Investing in Stocks or Real Estate
These are the age old questions we always hear…”do I buy equities or properties?” “Should I invest in stocks or real estate?””Where in the !@#$ do I put my money in this chaotic global economy?!”
If one person bought Apple stock 10 years ago and one person bought a beachfront home in Malibu in the ’90s and cashed out in 2006, I’m sure you would hear two VERY different opinions on which investment strategy is better. They both would be quite happy with their decisions, but they both obviously got in and out at the right times.
The nose dives we’ve been experiencing with the stock market should have been a HUGE wake-up call to anyone who was getting a bit too comfortable with stocks. This is similar to the wake-up we all received when the housing market crashed in 2008. During the recent stock slides, my rent checks came in as usual and the value of my property wasn’t affected. What I did notice, however, was the large one day drop (around 6%) in my retirement portfolio linked to stocks and mutual funds.
It’s Not Really About “How You Get There…”
Before I upset all of you stock investors out there, let me start out with the fact that I’ve invested in both stocks and real estate. They are both great investments and at certain times and market conditions, you may decide to use either of these tools. You may want to use both of them simultaneously. Having financial education and knowing how to use every investment tool to your advantage is key. If you decide to invest in real estate, we are happy to help, and continue you down the path to higher financial education!
Here are the topics we’ll talk about in this post:
- Why Invest in Real Estate?
- Comparison: Stocks vs. Real Estate without Leverage
- What “IDEAL” Investing Means
- Comparison: Stocks vs. Real Estate WITH Leverage!
- Real Estate Investing Risks
Why Invest in Real Estate?
We like real estate because it is an investment you can “kick.” In other words, it’s tangible and you have full control over it, unlike a stock where you only own a negligible part of the company and you won’t be sitting in the board room any time soon unless you really pony up some serious cheese. All in all, what investment vehicle you use is entirely up to you and your risk adjusted return, market direction, skills/education, and a number of other factors. It really depends on your own investment skill and if you are a good investor or not.
What I do want to point out is that often, real estate can give better stability than stocks and better returns with leverage due to the 5 “IDEAL” Reasons, as mentioned in my previous blogs. Real estate holding is not about getting rich quick–we’ll leave that for the 3am infomercials. The strategy is long-term holdings, with careful leverage, to generate immediate cash flow and a solid bed of equity to support your dream of financial independence.
There’s a way to get the rewards for a life of hard work without waiting until the end.
Comparison: Stocks vs. Real Estate without Leverage
Without further adieu, let’s test the theory and pit real estate and stocks head to head in a simple comparison. We’ll start out margin-free (What is buying on margin?) on the stock market side and we will initially ignore leverage on the real estate front so we can better compare both of these investment tools. We’ll also set stocks at an 8% year over year ROI average and real estate with 8% cash flow over 30 years with the same dollar investment.
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NOTE: This is a hypothetical situation! We understand a lot of people don’t have $100K to buy a property cash. This will be a nice “apples to apples” comparison of stock vs. real estate but don’t worry, we’ll get into leverage later on, and then it will only require $25K for your down payment and closing costs. For stocks, we’ll put $25K and then borrow $25K from the broker.
You have $100K to spend. You decide to throw this $100K into the stock market for 30 years. Luckily for you, an ideal situation occurred and market has done pretty well over the course of this time. You ended up realizing a 8% return per year on your stock investment. Imagine that!
Let’s Buy Some Stocks…
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After it’s all said and done, your stock investment earned you an extra $770,326. We didn’t consider commissions for purchase and sale since they are negligible ($7-$10 a trade.) One benefit of stocks in this example is that you are getting a gain off of your increased stock value, so instead of cash flow being pulled from real estate and not being used, you are technically reinvesting those stock earnings back into the same stock. You are compounding that 8% return.
Let’s Buy Some Real Estate…
One thing to consider in this example is that we are going to be collecting a lot of cash flow from the properties. Of course you could buy more real estate with your earnings, but we’ll just do one property with our example below. Let’s get started with the example…
You found a nice single family home in your neighborhood worth $100,000 with 8% ROI potential. You decided to hold on to this property for 30 years and rent it out, with your 8% ROI holding true year after year due to your rent increases. We are going to use a very conservative estimate of 2% appreciation.
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So, you can see at first glance that the non-leveraged real estate deal didn’t hit the ROI that stock did. After 30 years, the investment has earned $450,889.
There are a few things you could include in this example to benefit Real Estate further:
1) We bought this property at market value, so if you buy right, you could do even better with Real Estate.
2) In this example, the cash flow from real estate is not earning anything like it is in the stock market. That cash flow could be used for other investing opportunities, perhaps as part of a Real Estate Investment Trust (REIT), paying off debts such as your mortgage, or saving up for more investment properties that you could purchase all-cash or leveraged.
3) Do consider that according to Year 30’s Cumulative Annual Cash Flow, you earned a total of $380,632 in cash flow over those 30 years. This 30 years of cash flow, as mentioned in #2, is yours and not tied up like money is in a stock. The true benefits of real estate is that cash flow you can use to fit your lifestyle now and supplement your income. This is truly passive income, especially if a property manager is used.
4) We’re only using 2% appreciation a year. In other markets, you may get 3-5%. If the market is really hot, it could be even better, but don’t buy purely for home value appreciation!
What “IDEAL” Investing Means…
In our rental property projection in Table 2 above, you’ll see five different categories: Income, Depreciation, Equity, Appreciation, and Leverage. In case you haven’t seen some of our other blog posts on this, here is what each means below:
- Income (Cash Flow): Reinvesting that cash into something can give you an even better return (the example above is not doing any reinvesting with our cash flow!)
- Depreciation: Withhold taxes on cash flow received from the property, like “dividends.”
- Equity: Borrowing against your equity to support other investments.
- Appreciation: We used 2% a year, but that is conservative and some markets may support a better percentage
- Leverage: Put $25K down on one property instead of $100K on a property outright, and amplify Income, Depreciation, Equity, and Appreciation!
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What About Leverage?
You might have been looking over that stocks or real estate comparison and thinking, “With a stock, I can just set and forget, but with real estate, I have to go find a property and then sell the property afterward. Even if a property manager is helping, it’s a lot of work!”
Well, there is a lot of truth to that, but we were just buying a property with cash, at market value, without any leverage at all! We were also assuming only a 2% appreciation and leaving your cash flow sitting in the bank doing nothing.
So…should you invest in stocks or real estate? Well, let’s expand upon the great debate of real estate vs. stocks and kick it up a notch. Prepare to leverage and see how real estate flourishes!
Comparison: Stocks vs. Real Estate with Leverage!
What you saw in our basic “non-leveraged” comparison was an 8% Cap Rate real estate investment put head to head with a stock that received 8% ROI year over year. Now, let’s really juice it up and go with real estate that is 75% leveraged (25% down payment) and compare it to a hot stock with a 50% margin [Crap I forgot, I’m not a stock investor…can you tell me what margin is again!?]
Due to limitations on margin for stock vs. what the bank allows for mortgages, real estate already starts out with an advantage on the amount of leverage we can use. Stocks are 2x leveraged in this example (getting twice as much stock buying power out of your cash investment), while real estate is 4x leveraged (getting four times as much property buying power out of your cash investment).
We’re going to use an 8% ROI again to keep things consistent with our calculations earlier. You have $25K to invest in each asset class and 10 years to turn some rewarding profits. Why $25,000? Well, the real estate mortgage will require $2,500 in closing costs and we’ll put $22,500 down on a property we purchase for $90,000. We’ll allow the stock investor to use this to buy more stock since no closing costs will be required for them.
“I will buy $50,000 of a growth stock with $25,000 of cash, at 50% margin”, says the Stock.
“I will buy a $100,000 single family home for $90,000 (10% below market) with $25,000 of cash, ($22,500 with $2,500 in closing costs) 25% down payment”, says Real Estate. (In order words, I am spending $25,000 to control a $100,000 property.)
Cutting to the chase, we’ll run each scenario for 30 years with some fundamental criteria:
Stocks: 6.575% interest on the original margin loan of $25,000.
Real Estate: Mortgage at 5% interest and appreciation at a modest 2% (as shown in the first example). 30 year fixed mortgage.
Margin rates are pulled from Fidelity.
The Final Results of Leverage
Time to round up the contenders. Let’s look at the total income returned from each. Remember that we are putting $22,500 down in order to get a mortgage for our $100,000 single family home. We have $2,500 in closing costs to the bank, requiring us to pay $25,000 in cash total. Due to this, it’s only fair to use $25,000 of cash to purchase stock (with margin) to keep an even comparison.
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Leveraged Real Estate:
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Full disclosure: For real estate, I am still utilizing one of the best tax breaks the IRS has to offer the 1031 exchange. A 1031 exchange is a tax benefit where you can sell your investment asset and buy another one within a certain window of time to avoid paying taxes on gains. You can’t do that with stocks.
Real estate had the edge on this one. As with non-leveraged, you earned $254,532 of cash flow after 30 years which could’ve bought you at least 8-9 more properties over that time period (taking appreciation of home prices into account.) So, real estate is ahead without even investing $254,532 of the money you earned. Imagine running this scenario 8 or 9 more times over 30 years with extra properties you purchased, or if you also put some of your own money saved up from your job into properties. The value proposition for real estate is that the bank only requires you to put 25% down (maybe less) and control 100% of the asset when you purchase real estate. Appreciation and other benefits come upon you in droves once you leverage a $100,000 property using only $25,000.
Real Estate Investing Risks
Despite the hype, I won’t try to sugar coat this…you need to be extremely careful borrowing for investment properties. Consider vacancies and other issues with that property that would cause you to have negative cash flow for a month or more (we accounted for a 5% vacancy rate in our expense calculations.) We typically like to back each investment with at least 6 months of mortgage payments to weather the storm.
Take this example, Real Estate’s first year home expenses are $9,668. When buying a property, we recommend you cover roughly 6 months of expenses, in a savings account, backing the property. In this case, that would be roughly $5,000. As you buy more properties, you can adjust this rule a little, since you will have other properties rented out that can likely cover some vacancy gaps. Remember…this needs to stay liquid and easily available in the event that you have vacancies or unexpected repairs. Don’t go off and buy stocks on margin with this money!
As for stocks, they can certainly be bought on margin if you have a hot tip or think that a particular company is going to boom in the next 30 years. Be mindful, however, that if your stock drops too much, the broker will not hesitate to do a margin call and ask for some of that money back. If your real estate asset loses 75% of its value, it may be unfortunate, but as long as you are paying your mortgage on time, you will never hear from the bank if your equity drops below 25% of the total purchase price of the investment property.
As mentioned before, check with your accountant to find out whether or not you can offset other income with the tax losses from depreciation and mortgage interest.
One More Thing…
Next time you meet with a financial advisor to discuss your IRA or mutual funds, ask him/her what insurance you have against loss if the market crashes. Chances are, they aren’t going to guarantee you any protection against your loss! Good thing you can insure real estate.
Hopefully this helped you make a decision on whether or not you should invest in stocks or real estate. If you would like to see any of the expense details or dig deeper into how we came up with the sheets and calculations, leave us a comment below! Happy hunting!