Owning Stocks or Real Estate.. What’s Better?

When it comes to investing, the two most common assets that investors discuss are real estate and stocks. In fact, the desire to invest in real estate appears to be far greater than the desire to invest in stocks. But why is that? Could it be due to familiarity? marketing? fear of the unknown?

After talking with several uninformed and curious investors, the main reason seems to be fear of the stock market. Multiple people cited their concerns that stocks have the potential to collapse or possibly go to zero. Real estate, in contrast, is far more familiar and seemingly more accessible than the stock market for beginner investors.

My hope is to dispel this idea.

Real estate can be a great investment. Fortunes have been made in the real estate industry, and some call it the best investment opportunity. But is it better than the stock market? Real estate has a lot of downsides, possibly much more so than the stock market. Most real estate investors fall into two categories: those that act as landlords and purchase real estate for passive income, and those who buy undervalued properties, make repairs, and sell for a profit.

For the sake of simplicity, this discussion excludes the returns by professionals in both the finance and real estate industry. The returns of professionals will differ significantly from that of ordinary investors. The same would be true when comparing surgery done by a surgeon versus a wall street banker.

What are the Benefits of Real Estate Investing?

There are 3.5 primary benefits to real estate investing. The half point is an added bonus that I think is relevant in terms of investing.

Let’s get to it.

1) Tax benefits. Tax benefits are the number one reason for investing in real estate. The IRS has provided many reasons for investors to consider real estate a promising investment.

There are 3 primary tax considerations when evaluating real estate as an investment.

• Tax write-offs. The ability to write off expenses related to real estate allows it to act similarly to a business. The significant write-offs are mortgage interest, property taxes, management fees, and insurance. There are various other write-offs, but by in large, these 4 provide a cushion for the yearly expenses an investor has to shell out for owning real estate.
  
• Capital gains taxes. Selling real estate has similar taxes as stocks. When you sell your investment property for a profit, you will owe capital gains tax on your earnings. Like stocks, short- and long-term capital gains have various rates depending on your income level. The benefits come from long-term capital gains rates – or holding the property for over 1 year, which is very easy with real estate investing.
  
• Tax deferral (1031 Exchange). A 1031 exchange refers to the IRC Section 1031 (the IRS Code). This is the name used by professionals and investors to reference a tax-deferred deal. When used correctly, it can have enormous benefits for long-term investors.

A 1031 Exchange allows you to sell your existing investment property and buy another property without paying the taxes at the time of sale. This is called tax deferral. You still owe the taxes, but the taxes have been moved over to your new investment property. There are very specific details involved in the transaction that must be followed. Still, many savvy investors use 1031 exchanges for investing purposes.

2) Leverage. Using leverage in terms of an investment essentially means – borrowing money. Real estate is ever accessible to the masses due to the government and banking industry providing fair rates and high leverage for real estate. Having leverage allows an investor to pay a fraction amount upfront (10-20%) for an investment while still having ownership qualities.

The most common strategy that investors like to use is to make the initial investment (down payment) and lease the property to a rent-paying tenant that will cover the monthly mortgage costs of the mortgage.

Using this method allows investors to scale their portfolios at a much faster rate. Using leverage allows an investor to make outsized returns.

3) Cash flow. Most real estate offers a form of cash flow. This involves having a structure, such as a house or building, that is rentable. From a cash flow perspective, real estate is much better than stocks. While some stocks do pay dividends, most do not. Moreover, most do not pay dividends every month like a rental property would.

Real estate’s monthly income would better serve those dependent on monthly income.

3.5. Less emotional. Psychology plays a huge role in investing; specifically, price volatility. Real estate is much more stable with respect to price fluctuations than the stock market. In addition, it’s not easy to look up a accurate home or real estate values every month. This has built-in psychological security for many investors.

Stock investing allows you to see the real-time value of your portfolio and can shift quite a bit from month to month.

Many investors have some familiarity with real estate. Most have either purchased a home or have known someone that has gone through the process. This familiarity offers a huge psychological advantage to many people by reducing the emotional constraints of making a decision.

What is the Downside of Real Estate Investing?

As investors, the most crucial aspect of making an investment decision is to look at the downside or the risks of such investments. The upside should disproportionately outweigh the risks.

