What Makes Real Estate Such An Attractive Asset

And why that is bad for society and wealth inequality

I want to talk more about why real estate is so ungodly expensive these days as it’s a major problem that contributes to growing wealth inequality. And wealth inequality grows until the masses have had enough and demand either redistribution or revolution — so it would be foolish to keep ignoring this.

Last time we talked about leverage and the way policy makers and the big banks are incentivized to keep home prices stable and rising because real estate is the bedrock of the financial system, in that it backs a massive amount of loans. One just needs to look to China to see how bad things can get when that foundation gives way.

But that’s the problem — why is real estate such an attractive asset? Here’s why both individuals and institutions love investing in real estate (i.e. why prices are perpetually frothy):

1. Land is a scarce resource so its value should not only keep up with inflation but also exceed inflation as populations rise.
2. Land earns a return in multiple ways. First even undeveloped land has value because it is scarce and has the potential to be developed into say housing or offices. And once developed, it earns regular cashflows from rents. This combination of appreciation and cashflow is very attractive to investors (see bullet 3).
3. Real estate returns tend to be less volatile than stock returns (an attractive thing to investors looking to raise their Sharpe ratios). Part of the reason is artificial — real estate is illiquid and transactions are much fewer and further between so real estate valuations tend to lag REITs (in the same way that private equity lags public equity). But there’s also real diversification to be had. When inflation goes up (causing rates to rise and the economy to slow), the decline in rents due to higher vacancies is offset by the ability of the underlying land to keep up with inflation. Thus, the inflation hedging component of the underlying land provides a hedge to the riskier aspects of real estate.
4. This inherent stability makes land not just a popular source of portfolio diversification but also an attractive collateral. This means that institutions (and the rich) can borrow against their real estate to finance the purchases of even more assets. And in most cases the rent earned from the real estate is more than enough to pay for the interest — so they can have their cake and eat it too.
5. Similarly for individuals, the easiest way to borrow a bunch of money to purchase an asset is via a mortgage thanks to banks willingness to lend against housing. The easy availability of credit to finance real estate increases the demand for real estate relative to other assets.

And that’s why real estate is so expensive. As long as it’s regarded as a highly attractive investment asset instead of a basic need, there will always be an incentive from those that own to keep things scarce and prices (as well as rents) rising. This only gets worse as time goes on because the attractive ex post rates of return and easy leverage suck in more investors, which makes the returns look even better.

And because shelter is the largest portion of most peoples’ expenses, living costs will keep rising, increasing the wealth divide between those that own and those that don’t.