Real estate versus stock market

Today we will compare real estate versus the stock market – based on 11 different factors, including rate of return, tax benefits, use of leverage, effort requirements, and chances of making mistakes.

If you have never wondered how real estate investing compares with stock market investing, then you haven’t taken up investing seriously yet. Following are the 11 factors that I have compared for the two most common investment avenues – real estate and the stock market.

Real estate versus stock market

Let us first understand these 11 factors and then do the comparison.

1. Return on investment – This is the most important factor that I look for in any investment avenue. How much is the return on investment?
2. Tax benefits – As we already know, not all income is taxed identically. The tax treatment of stock market is different than the tax treatment of real estate returns.
3. Tangible – Humans have a natural tendency to gravitate towards things that are tangible – that they can see and experience.
4. Use of leverage – Leverage enhances returns, we will explore how leverage can be used in the stock market and in the real estate, and see if one is more effective than the other.
5. Passive – We do not want to work for our money, we want our money to work for us. We will examine the ‘active involvement’ required in the real estate market as well as the stock market.
6. Possibilities to make mistakes – Money is funny, that is one place where we do not want to make mistakes and that is one place where we invariably make some mistakes. Still, we would rather be in a ‘market’ where mistakes are less likely.
7. Diversification – My grandmother used to say “Do not put all your eggs in one basket”. We will discuss how easy or difficult it is to achieve diversification in real estate v/s stock market.
8. Clear valuation – Nobody wants to spend more than the item is worth.
9. Entry and exit costs – Entry and exist costs are not the same in real estate as they are in the stock market.
10. Liquidity – Simply states liquidity of an asset is the ease at which you can convert it to cash – quickly and at a fair market value. Everyone prefers liquidity.
11. Good historical information – this ties to clear valuation point. You can value something only when you have good information about the asset you are purchasing, otherwise it is just GIGO (Garbage In Garbage Out).

Now let us compare real estate and stock market:

Rate of Return

S&P 500 has historical returns of 10.3% while real estate has returned 2% – 4%. So clearly stock market is a better investment than real estate if rate of return if your primary motive.

A friend of mine argued with me saying there is huge potential for capital appreciation. I countered him with facts and figures – the best data to understand housing capital appreciation is HPI (Home Price Index). If you export the data from here-  S&P/Case-Shiller U.S. National Home Price Index , you will see that if we baseline the HPI to 100 in 2000, current levels are close to 183 – that only  represents a 3.8% capital growth.
This 3.8% is also high in my humble opinion – because the data started with Jan 2000 – and the real estate prices increased significantly during 2000 – 01 time frame (more than 12% in 2000 itself). If I go and find data from 1995 – 2015, I think the capital growth will be less than 3%.

Tax benefits

Although stock market has several tax savings strategies and we will discuss them in the coming days; for today it suffices to say that real estate tax benefits are superior to those offered by the stock market. Particularly the following 2 items stand out:

  1. 2.7% depreciation per year adds a lot of ‘cashless expense’ to the accounting.
  2. LKE (Like Kind Exchanges – 1031) offer a perfect way to avoid capital gains tax

Tangible

You can see real estate – you can see the house or condo you own. You own it. You cannot see stocks. You just own it in your electronic account.

Use of leverage

Leverage is when you put some of your money and borrow the best to make up for the price of an asset. A typical example is buying a house with 20% down. The house was worth $100,000, you put down $20,000 and borrow the rest from a bank ($80,000 mortgage) and buy the house.

You can use leverage in the stock market (buying on margin) as well as in the real estate market (mortgage).

What happens when the asset prices falls? You own a house worth 100,000 and owe the bank $80,000. After a year, let us say you owe the bank $75,000 and the value of the house falls to $70,000. You are ‘upside down’ but as long as you keep making your monthly payments, the bank is not going to force you to sell the house.

In stock market, if you are upside down, the lender of funds (brokerage) will force you to sell the stocks – in fact if you do not sell it soon enough, they will sell it for you. And then you are in the ‘buy high sell low’ situation.

So use of leverage is more appealing to the real estate market v/s the stock market.

Passive

We do not want to go and work for our money, we want our money to work for us. There is more work to be done in owning real estate than owning stocks. I say this for the following reasons:

  1. When one is starting out in the stock market, sure you will need to spend a lot of time understanding concepts like risk tolerance and asset allocation. But once you have understood the concepts, you do not need to spend a lot of time every time you would like to invest. In real estate, you will need to do it every time you buy.
  2. Real estate also has some ongoing effort requirements – maintenance issues etc.

Possibilities to make mistakes

Real estate offers more possibilities to make mistakes. In the stock market, as long as you invest regularly and are well diversified, the chances of not making money are minimal.

Diversification

Diversification is one of the key factors in any investment strategy. In the stock market, you can diversify with very little money – yesterday I bought VOO at $188.22. VOO is an ETF that tracks S&P 500 companies. So with as little as $188.22 I now have a diversified stake (in 500 companies).

In real estate, even if one property costs $50,000; you would need $25 Million to own 500 properties.

Crowdfunding platforms are changing this aspect – more on my experiences with them another day.

Clear valuation

Real estate versus stock market _ VOO historyAbout 2 Million units of VOO change hands every day. Assuming a rather high average trade value (per party) of $200,000; we are talking about 2,000 different parties buying and 2,000 different parties selling VOO.

Compare that to a real estate scenario – an average property is seen by say 25 investors, has 5 offers, and one offer gets accepted.

It is more likely that 4,000 parties have nailed down the fair market value of VOO as compared to the two participants in the real estate transaction (1 buyer and 1 seller)?

Note: This might also mean that it is possible to discover hidden gems in the real estate market. But then with the hidden gem discovery journeys, the chances of making mistakes increase.

Entry and exit costs

Selling real estate usually costs 5 – 6% of the selling price. While buying and selling stocks can cost anywhere from $0 to $10 per transaction.

{Note added on 12/31/2015 – A reader Martin Sage pointed the following via his comment: Because stocks are so easy to get in and out of, many people panic and sell during downturns.

I kind of agree with him, it takes a lot of discipline not to panic and believe in your investment philosophy, and hold on to your target asset allocation. Selling in panic leads to ‘buy high and sell low’ situations’. Thank you Martin Sage}

Liquidity

If I want to liquidate my stock market holdings, I can sell today (Wednesday 11/18) and the cash proceeds will be there in my account Monday 11/23.

Try selling a house at fair market value – you are lucky if you have the cash in 6 weeks !

(I can withdraw cash from my stock positions using margin and have the cash wired to my checking account within half an hour).

Good historical information

Real estate versus stock market _ VOO yieldIt takes me a total of 3 seconds to go on the morningstar website and see accurate historical information about VOO. You can see the 12 month yield and 52 week price range right on the home page of the ticker. It takes a lot more effort and analysis to figure out the historical information.

Conclusion

It looks to me that the stock market is for people who want to make most money with limited effort; while real estate seems to be for people who want to be actively involved and derive a certain sense of pride in owning real estate.

42 thoughts on “Real estate versus stock market

  1. Very good article! The comparable analysis is very accurate. Both stocks and real estate investing requires superior sense of knowledge to do it properly without risking too much.

    • Nathan – thank you for the appreciation of my article. I completely agree with you that both stocks and real estate investing requires superior sense of knowledge to do it properly without risking too much.

      In my opinion though, for the reasons I mentioned in my article, acquiring that superior sense of knowledge to make money in the stock market is relatively easy. Evaluating a stock index is far easier than evaluating a real estate investment property.

      • I loved your article. I currently own 3 properties in Canada and find it is some work but the prices have appreciated over the past 10 years substantially but are now in decline. I am looking to diversify and invest in the stock market but am “scared” as I am ignorant in this area. Do you have any suggestions on how to learn to evaluate a stock index and how to make good decisions in choosing a stock?

        • Hi Jack, I will try and come up with an entire post about asset allocation.

          For now – there are the following major asset classes in the stock market: domestic (large cap, mid cap, small cap), foreign (developed and developing), domestic bonds, foreign bonds, and commodities.

          Ideally you should pick an ETF that covers each of the following. I love VOO, IJR, VWO, DBEF, and BIV.

          I have limited exposure to bonds and commodities. I do not like commodities http://wp.me/p6V9kv-g , my p2p loans are equivalent of bonds holdings http://wp.me/p6V9kv-2n

  2. Very nice if all you are considering is capital increases. As a rental multiple other factors come into play. That $20,000 down payment will bring in multiple benefits.
    1. Tax deductions. Depreciation as you mentioned, property tax, interest, insurance all come off your income, and all are payed for by your tenants!
    2. Maintenance should be handled by a management company bringing your time involvement down to hours per week if handled properly.
    3. Cashflow. A $100,000 dollar home should bring in cash above expenses of $100 to $200/month or more. This in addition to equity buildup in the form of principal payments.
    4. Free money. Yes free money! If you refinance that home in 10 or 20 years the money you take out of it is tax free! It is a loan not a capital gain.
    This is just a short list but I wanted to bring a small plug for real estate into this discussion.
    There are ways to use leverage even beyond the basic bank loan and a little negotiating during purchase can increase your margins considerably.

    • Charles,

      I appreciate your comment. It brings in a different perspective and gives us something to discuss, so thank you.

      I actually was not only considering capital increases. I later added a small paragraph about HPI in the main post, please see it. So per my calculations, the capital appreciation is in the 2-4% range.

      1. Tax deductions – I completely agree. Tax deductions in owning real estate are amazing, so much so that sometimes (specially in the initial years), I have seen landlord friends of mine deduct real estate business losses from their ordinary income.

      2. Agreed. My next door neighbor owns 300 rental properties and I do not think he works more than 3 – 4 hours a day. So for someone with 1-5 investment properties will spend less than 2 – 4 hours a week.

      But most property management companies (PMC) will charge 10% of the collected rent, and additional charges for other issues like eviction, finding a new tenant etc. So the cost needs to be factored in the decision on whether to hire a PMC or not.

      3. Positive Cash flow – that goes for stocks too (dividends).

      ‘A $100,000 dollar home should bring in cash above expenses of $100 to $200/month or more. This in addition to equity buildup in the form of principal payments.’ – Agreed but as more detailed example is required to evaluate the rate of return.

      Here is an example I created – I buy a house on 1/1/2016, rent it for the year, sell it on 1/1/2017. You mentioned monthly cashflow between $100 to $200. I took the average, $150. I multiplied it by occupancy of 88%. So, monthly cashflow becomes $132.

      I assumed 3% capital appreciation (based on my HPI data). I bought for 100k on 1/1/2016 and sold for $103k on 1/1/2017. And in between twelve $132 monthly payments). The returns (Internal Rate of Return – IRR) turn out to be 4.6%.

      You can see the Excel image here – http://wp.me/a6V9kv-gQ

      I have not even included the 6% lost on commissions to the agents who will help sell.

      (The IRR would be exactly the same if I hold the property for 30 years).

      4. Free money – this you can achieve easier in the stock market. Borrowing on margin is quick and easy. It does not even have the ‘initial’ costs that exist in refinancing. Last week, I asked my mortgage officer, how much will it cost to refinance my primary residence mortgage – and he told me it will cost me about $5,500 to refinance my mortgage with the same bank. He said about $2,000 will go to the state, $2,500 to reissue title, and about $1,000 goes to the bank itself.

      2 questions for you:

      1. I know it is a vast subject, but can you please give us a glimpse about the ways you can use leverage beyond the basic bank loan?

      2. I am curious to know your location/ occupation? Please share if you are comfortable otherwise no big deal.

  3. Great comparison, Bobby. Thanks for a cogent breakdown. Like you, I’m a fan of stocks over real estate (see https://financialpiggy.wordpress.com/2014/09/25/finance-101-part-4-overview-of-savings-vehicles/ for a bit more info).

    One departure from your analysis is the use of leverage with stocks. In your example, you use an S&P 500 ETF to proxy the stock investment – which I heartily agree with for beginning investors. Beyond margin trading, one can use derivatives such as futures and options to structure levered investment in stocks. For example, a $100,000 investment in the S&P 500 ETF you mention can be mirrored through purchasing 1 E-mini S&P 500 future; this future will provide the same gains AND losses as the ETF position, while requiring very little cash upfront (around $5,000, according to the CME). There is no ‘borrowing’ involved here, nor any interest payable. As to the liquidity point, the S&P future is one of the most traded markets worldwide – no issues understanding valuation or getting in/out of a position, nor spending a great deal on trading costs. More here: https://financialpiggy.wordpress.com/2014/09/29/finance-101-part-4-extension-derivatives/

    • Great article (Overview of saving vehicles) Matt, thank you for sharing.

      Technically I agree with you when you talk about futures and options. But there are a couple of points where I would like to present a differing opinion:

      Futures are typically only 15 months into the future and most options are perhaps 3 years: When I think investing, I think long term (minimum 7 years). Therefore I do not talk about futures and options much.

      Futures and options are for people who speculate while I am talking about long term investing.

      I have saved your blog link for future reference too, will read more articles and comment in coming days.

  4. Pingback: Rent vs Own – Our experiences after 10 months | Next Chapter Journeys

  5. Wecome to Real Life. In the real world it’s been Real Estate NOT not Stocks that have made me and my friends $$ in these 60+years. The article doesn’t take in human nature into account. The ease/low cost at which stocks can be sold make it too tempting for anyone to sell. I remember a learned Phd prof. complaining in the ’90s about how he had bought a real dog of a stock..Apple and was selling for a loss because he didn’t want to see the price drop any lower. I bought MC on it’s IPO day of $45 it quickly shot up in the yr to $100 and I got greedy and sold. Since then it’s split and if I had held on I would have made much more. It takes an unusual man who can buy stocks and forget about them. Most people become day/wk traders and most only make their brokers rich. Fear +Greed rule on Wall Street and they are very powerful. They will cloud your judgement. On the other hand RE is a slow moving but steady money machine…income property only goes up because rents Never go down.

    • Martin – great point. If I ever write this post again, I will make sure to include the ‘discipline’ factor as a 12th factor. It does take a lot of discipline to not sell in panic (or vice versa).

      As for the ‘unusual’ man, I guess it just depends on the conviction one has in their investment strategies. I am that unusual man. I have sold stock only under the following conditions:

      1. I had individual stock that I acquired as part of an employee stock purchase plan (ESPP) – so it was given to me at a discount to the market price. I sold it as soon as I changed jobs – I like only market based ETFs

      2. I sell stock during tax loss harvesting, you can see my 2016 calendar here – http://wp.me/P6V9kv-8R

      3. In rare situations, I might invest a little in commodities just as a hedge (for a very short term), you can see my entire post here http://wp.me/p6V9kv-g

      Having said that, I completely agree with you that being a disciplined investor is not easy. It is not easy to buy the same amount of stock every paycheck when you started to invest in 2008 and the S&P 500 index made 40% loss in a single year. This discipline becomes even more difficult when you have dependents (family, kids, others).

      But if you are disciplined, then stock market is the place to be. It is similar to the story about ‘credit’ – if you are disciplined then borrowing has huge advantages but if you are not, then it is dangerous. You can see my entire post here – http://wp.me/p6V9kv-aF

      A slight point where I will disagree with you though – you say rents never go down. I can go and pull data but rents go up and go down too.

  6. Hello your information on the website are extremely valuable!

    I have questions about your comparison with real estate vs stocks!!!
    There are some income producing commercial property which you never discussed about. Some of them seems to have much better return than stocks!!

    Let me know your thoughts

    • Hello Prem, I am glad that you find the information useful.

      You are right when you say that I never discussed the commercial real estate. Many of my ‘real estate’ friends use http://www.loopnet.com/ to search for commercial property.

      Sometimes the answer is in the question itself. You yourself said “Some of them seems to have much better return than stocks” – they key part here is “some of them”. My problem is – how do you find those? It comes back to all the things I mention in my post – lack of good data, lack of long term data, lack of diversification, etc.

      And if you were to compare ‘some’ of commercial real estate properties, then a good benchmark would be to compare ‘some’ of the stocks. Take Apple for example – it has returned more than 35% annual over the last 15 years.

      So we should either compare ‘some’ to ‘some’ OR ‘all’ to ‘all’. Because as soon as you say you have the ability to pick real estate investments, I will say picking up stocks is even easier (because the historical data is there).

      Also another thing with commercial real estate – it’s higher risk as compared to residential. In periods of recession, people will still need houses but businesses will shut down so commercial real estate suffers more than residential real estate.

  7. I’m going to focus on the rate of return portion here but bundle leverage into it because not considering leverage in real estate investing is a critical error.

    First, we need to examine real geometric not average rates of return this is because the compounding effect has a disproportionately high impact on losses vs gains. In any long term study of the geometric returns of the S&P500 those returns are more like 7-8%/yr than 10.3%. Yes, you can pick your years to manipulate the data but the longer term you go the more you tend towards these levels.

    Does real estate under perform this? Certainly. By how much is a little unclear because good broad long term data isn’t easy to find. Real estate is also much more heavily impacted by interest rates than stocks due to the effect of leverage so you’ll see faster increases in the last 30 years amid falling interest rates than over the past 60. This being said generally the geometric returns I’ve seen in typical cities (location matters a lot in real estate and though the majority of land is outside cities the majority of buyers and renters will be inside) have been in the 5-6%/yr range. Let’s assume the lower of the two. The reason the returns are disproportionately closer to stocks when measured geometrically is because of lower volatility, which has a positive effect on real real estate returns.

    However, this doesn’t take into account leverage. In real estate an 80% LTV is pretty much the norm. You can get leverage in stocks but most people don’t and if they do they are typically looking at around 50% LTV (most banks won’t give beyond 70% easily in my experience). If you multiply the impact of this leverage on the returns you double say 8% stock returns vs five times the real estate returns so you’ve got 16% vs 25%. Even if you said real estate was 4%/yr (you’d expect at least inflation) it’s 16 vs 20.

    Leverage is as you mentioned easier to apply in real estate and more likely to be covered by the cashflow of the property especially over time vs the dividends of the stock (average stocks pay less than 3%/yr and your borrowing costs are going to be higher than that most of the time).

    There are fees yes for buying and selling real estate and maintenance and management and vacancy etc. But then again you can also force appreciation through renovations, which you can’t do with stocks. Most people also invest in stocks through funds with a lot of fees 2%+ fees are extremely common especially when you consider trading fees within the funds on top of the MER. Yes, you can minimize these but then again you can do all kinds of fancy things in real estate as well.

    There’s a big advantage to real estate you didn’t mention though, which is the ability to buy today for less than it is worth and thereby increase your net worth the day you buy. Yes, this requires knowledge and shopping but is something you simply can’t do for the average person in stocks. You could buy when a stock is undervalued but then you’ve got to wait for it to come back up.

    Real estate generally has better cashflow but that cashflow is taxed at a higher rate.

    The fact is how well you do stocks or real estate makes a big difference in the results you get so they are hard to compare directly. When I’ve done analysis I’ve found unless you’re very good at stocks (meaning you’re decent but not outstanding at either) they tend to pay similar long term returns but for the average person looking to build wealth not merely have their money grow real estate is easier for them.

  8. I’m not sure if this was said in a different way by some of the earlier commenters, but you are not calculating the returns correctly for the real estate.

    If you pay cash for a $100,000 house, it will cash flow a lot more than $100 per month. It will rent for something like $800-$1200 per month. Using a generous 40% expense allowance for vacancy, taxes, insurance, maintenance, etc, you would end up with at least $500 per month cash flow = $6000 per year. Add the 3% appreciation you allowed and you’re at 9% or right with the stock market.

    I’m guessing when the $100 cash flow figure was used, it was from a situation where the landlord had a mortgage to pay with balance of say $70,000. Then indeed the cash flow is $100X12 = $1200, appreciation is $3000 so the return is $4200.

    However now the investment is not $100,000. It’s $30,000. 4200/32000 = 13%+ return. You earn all the “interest” on $100,000 even though you’ve only invested $30,000.

    Buying real estate and letting it sit – now you’re at 2-4% or much less and for sure lousy investment.

    • Rick – thank you for taking the time to share your views on the subject.

      Talking about the $100k cash house, even if we go with the 9% returns you are calculating, that is right with the stock market. But there are challenges with real estate that are not there with the stock market:
      1. It requires active management or you have to figure in 10% property management costs
      2. Optimum Diversification is next to impossible for retail investors – Mathematically one would need at least 30 properties to reach somewhat of an optimum level
      3. Six percent cost when you sell it
      4. Liquidity – one cannot just get up one day, sell a property, and get the money in 2 days

      Coming to the second part of your comment – where one has a mortgage; like I mentioned in my original post, real estate offers better leverage options than the stock market. Though leverage is risky. We all know many foreclosures happened after the 2008 – 09 crises.

      When you buy a property on mortgage, it is great till the time you have tenants but when there is recession, tenants will be unable to pay the rents, and then it will come on you to pay the monthly mortgage…. and if you do not have the means, then you lose the property.

      So while I agree that leverage is easier to use in real estate as compared to stock market, it is still risky.

      • By no means are the investments apples to apples, and I agree with just about everything said in your reply.

        In fact there are further differences beyond what you mentioned, both pro and con for real estate.

        Main issue I hope to clear up is that there is income from real estate that adds to its return which didn’t seem to be considered, or was considered only in a leveraged scenario, and if leveraged, the wrong figure may have been used to calculate the returns (the actual amount invested, not the total value of the asset)

      • Mohsin – $100,000 was just an example.

