Over the last 20 years, Australian residential real estate has delivered strong returns. There is also a common perception that it has delivered these returns with low risk. However, this perception stems from an uncritical use of flawed historical statistics because residential houses are not traded on exchanges with continuously observable prices. As a result, risk is underestimated.
Consider the following analogy*: a bat is flying through a dark tunnel. While it is inside the tunnel, you cannot see it. The bat may exit the tunnel at about the same height it entered the tunnel — see the image above.
However, the bat’s actual flight path within the tunnel, if it could have been viewed, would have been seen to go up and down erratically.
In this analogy, the time in the tunnel corresponds to the time between a particular house being bought and later sold, and the height of the bat’s flight corresponds to the true price of the asset. By only measuring the bat’s height at points of entry and exit from the tunnel, we would underestimate the real volatility of the price. Asset liquidity corresponds to the end of the tunnel, when the true price is first clearly visible.
In the case of residential real estate, owners leave their houses on the market for extended periods when they don’t receive an offer to their liking, even taking it off the market altogether when they can’t get what they think it’s worth. This behaviour leads to a data series that is overly smooth and greatly understates the risk or volatility in the price of the asset. It is an interesting thought experiment to imagine what range of prices your house would realise if it absolutely had to change hands on each and every business day.
* Bat diagram and analogy from Managing Investment Portfolios: A Dynamic Process edited by John L. Maginn CFA, Donald L. Tuttle, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA
