[Editor's Note: Today's WCI Network post is from Passive Income, MD, and discusses his preference for real estate over stocks. Those who came to WCICON21 will recall that Peter's portfolio is 80%+ real estate. Mine, of course, is almost the opposite at 20% real estate. I've discussed the “real estate versus stocks” dilemma before. In this post, Peter gives his take. The truth is that Peter and I agree the right answer is “Both!”, but simply disagree on how much of each to include in a portfolio. There are many roads to Dublin. Pick something that is reasonable and right for you and stick with it. ]
Should you invest in stocks or real estate? It’s a big question, and there are many, many opinions out there.
While both certainly have their pros and cons, I thought I would give you an idea of exactly why I prefer real estate over stocks.
Of course, investing is different for everyone, and everything depends on your personal goals. But for wealth creation and achieving financial independence, I believe that real estate is the best and most efficient method out there.
Here are five reasons why.
#1 Cash Flow
The main reason I started investing was to replace my clinical income with other sources of income. Financially speaking, I wanted to make sure that I wasn’t reliant on medicine alone to take care of myself and my family.
I developed this goal after experiencing some issues at work, and I realized that if I ever wanted to achieve financial freedom, I needed to gain control over my time, and stop trading it for my income.
It didn’t take me long to discover just how much I’d need in monthly income in order to live the lifestyle I wanted. I simply tallied up my current expenses and made it my ultimate goal to cover these expenses with another form of income—not from my day job.
It occurred to me that I had met other doctors who’d achieved this same goal through real estate investing. As you might have guessed, I decided to follow in their footsteps.
Of course, I did heavily weigh this decision against the traditional wisdom of investing in the stock market. Obviously, stock values can increase. In fact, though my 401(k) and Roth IRA would go up and down in value, they did increase overall in value.
Still, it wasn’t spinning off cash that I could feed my family on. Just the opposite, actually; in these protected accounts, I’d have to take a penalty to withdraw those funds early or simply wait until I was 59.5 years old. I wasn’t okay with waiting that long.
There are stocks that pay off some small amount of dividends, but I discovered the portfolio size necessary to get a meaningful amount of cash flow with these dividends simply wasn’t practical. Plus, they weren’t as predictable as the cash flow I was receiving monthly from my real estate investments.
So I went about building up a real estate portfolio, using both direct ownership of properties and passive investing through private deals like syndications and funds. It’s not a get-rich scheme, but using the income from my day job, I was able to funnel a good amount of it into passive income, cash flow producing investments.
This cash flow, built up one investment at a time, allowed me to buy my time back. It allowed me to give up shifts knowing that income was coming from my passive investments reliably. This has been the greatest benefit of investing in real estate and continues to grow and pay off today.
# 2 Inefficient Market
I do know that, historically, the stock market has increased in value year after year, at an average of 7-10% annually. So I understand when people want to just park their funds there and forget it (in fact, according to many, this is the smart way to play the stock market).
However, the fact that it is an extremely efficient market means that you, as the little person, aren’t going to beat the professional investors with all the information necessary to make the big moves and make huge gains in the stock market.
Don’t get me wrong; I do know some investors (and some doctors, in particular) who have done quite well trading stocks. They’ve succeeded because of intelligence, strategy, and some luck. However, these results are not typical—especially for someone who isn’t watching and studying the market extremely closely.
However, the world of real estate is very much an inefficient market. This means that although real estate prices seem to be dictated by the overall market, in reality, many investment property values are not bought and sold at their true value.
You can find tons of good deals in many different situations. For example, maybe the seller is a mom and pop owner who hasn’t run the property to maximal operational efficiency and is now selling to cash out. The following buyer and owner can then buy the property under market value, and add value themselves.
This level of control really allows you to make profits based on your skill and effort, rather than timing and luck.
# 3 Forced Appreciation
When you buy a stock, it’s highly unlikely you have any influence over its stock price unless you’re someone like Carl Icahn or Warren Buffett. You’re more or less just along for the ride.
However, as mentioned above, a real estate investor can use strategy to improve operations and cause what’s known as “forced appreciation”.