Buying and renting or buying and flipping real estate must be done with caution. Every one of our generations most likely remembers the 2008 financial crash directly related to mortgages.

Here’s a look at the downside of real estate investments.

Liquidity. In terms of investable assets, real estate is one of the most illiquid assets. This means you cannot quickly get your cash out of your investment. Converting your property into cash (selling) could take anywhere from a few weeks to several months. And if you need the money in a hurry, which would likely be at an inopportune time, you will probably be doing so at a loss.

High transaction costs. Real estate has some of the highest transaction costs for any investable assets. In addition, there are costs associated with purchasing and even more costs associated with selling.

Investors using a mortgage to purchase a home will pay several fees to the bank to acquire the loan and closing costs to finalize the purchase.

Selling the home is another story. Most real estate will require repairs, finding and paying an agent, and closing costs. In total, it’s pretty easy for these costs to be 10% or more of the property value.

Maintenance costs. All real estate comes with a tremendous amount of yearly maintenance costs. These costs come in many forms, including property taxes, major and minor repairs, general upkeep, insurance, and likely a property manager.

These costs could amount to quite a large sum of money, especially the taxes, and potential major repairs, if proper due diligence wasn’t performed before purchasing.

Taxes alone range from 1-3% of the home value. The annual costs can easily be 5% of the property value with additional expenses.

The barrier to entry. The planning and execution process for real estate is far greater than that of stock investing. With any investment, proper research and due diligence should be performed before considering any investment. Real estate is no exception, although I know many people that don’t do adequate diligence.

Most real estate investors will require the assistance of a real estate agent, an attorney, and a banker to finalize a transaction. In addition to hiring all these professionals, investors still need to do their own proper research and some financial planning for managing the real estate after the purchase.

Investing in stocks requires opening a brokerage account, minimal ETF research, and automated purchases. Quite a significant difference in needs.

NOT Passive. The truth is there is no such passive income in real estate. It requires either additional time or money to pay someone manage your real estate. Both of them eat into your valuable time or your bottom line.

Hiring a management company can save you a lot of time, but it also comes at a cost.

Most important: Your time is NOT free.

Purchasing real estate requires your time to find deals, work out the details, and ultimately make the deal happen. Your time is extremely valuable, and should always be considered in the time it takes to invest. Put a price on your time when considering investments.

More goes into real estate investing than most investors consider. So, out of curiosity, I’ve asked several friends and acquaintances if they know their actual yearly cash flows on their real estate investments.

A couple of them knew they were cash flow positive. One of them knew they were getting around a 5% return yearly. The remainder were practically clueless. They hoped they would make money in the future as the prices went up – price appreciation.

Real estate investing requires a lot of upfront costs, maintenance costs, selling costs, and a significant amount of planning and research to be profitable.

The questions you should ask yourself are:

“Are all of these troubles worth the returns I’m getting?”

or

“Can my real estate investments perform well or even better than a simple S&P 500 Index ETF?”

How Does Real Estate Compare to the Stock Market as an Investment?

So, how does real estate compare to the stock market? This is the real question in terms of investing. Owning real estate does seem like it requires far more from an investor than investing in stocks. Shouldn’t we be able to expect the returns to be at least as good for all of the hassles and headaches that are involved?

Real estate has numerous markets, so creating a benchmark value for the overall real estate market can be tricky. For example, prices for real estate Miami varies significantly from prices in Las Vegas. In addition, nearly all real estate is held privately, so gathering such specific data can be challenging.

The stock market is the complete opposite. Nearly everything is transparent, so much so that it can overwhelm the average investor. For this reason, using a benchmark for the entire market is a great place to start. The Standard & Poor’s 500 (S&P 500) is the most preferred benchmark for the overall market and can be tracked backward for decades. The S&P 500 is comprised of the top 500 companies in the world.

In terms of real estate data, nearly all real estate is held privately, so collecting such specific data can be challenging. Thankfully, NYU Business School Professor Aswath Damodaran has compiled historical data for many companies, industries, and financial markets. His data has provided historical references for the S&P 500 and the broader real estate market as a whole, dating back to 1928.

Looking back to 1928 at the inflation-adjusted returns for both the S&P 500 and the broader Real Estate market, it becomes pretty apparent which is the better performer. Over nearly 100 years, the S&P 500 has outperformed the broader real estate market by 162,000% or 162x. But, this does not include any income the real estate market may have earned; this is simply from an asset price appreciation standpoint.

There is a notion that real estate is a great hedge (prevent losses) against inflation. From this observation, I must say that real estate does make the perfect case for an inflation hedge. It does beat inflation by a slight margin over long periods of time.

Let’s look at this for a shorter period of 50 years, dating back to the 1970s until current. You will see from the data that there was a period from 1970 until about 1985 when real estate and the S&P 500. This was the last significant period of stagflation that the US dealt with, similar to what we could be facing going forward.

During this period of high inflation, the stock market had significant swings in both directions, causing confusion for investors and company management alike. During this time, real estate experienced growth despite other markets being very rocky.

Fast forward to our (my) lifetime.

Most of us remember the 2008 financial crisis and its impact on both the real estate and financial markets. However, the financial markets have changed significantly since this time, with a massive amount of cash injected into the US economy through quantitative easing (QE). Consequently, every investable asset has seen significant increases in value over the last 14 years.

In the following example, I want to demonstrate two things:

1. Real estate investing can be accomplished with stocks, or in this case, Exchange Traded Funds (ETFs).
2. Professionally managed real estate investments can provide better returns than an average real estate investor that doesn’t do proper research and analysis.

To include a broader look at real estate investing from a stock investment approach, we will include Vanguard’s Real Estate Index Fund (VNQ). The holdings within the VNQ ETF portfolio contain various real estate stocks from the broader real estate industry. These include hotels, healthcare facilities, industrial, office, residential, retail, specialized properties, development, and real estate services. In addition, VNQ can easily be purchased through all notable brokerage accounts such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, among others.

The VNQ ETF should not be taken as a perfect indicator of the broader real estate market because it primarily consists of stocks. Stock prices and company valuations may be higher or lower than historical valuations or in comparison to real estate prices.

All three data sets use inflation-adjusted returns (this means inflation has been either added or removed from the overall return) over the period, and both VNQ and the S&P 500 have dividends included.

From this data, we can conclude several things:

In the past 14 years, investments in the S&P 500 or a Real Estate ETF such as VNQ have performed nearly equally.

Real estate price appreciation alone is an excellent hedge against inflation.

Investing in real estate for price appreciation by itself is a poor investment.

Conclusion

Most investors will benefit far more by investing in the stock market versus real estate. The simplicity of creating a portfolio of ETFs, the long-term average returns, the added tax benefits, and the liquidity from the stock market make investing in stocks ideal.

Real estate can offer good returns to the investor that takes the time to research the market, coordinate with professionals, and have a plan of action to generate cash flow. Most investors aren’t willing to do this. The investors that either don’t have the time or value their time more than real estate investing can benefit from the ease of stock market investing.

Investors willing to spend some time educating themselves on how to research and invest in the stock market will be well rewarded for doing so. For those that can’t stomach the stock market volatility there are two simple solutions.

1) Use automated investing and only review your portfolio once or twice a year.

2) Educate yourself. The more you know about something, the less you will fear it.

Investors looking to purchase real estate as an investment should spend adequate time understanding what they are buying and how they plan to monetize it. For example, monetization may include positive cash flow through leases or utilizing real estate for its tax benefits, such as 1031 exchanges. But if an investor cannot create a short-term plan for cash flow profitability with the real estate, then the investor would likely be better off with a simple investment using stock ETFs.

Investing in real estate takes considerable planning, execution, and, even more importantly, valuable time.

While there are good reasons to use real estate for its tax advantages, your average investor doesn’t take advantage of these benefits. Owning property for price appreciation isn’t enough over the long term. Yes, your property value may rise, but merely above inflation. You will later be rewarded with reduced taxes on your gains. Still, the same capital gains and savings from real estate also exist with stocks but with far fewer headaches.

Building a diversified portfolio with ETFs is, by in large, is the most straightforward and least time-consuming way to invest. Both real estate and S&P 500 Index funds can fit into a portfolio one chooses. Those that can tolerate volatility in the stock market will be well rewarded over the long run. Like any intelligent investor will tell you, the best investment always depends on what fits the investor’s risk profile, desired timeline, and expected returns.

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