        Having said that, $100,000 is a lot of money in most parts of the country. If urban cities mean Manhattan (NYC) and the like, then perhaps $100,000 will not get you anything, but read this:

        1. The median house in “Champaign-Urbana, IL” was only $149,400 in third quarter of 2015.
        2. Akron, OH was $130,400
        3. Binghamton, NY – $121,100
        4. Buffalo-Niagara Falls, NY – $136,800
        5. Mobile, AL – $120,000
        6. Ft. Wayne, IN – $120,700

        Source: http://www.realtor.org/topics/metropolitan-median-area-prices-and-affordability

        • Great article but If you do live in Manhattan or SF it is very difficult to find a residence where the rent covers the monthly mortgage payments. If you rent you will also have more money to invest in stocks initially plus the income requirements (a high multiple of your salary is required by banks to allow you to have a low down payment). So again in the ridiculous high property cities you have to start out richer to own than rent. In a down market you can more easily move to a smaller apartment or a less expensive neighborhood than sell a house perhaps at a loss and do the same. So with residential real estate it really depends where you live when comparing the rent v buying decision.

          • Great point. So stock market in general fares better as compared to real estate in 8 of the 11 factors I studied. On top of that, real estate has one further disadvantage in mega cities like NYC/ SFO…. thank you for sharing Sam

  9. Great summary comparing real estate to stock investing. I think some of the commenters brought up some good points too. As far as indexing goes, I have read that many actually project much lower returns in the next decade, more like 5-6% real return. I believe that Vanguard’s Total Stock Market Index increased by an even lower percentage in 2015.

    • Thank you.

      Why is the IBM stock trading at $140? Because someone believes the stock will go down and someone else believes it will go up. In fact, many people people that it will go down and many people believe it will go up.

      Similarly, many people think S&P 500 is trading at a good price, while many others think it is too high.

      My view is, specially in the accumulation phase, not to worry about ‘market forecasts reports’ and stick to the basics of long term investing – maintain the target asset allocation and buy ‘boring’ low cost ETFs.

  10. On the real estate, I think you underestimate the value for these reasons.

    1. Leverage. 3.8% appreciate is on the full value. If you only put down 1/3, your appreciate is 3X that or 11.4%. So, if you put $33,333 down on a $100,000 property, and it appreciates 3.8% or $3800, that return is 3800/33,333=11.4%
    2. Any amount paid to principal by your tenants is further return, added to the gain. If you take out a 30 year mortgage and in year 1, $2000 of payments go to principal, that is $2000/33,333 or another 6%. Admittedly, though, that would be ordinary income.

    • I agree Mike – this is an often forgotten point when comparing property to stocks. Leverage. It is oh so critical to the comparison.

      • I did include leverage in the original post. Though reading all the comments now, may be I should have quantified the effect of leverage.

        But one can use leverage in the stock market too. So the difference between benefits of leverage in real estate is not overwhelmingly different than it is in the stock market.

    • Mike, I partly agree with your first point and will rephrase your second point.

      1 – I agree that leverage enhances returns but I do not think the calculation is simply to multiply the returns by leverage factor.

      Let us take an example – you have 100k, you buy a property in cash, the appreciation is 3.8% = 3.8k.

      If you were to put down only 1/3, you will buy a property worth 300k, the property will appreciate 3.8% of 300k = 11.4k (right in line with your comment).

      But now will you not pay interest on this 200k mortgage? 30 year fixed on rental properties are easily in the range of 5%. So interest on 200k = .05 * 200 = 10k.

      Essentially you are left with only 1.4k…. so 1.4% returns.

      2 – If you are talking about current income / rental income – and that it can pay off the principal, then yes I agree that there are two different types of returns – current income stream and long term capital appreciation.

      Tenants will pay enough rent that will cover all your expenses (including mortgage) and may be a little will remain in your bank account.

      Also, the property might appreciate a little in the long run… so those are the capital gains.

  11. As somebody who works as a stock market professional (RIA) with substantial personal real estate holdings ($10M), your write-up is terribly misleading. The statistics are wrong. 10.3% stock market returns assume 100% reinvestment (0% taxes). The current stock market is pricing 4-6% returns as a commenter posted. That also assumes 0% bonds, which few professionals will recommend. As an earlier commenter pointed out, real estate needs to be analyzed with leverage. 2-4% appreciation with no leverage is 6-12% with 75% leverage. That does not include cash on cash or mortgage amortization. You are cherry picking statistics to prove your point.

    • Bill – I appreciate your perspective, specially because you are an ‘insider’ – being a RIA (Registered Investment Advisor – for readers who are not as familiar with the acronym) and a real estate investor yourself.

      It is true that 10.3% stock market returns assume 100% reinvestment, why is that wrong? That is the only correct way to calculate the total returns of any index – stock market or real estate – to assume 100% reinvestment.

      You make a good point about 0% bonds but fixed income asset class returns have averaged 7% for the last 30 years. So it is not all that bad even if a small percentage of portfolio is allocated to bonds.

      If real estate needs to be analyzed with leverage, then stock market also needs to be analyzed with leverage. Nonetheless, I said ‘Leverage works better in real estate than in stock market’ – I said that even in my original post too. Though I still maintain that leverage is risky and that should not be the primary reason of choosing real estate over stock market.

      I did not intend to cherry pick statistics – I am only analyzing publicly available information to make more informed investment decisions. If you can point me to more verified sources of information, I would be more than happy to include that in my analysis and share revised results.

  12. I concur that real estate leverage needs to be a major factor. Leverage is the only reason real estate is better, but IMO it MUST be considered. Nobody yet has quite thrown in all the factors either. Raising RENT rolls has not been mentioned either (that I saw), and is a huge thing to miss. Assuming a healthy city, but not growing crazy, you will see rent at least keep up with inflation. This is compound growth too, not simply 10 years x 30%. Which changes the math by over $4,000. We’ll just assume 3% rise in rent and appreciation.

    $100,000 day one value = $134,391 after 10 years

    $800 rent = $1075.13 after 10 years

    “First year” at 3% 19% return CASH ON CASH from your 20% down for appreciation. Let us say the property cash flows $100 a month after accounting for maintenance. After a decade it will be cash flowing $375 a month. Factor in the equity built and that’s more money on the table in your favor, and tax free of course, and can be pulled out via loan which would also be tax free.

    This is also assuming 20% down. If one is smart and willing to put up with the hassle, and in it for the long haul in the same region, one could put down far less. You may need to put down 20% on a property you tell the bank is for an investment, but you could also pull the “buy a house and move every few years” trick if you care to game the system a bit, while still being technically totally legitimate. You could then do 10%, or even 5% down and dramatically increase your leverage and returns. At 10% your 19% return becomes almost 40% per year!

    There are other factors, and you need a pretty fancy Excel sheet (or other calculator) to properly get the ROI from real estate, but suffice to say it is vastly higher than you portrayed it to be. As far as the “you can use leverage in stocks” argument… Yes and no. It is a super risky thing to do for stocks. It kills people all the time because of how volatile the stock market is. If you have cash flowing real estate (KEY because this allows you to not sell during a downturn), in a stagnant, not even growing market, it is essentially a non issue in real estate. Inflation alone will save the day, even if there is no “real” growth after accounting for inflation. You’re locking in your loan at todays dollars, but inevitably there will be more of them in the future, hence higher prices for real estate.

    Real estate is a LONG game. If you’re looking to invest for less than 10 years you’re a fool. Optimally you should be looking at real estate exclusively as a forever investment. Until the day you die. If that’s how you’re doing it, you basically can’t lose. I bet even people who invested in Detroit real estate have had some semblance of a positive return over 20-30+ years due to the inflation factor. Tell that to people who bought stocks in companies that failed, which get zero.

    So you factor in that your $100,000 you have to invest can buy you a minimum of $500,000 of appreciating property, and it hands down beats the stock market IMO. Plus it is something you can actually control, and touch, and run better or run worse. Good luck telling GE they’re doing it wrong if they’re not doing well on the market.

    • VK – thank you for sharing your thoughts.

      Raising rent
      has not been mentioned because we aren’t talking about companies raising dividends either. Corporations also ‘improve’ every day – there are people working there day and night in order to increase revenues and decrease costs, thereby maximizing profits.

      I would like to differ with you on ‘If you have cash flowing real estate (KEY because this allows you to not sell during a downturn)’ – this is not true, there were enormous foreclosures during the 2008 – 09 downturn, including positive cash flow real estate. When tenants lose jobs, they will not be able to pay rents, and then landlord is likely to default on the mortgage.

      This is exactly the same as what happens in the stock market – you buy on margin, and you might have to sell when you get a margin call.

      Having said that – I agree that leverage works slightly better in real estate (factor number 4 in my original post), but not by the 4x – 5x factor you are projecting.

      I agree with you about the “control, and touch, and run better or run worse” part
      – I referred to ‘control and touch part’ as ‘tangible’ (factor number 4 in my original post).

      “Run better or run worse” – Factor 5 in my original post – as soon as we talk about ‘running’, we are talking about running a business… and not managing a passive investment.

      • Hi Bobby,

        I know you had touched on a few of those points in the main post. You’re obviously a very intelligent person, and thoughtful in these posts. Academic comes to mind as a good descriptor!

        That said, I still think my “positions” are a little more real world vs real world. For instance in the case of a company increasing their profit… Yes, of course they’re always trying to do this. However when they actually achieve it, this typically (more or less) directly increases their stock price. This is (in theory) more or less the ONLY thing that will increase their stock price. Obviously speculation of future profit increases increase stock prices as well, but it’s still largely tied to either current profits or assumed future profits. Hence any increases in profits are essentially already included in estimate of the appreciation of the stocks value. Dividends are also essentially factored into the price.

        With real estate the asset value and the rental value often move in similar directions, but are still fundamentally unrelated in the strictest sense. Hence in my mind it is a separate factor to be considered separately. A 100K house you bought 20 years earlier, which is now worth 200K, might rent for $2000 a month now. That needs to be included in the math as its own separate sub calculation.

        As far as foreclosures, there is obviously validity to that. However a well prepared property owner can easily mitigate the issue, whereas a stock investor has very little control over things. If you do not have enough secure income to cover the mortgage in the event of non payment for a few months from your other income, then set aside that sum to cover it. You can always evict bad tenants and get new ones in fairly short order on residential property. So a couple months worth of slush fund money can basically avoid this issue entirely. If you own multiple properties you could keep a relatively small amount set aside as you’re unlikely to have EVERY tenant lose their job and stop paying at once. If you only have 1 or 2 properties it would be well worth keeping a few months total mortgage set aside though. If one considers this “invested capital” (as one should) it would reduce the effective return rate by some degree, but nothing mind boggling.

        Granted, one could keep a slush fund account to cover margin loans as well, or simply sell out and repurchase a smaller number of shares if they have long term faith in the stock.

        I don’t know. I just think the ease and relative safety of leverage in real estate helps it out perform the stock market. I’m a business owner and a control freak so I also greatly prefer the idea of having control of the situation. The stock market is out of any one persons control, whereas real estate allows for a lot more cleverness if you get in a pinch. It is NOT as passive as the stock market, and there is certainly room to have both types of assets, but I think real estate done right can easily out perform the market.

        Out of every single very high net worth individual I have ever known personally, not a single one has ever become fabulously wealthy by investing in the stock market. A LOT of them did by investing in real estate. I would in fact probably say the majority made it in real estate. I think the leverage is why. Every single person I can think of either owned an active business that made them a ton of money, or it was real estate*. They mostly all HAVE stocks, but that was not how they made their money, that’s how they diversified to protect their money. I have known a lot of decamillionaires, and a few people worth north of 100 million. I’ve even met a couple (literally 2) billionaires. They were real estate and real estate by the way. It may be anecdotal, but I think that says something. Also I do believe statistics back up the fact that real estate is one of the most common threads for self made multimillionaires. I believe the book The Millionaire Next Door has some good stats on this, but I can’t remember them off the top of my head. I believe it more or less said owning a business or investing in real estate were the best predictors of becoming wealthy though.

        Other than Warren Buffett and a few other anomalies who have made investing their “business” I can’t think of anybody who “made a fortune” by investing in stocks. Keep in mind I’m not saying stocks are “bad” or anything… Simply that I do not think they have the potential to take you from one level of wealth to another. The growth rate is too linear, and not geometric enough.

        * I have also known a few people who became very wealthy by investing in private businesses. Some with the expectation they would go public, some with the intent of staying private. I’m originally from the Bay Area, and live in Seattle now, so this was mainly tech stuff. Even of those people not a single one of them, as far as I am aware, “made” their money by doing this while they were working a day job or whatever. They made a bunch of money after the fact with these activities, but the basis for their fortunes were from owning businesses or investing in real estate prior to them getting involved in private equity investments.

        • Hi VK,

          I am glad you find my posts intelligent and thoughtful. The feeling is mutual – I also find you very learned and informative.

          About the corporations incerase in profits/ dividends/ stock price:
          1 – I do think that dividends increase when profits increase. They use what is called a ploughback ratio – many companies try to plough back somewhat of a fixed ratio back into their business (out of earnings).
          2 – Even if that were not true, an increase in stock price has the same effect for an investor. An investor can sell a little bit and still have the ‘original money invested’.

          I agree when you say “With real estate the asset value and the rental value often move in similar directions, but are still fundamentally unrelated in the strictest sense”. Do you have a mathematical proposition on how this factor can be considered in my analysis?

          Your point is very valid about ‘Every tenant losing their job and stop paying at once’ – the same goes for the stock market. When I have 500 stocks in my portfolio, what is the likelihood of each stock losing 30% value?

          (Just to put things in perspective, there have been about 14 million foreclosure filings since 2008 – with close to 6 million in 2008 and 2009 alone.)

          When you say “the ease and relative safety of leverage in real estate helps it out perform the stock market”. I cannot agree with the ‘ease’ part – I think one can use leverage in stock market with much more ease: with just one mouse click and no upfront costs, I can increase or decrease my leverage – as many times as I want.

          ‘Relative Safety’ – true, like I have maintained throughout, use of leverage is relatively safe in the real estate.

          Though one of the reasons is – people do not use leverage in stock market as much while people are used to using leverage in real estate.

          I agree that real estate is not as passive as the stock market – though I do not know whether that is certainly a good thing. Many investors would like to have a passive income rather than a business they operate.

          You say “Real estate done right can easily out perform the market” – and my worry there is how many people will get it right? I can make you a good stock market investor in a month. I do not think real estate investments can be as ‘scientific’.

          You also made a point about owning multiple properties – when you were talking about ‘investing money’. I agree and even that is easier to do in the stock market – owning multople stocks cheaply and quickly.

          Once again, thank you for your inputs. I do enjoy sharing what I know and learning what others know.

  13. Hi Bobby,

    I like your article. I’ve very recently gotten into investing and am currently still doing research, so I’m a bit of a noob when it comes to these things. Anyway, I thought I wanted to throw a scenario out there for analysis. Perhaps some questions might arise as well.

    I have a friend that bought real estate in Manhattan just before the 2008 crash. The property was for about 600K at the time. A few months ago, she sold the property for 1.3 mill. (I’m not sure of the exact figures, but those are the ball park ones). At the end of the day, I believe she netted somewhere around 500K in her checking account. And after talking to a banker, she discovered she had about an 8% rate of return over the 7 year period she had the property–which was similar to the stock market performance during that time from what I was told.

    Here’s the thing though: the quoted figures were based on the current value of the property, and not on what she actually invested. She made the down payment on the property of about 80K, and she rented it out, which pretty much covered the mortgage. So her actual investment was around 80K. From this, she made 500K in 7 years. Now that’s a fantastic rate of return, of about 525% over 7 years.

    So that’s the scenario. Now for the analysis/questions. I think sometimes when looking at R.O.I, it’s based off of the value of the property at he time of purchase, but I feel like with real estate investing, that would almost never be the actual money that an investor pays out of pocket. So looking at how overall real estate returns 2 – 4% can be misleading, or am I wrong? Like I said, I’m a noob. It can also depend on where the property is. Like I said, it was in Manhattan. Property always seems to go up in Manhattan, even during recessions. So the location/use of property might be a point of concern as well.