This differs from “market appreciation”, which is driven by overall market factors, like the global and local economy. It is based on comparables (how other things are doing in the area) and is simply not under your control as an investor. You can look at trends, but even those are unpredictable.
One great way to force appreciation is to take units that are underperforming in rent because they’re in relatively poor condition compared to the market, renovate those units, and command a much higher rent.
It’s also possible to decrease expenses by more strategic overall management. Perhaps you find a property manager that has better resources to maintain the building at a better price. If you take better care of tenants, perhaps you’d get less turnover and the repairs/fix-up that goes along with that.
Changes like these result in a higher net operating income, which in turn can increase the value of the property significantly—regardless of what the overall market is doing around the property.
You simply don’t have this opportunity with stocks.
# 4 Leverage
Leverage is one of the most powerful aspects of real estate investing. You’re able to control 100% of an asset by only utilizing a smaller portion of capital (say, 20% of the value of the property for example) and using a lender’s capital for the rest. However, as an investor, you get 100% of the upside of the investment.
Let me show you why this is powerful.
Let’s say you purchase a $1 million rental property by investing $250,000 into a property and borrowing $750,000. Through market and forced appreciation, you’re able to increase the value of the property by 25%, so the value is now $1.25 million. That’s a 25% increase for you as the investor, right? Well, actually, it’s a 100% return on investment.
Remember, you only invested $250,000, and the property increased in value 25%–or $250,000. So, based on the return on investment formula (return ÷ amount you invested), that’s a 100% increase.
That’s the power of leverage. It’s how investors are able to generate outsized gains and create massive wealth.
Of course, leverage is a double-edged sword. It can multiply returns, but it can also magnify losses. That’s why it’s absolutely crucial to mitigate risk and understand the downside. But again, with real estate being an inefficient market, it is possible to mitigate that risk.
Plus, since real estate grants the level of control we discussed previously, you are fully able to use a sound strategy to not only mitigate risk, but set yourself up for greater returns.
Sure, with stocks there is some ability to use leverage through a margin account. However, these are for short-term plays, and you’ll likely come across something called a “margin call”. In this scenario, the investor will have to come up with capital to cover what they borrowed immediately. It’s not a long-term solution and can be extremely risky.
# 5 Tax Benefits
Investing in real estate brings numerous tax benefits—too many to list here (be sure to check out this post for the full details).
Suffice it to say that there are many, many amazing tax benefits available to real estate investors. These are not loopholes, but incentives put in place by the government to encourage the holding of real estate. After all, it serves a need by providing housing, jobs, revenue for local governments.
Arguably the two biggest tax benefits are depreciation and 1031 exchanges.
In general, rental properties depreciate at 3.636% yearly (for up to 27.5 years in the case of residential properties). This reduction in value can be deducted from your reported income, which can greatly reduce the amount of taxes you owe for the year.
For example, let’s say you bought a residential rental property for $400,000. A quick method would be to divide the purchase amount by the maximum years of deprecation (27.5). This allows you to offset your passive gains by $14,500 each year.
With current laws in place, something called bonus depreciation allows you to accelerate depreciation for much of the property, resulting in a massive deduction in the first year of owning the property.
This tax benefit gets passed along to you as both a direct owner of the property and a passive investor in a syndication or fund.
A 1031 exchange allows you to defer capital gains tax indefinitely. Normally, you’d have to pay a very large amount of taxes upon the sale of an investment property. But if you were to use the money from that sale to purchase another property, this is considered an “exchange” by the IRS.
In other words, you can essentially defer paying capital gains taxes forever, simply by using the profits of a sale to purchase a property of equal or lesser value. This is a powerful tax benefit for real estate investors.
When it comes to stocks, you are able to get a few tax benefits from qualified dividends and certain write-offs. However, they all pale in comparison to the massive benefits you gain from real estate investments.
Summary
These five benefits are some of the biggest reasons I chose to go with (and continue to go with) real estate over stocks as my main vehicle to create financial freedom. Real estate allows for significant wealth creation (and preservation, if that’s your goal) and it’s created an amazing side income stream for myself and many other physicians.
