Investors have focused considerable attention over the past four years on bond markets and real estate, both related to the generational low in interest rates. But they may be ignoring some of the lessons of history.

Many investors are seeking certainty and security after their experiences with high tech stocks in 1999 and 2000. Their interest in bonds combined with low central bank rates have pushed bond yields down to generational lows and bond prices to generational highs. As an investment specialist, I believe that some fixed-income investments are needed in most portfolios. But investors should understand what they are doing when they lock into a five-year GIC at 4.3%, or a Government of Canada 10-year bond at 4.38%. There is a price they are paying for their security.

Low interest rates and a growing economy have also done amazing things to real estate prices in the Okanagan, across Canada and worldwide. After a decade of dormancy through 2001 (an average 1.7% gain per year), standard two-storey homes in Kelowna increased in value by an average 24% per year over the past two and one-half years. And people are excited about it.

Should they be? That works out to 5.6% a year over the longer term, at the high end of TD Economics’ assertion that housing prices grow 2–3% above inflation over the long term, or 4–6 %. To me, it looks more like catch-up than the next big thing. We noticed that North Okanagan home prices seemed exceptionally good value in BC when we moved here from Indonesia in 1999. Now that value has simply been realized.

How do real estate gains stack up against the markets? A $160,000 investment in a Kelowna two-storey house in January 1995 would be worth $280,000 today (a 5.8% annual return), compared with $350,000 if the money had been put into the Toronto S&P/TSX (8.1% per year). Over the long run, returns in financial markets tend to outpace returns from residential real estate, as seen in the chart above.

I should point out that this is a simplified apples-to-apples comparison that will work for most people, measuring financial market investments against land or housing investments. For example, in looking at housing investments in the Okanagan Valley, I have left out costs like taxes, maintenance, and the time value of dealing with tenants.

I have not compared primary residences as investments, because for most people they are homes. While homes may enjoy freedom from capital gains costs, they can be very illiquid, have high transaction costs (like realtor fees, moving expenses and renovations), and will usually incur an immediate counterbalancing cost to buy or rent a new home. And the impact of being unable to deduct interest costs from current taxes is huge.

There are better ways to benefit from the housing boom than buying a second house. For example, real estate investment trusts (REITs) give investors exposure to a diversified basket of real estate investments. And astute fund managers have put some of their clients’ money into areas like home renovations and furnishings.

Investors should also consider where most of the money is made in real estate. Consider a large acreage that is zoned for development, supplied with services, built up and sold. Investors recently paid $22,500 per one-third acre of a particular property in Edmonton. If history repeats itself, they will sell at $45,000 per one-third acre in five to seven years, after the management company zones it. The developer will spend about $17,000 to put in services, and will sell the lot for $100,000 (the current value of nearby lots) and make another 20% on the house. From there, the properties will likely go back to making 4–6% annual gains over the long term.

Huge risk and the majority of profit go to the developer. Investors without the same development skills or appetite for risk can still make 10% per year or more by holding land as it goes through the zoning process, but history shows that the raw land or finished houses are the least profitable segments over the long term. It really comes down to whether a person wants an investment that makes them more money, or one they can walk on.

Remember that record housing prices have been driven by a generational low in interest rates. Real Estate can have a place in any diversified portfolio, but consider investing in the rezoning portion of the cycle rather than in finished homes. Talk to your financial planner and learn from the lessons of history.