an average San Francisco house at the beginning of 2007, it would be worth $108.5 today. That’s an extra $8.5, and I’m not even sure if that’s enough to afford a cup of coffee in San Francisco today. The same amount invested in the NASDAQ would now be worth $227.9, which is quite a difference.
I compared the SF index with the S&P 500, which is an index that reflects the American economy to a great extent. You would still end up with $58.4. Enough for a dinner in the city, right?
I’m certainly not the first person who has tried to understand if buying a house is a smart economic move, but you should have this information to consider before making one of the most critical decisions of your life. It should be noted that the comparison is not adjusted for other factors besides appreciation of assets, such as rents and mortgage payments, and this will be the topic of another post.
For this post, I am only referring to the San Francisco metropolitan area and the NASDAQ index. I think it’s a good comparison since the NASDAQ is composed of many stocks of companies based in San Francisco. It is not a scientific study, but it is an interesting experiment that may have implications for other metro areas. What about Los Angeles and the showbiz industry? Houston and oil? New York and finance?