Stocks just experienced their worst December since the Great Depression. While the stock market has bounced higher so far in the new year, analysts warn that after a decade-long run, a bear market in equities is increasingly likely. Where can an investor go to preserve capital if stocks weaken further? How about real estate?
“Wait,” I can hear you saying, “during the 2008-2009 bear market in stocks, real estate was a poor investment like most all other asset classes.” That is very true, but here’s the thing: The Great Recession may have been an anomaly for real estate. We say this because history tells another story — real estate has generally held up well during bear markets.
But don’t take our word for it. Robert Shiller, Nobel Prize winning economist, co-creator of the Case-Shiller Home Price Index, and someone who predicted the last bear market, recently told MarketWatch this: “I have calculated that there is virtually no correlation between prices in the housing market and in the stock market over long intervals of time (back to 1890).” In a 2015 Barron’s interview, Shiller said real estate’s negative performance during the great recession “looks just like chance.” We would point more to the tendency toward rising correlations across asset classes in the context of financial crises than to “chance”, but either way the data does support that typically housing has held up well, even when equities are in a bear market.
According to Shiller’s research, in 20 equity bear markets going back to 1950, real estate prices rose in all but two – the Great Recession, and one in which prices fell by just 0.4%. In the Barron’s interview, Shiller said that residential real estate’s poor performance a decade ago was caused by idiosyncratic factors such as “subprime mortgages, securitized in tranches, and dubious innovations, [as well as] liars’ loans.” The economist said those developments are unlikely in the future, due to the greater “vigilance” that regulators now exercise over the real estate market – such as the Dodd-Frank act, which became law in 2010.
Residential real estate might even be a better hedge than bonds in the next equity bear market. While real estate historically has risen along with inflation (positive correlation), bonds have been inversely correlated, tending to fall when inflation rises. If inflation heats up during the next bear market – as it did during the stagflation era of the 1970s, for example — expect bonds to underperform.
Even when interest rates rise – a big worry of investors these days – real estate has done relatively well. Because while rising rates mean the cost of borrowing increases, a potential negative, inflation may also mean real estate values rise. Rising interest rates and inflation tend to counterbalance each other during economic downturns/bear markets.
So, hedging by allocating to residential real estate makes sense. But it’s not as simple as buying an ETF — there isn’t a vehicle that neatly tracks the Case-Shiller Home Price Index. Real estate investment trusts (REITs) are liquid and might seem like a place to park funds in a down market. But according to Shiller, REITs “pretty much track the stock market.”
The same goes for stocks of home construction companies. Over the past two decades, for example, there has been insignificant correlation between the S&P 1500 Homebuilding index and the Case-Shiller Home Price Index. In contrast, those homebuilder stocks have been highly correlated with the overall stock market.
Futures that trade on the Chicago Mercantile Exchange and track Case-Shiller are woefully illiquid, and given that the average bear market lasts over 12 months, futures would tend to be impractical anyway.
Investors could best be served, then, by investing in individual properties to hedge against a bear market. Of course, we know that real estate performance is local – so there’s no guarantee a specific property will track the Case-Shiller index. That’s where investor savvy comes in. During the last downturn, there was considerable variation for real estate returns, depending on the area, property type, neighborhood, etc. For example, the DC residential real estate market (an Aloha Fund area of focus) continued to expand in the years after the 2008 financial crisis due to massive government spending and strong job growth in the government sector. On the other hand, the Miami condo market contracted sharply during this time. Further, property types react very differently to a bear market. Vacation homes and the ultra-luxury sectors are likely to contract greater than the typical residential property, that’s more in the wheelhouse of Aloha, if there’s a bear market.
Soaring technology stock values created vast wealth for Silicon Valley-related professionals in recent years, and contributed to bubble-like real estate conditions in some tech-centric markets like San Francisco. If the tech sector undergoes an extended correction, we can envision softness or corrections in the most exposed regions.
On the other hand, real estate markets that have not soared, but are experiencing a more steady income or appreciation growth, continue to offer opportunity in our view. Midwest cities like Kansas City, MO, Columbus and Cleveland, OH, or Indianapolis, IN still have supply and demand imbalances in certain market segments. And when equities go into a bear market, property values in these areas may certainly correct, but ultimately/historically have exhibited a fraction of the volatility of stock market portfolios.
If history is any indication, the next equity bear market may not bring strong headwinds for residential real estate. On the contrary, a shrewd real estate investor can avoid the bear, hedge their stock portfolio and potentially thrive by allocating capital to properties that offer good value and the right risk reward profile.
As always, feel free to reach out with questions and interest in working with Aloha Capital in this excellent investment–Aloha LTD Income Fund.