    As far as data concerning what cash real estate investors actually put into a property, vs their return, is there any data on that? I think, especially in the scenario I brought up, real estate is able to contend with stocks far more aggressively if it is done right, in the right location, and actual cost is considered, rather than the worth of the property.

    I’d be very interested to hear your take on this.

    • First off – Your thinking is very rational and scientific. Let me put your thoughts in ‘real estate terminology’:

      Cap rate – this is the ROI you explain. Cap Rate = Annual NET Income / Purchase Price.

      Cash on Cash returns = this is the 525% over 7 years in your friend’s case.

      Let us take a simple example to understand these two terms: You buy a property for $250,000, it pays a monthly rent of $3,000. Your typical monthly expenses will look like:
      Property taxes: $300
      Insurance: $200
      Property management fees (10%): $300
      Vacancy (10%): $300
      Repairs (10%): $300
      Owner-paid Utilities: $100
      Total Monthly Expenses- $1,500
      (This is a simplistic scenario – I am not taking into account tenants not paying up, you going to court to get them vacated, unexpected expenses like roof replacement, property management charges to find a replacement tenant etc).

      So in this example, you get $3000 rent, your expenses are $1500, you make $1500 per month. For 12 months, that is $18,000. Cap Rate = 18000/ 250000 = 7.2%

      If you would have financed (mortgage) the property, then you would have paid 20% down – 20% of 250k = $50,000. If you would have paid 5% interest on $200,000; the interest payments are $10,000 a year. Rent is still $36,000 per year, expenses are now $18,000 + $10,000 in interest; so you have $36,000 – $18,000 – $10,0000 = $8,000. And you invested only $50,000.

      So your cash on cash return = $8,000 / $50,000 = 16%.

      So far so good?

      When you take a mortgage, you are taking a loan from a bank – the bank does not care whether you have tenants or not, whether the property prices rise or fall. You are making 16% in the ‘good times’ but might lose the property in ‘bad market times

      The other difficulty with real estate – may be your friend got lucky? You buy one stock and it doubles next year, that does not mean 100% year on year returns will be typical of your investments.

      And lastly diversification – will your friend be able to buy 20 – 30 such properties? I can try to explain it statistically but having 20 – 30 different investments is a minimum that is required to achieve adequate ‘diversification’.

    • Yes, of course. $1,000 is a great beginning – everyone who is self made started somewhere there.

      A friend of mine who is 35 years old and makes $130,000 a year has only $4,000 in her trading account. So you are not that far behind my friend.

      If you are young, have at least 7 -15 years to retirement, then read up about asset allocation and expense ratio. If you get these two things right, you already have mastered the art of long term investing.

      Keep saving every pay check and keep investing (keeping target asset allocation and expense ratio in mind) and you will do well.

      • You say “If you are young, have at least 7 -15 years to retirement, then read up about asset allocation and expense ratio. If you get these two things right, you already have mastered the art of long term investing.

        Keep saving every pay check and keep investing (keeping target asset allocation and expense ratio in mind) and you will do well.”

        I would love to learn more about asset relocation and expense ratio!

        • I think you meant asset allocation, even though you said asset relocation.

          Once you have started to save and decided upon how much to save, asset allocation and expense ratios are the most important items to worry about.

          An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term. By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.

          While bonds on the other hand might return 10% in a given year or lose 10% in a given year. But over a long period of time, their returns are most likely to be lower than those of stocks.

          Just to put things in perspective, stocks returned 10% over the last 28 years while bonds returned about 7% in the same period of time.

          Simply stated – asset allocation is just the % of your portfolio you put in each asset class – a 50%/ 50% asset allocation means 50% in stocks and 50% in bonds.

          A more aggressive asset allocation (higher in stocks as compared to bonds) is better suited for risk prone investors – say a 25 year old young chap who just started to work – no dependent, no large expenses, and a long working career.

          While someone who is 55 year old and is contemplating retirement in 2-3 years might not be (and should not be) as comfortable with the riskiness (volatility) of stocks.

          Various thumb rules exist – two most common are 100/110. So 110 minus your age should be in stocks. So if you are 30 years old, then 110 – 30 = 80% of the portfolio should be in stocks. For a 60 year old, only 50% should be.

          Now let us briefly talk about expense ratio – expense ratio is the expense that you are paying annually to the fund/ ETF – this covers their management fee, admin fee, operating costs etc.

          To put things in perspective – the lowest expense ratio I have in my portfolio is 0.02%, highest 0.48%, and overall average is 0.26%.

  14. I got to your article from another article about real estate vs stocks. I have never invested in the market on margin, but feel that you always have to “borrow” to invest in real estate because no one has 100k on hand. I guess when I can make a good return (100-200% over 10 years) on money I earned without borrowing, that is more valuable to me. Now, the stocks I have chosen have sometimes gone down. It happens. One thing I found surprising was someone saying they were still getting rent checks for their property. I always assume that these properties all have a mortgage, so you’re really only taking the excess rent/mortgage, right? Sometimes that’s a wash. I feel like stocks vs real estate is always going to go the way of stocks.

    • Investing on margin is only for advanced investors.

      And you are also right that “you have to borrow to invest in real estate”.

      You are right about the excess rent/ mortgage point BUT there is more: just like stocks go down, rents also go down – rents can go down or vacancy rates can increase or existing tenants need to be evicted when they cannot pay their rent… so on and so forth.

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