Don’t get me wrong, I still have some investments in the market, but that’s purely for diversification (as you know, I’m a big fan of diversification).
But since my ultimate goal is to create income for financial freedom now and to live how I want to live, I believe real estate is the best way to get there—for myself and for many others.
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Do you take a side in the stocks vs real estate debate? Which do you prefer for building wealth? Sound off below!
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I am a huge fan of real estate investing and agree with all of the points that Peter makes here.
There are however still advantages to stock investing over real estate. Simplicity for one. And that is an advantage that is at the forefront of many doctors minds. Also diversification which he points out. If you own a bunch of syndications or actual properties in one area, you are really not diversified.
That’s why I think a hybrid approach is best. It seems this is what Peter has as well!
PrudentPlasticSurgeon…….I agree with the simplicity point in terms of index funds. If you invest directly in real estate it is going to take a whole lot of time, energy, education, liability, headaches.
If you invest passively in private CRE syndications….you still have to do a ton of due diligence on each deal. And that takes time and expertise. And in the end you are really making a bet on the sponsor of that syndication. Because there is no way anyone has the time to really dig into say a 500u self storage project in Georgia or a 500u MF building in Dallas. Even someone who spend their whole lives in CRE would struggle with reviewing the proforma, assumptions, local market of the deal. In the end you put a lot of blind trust in sponsors expertise.
Private RE debt funds seem to a bit easier since they are 1st position liens. But still, a lot of faith in the company that runs the fund and you have to do research into the types of loans they are making, track record, etc….
Great summary! No argument that RE is a great way to build wealth.
I have both but mostly use no-load broad index funds because it takes about an hour/year, making stocks much more “passive” in my mind. ( I do use a REIT index also, but that isn’t really what you are talking about in the article)
Your items #2 & # 3 require actual work – if you enjoy that work , then that’s great- but it is still a part time job!
There are many nice features of RE investing that Peter points out. Furthermore, you can make direct ownership of investment real estate essentially passive by hiring out management etc. However, I don’t often hear too much about the spending shocks (roof leak, appliance failure, storm damage, etc.) that can come without notice with direct RE investment that require the owner put up large sums of cash right away to fix. My index funds, REITs, and syndications will never require that. I also have no interest in being a direct landlord. I deal with enough messy personal life situations as a physician. Thus despite the advantages pointed out above, I prefer the truly passive approach. Thanks for what you do!
Those things certainly happen in syndications, you’re just more diversified. For example, you own 200 units instead of 1, a bum water heater isn’t going to suck up all your cash flow.
About #1, you can create DIY dividends; sell some stocks. #2 and #3 are arguments in favor of active management, with the rationale being that there are more opportunities for outperformance in real estate. However, the flip side is that there are more opportunities for underperformance. But if you’re above average, real estate could be to your favor. However, transaction costs will be a greater headwind. About leverage, for every $1 in assets in US stocks, there is $0.65 in leverage. There’s lots of embedded leverage in stocks. And if the leverage goes against me, my liability is limited to my ownership share of the company. However, tax benefits might be in favor of private real estate. I do know though that the tax benefits of publicly traded REITs haven’t persuaded me to invest in them, outside a market cap index fund.
I can’t edit my previous post anymore. Real estate may be less efficient, and there may be a greater opportunity for alpha. But alpha is net zero, and alpha can be negative, as well as positive. IMO, a full time physician for whom real estate is a hobby has a greater likelihood of generating negative alpha with real estate than stocks.
Park….I don’t know if I agree with you that there are more opportunities to “underperform” in RE than stocks? I would argue actively trading indiv stocks or etf’s, and attempting to time the market, has far more opportunities to underperform then passively investing in RE syndications with experienced sponsors.
If you are talking about a set it and forget it type of stock/bond/other index portfolio….over 15+ yrs at least… you probably have less opportunity to underperform passive RE syndications. But you can’t have money in stocks you don’t need to use for at least 10 yrs….maybe really 15-20 to be safe in case we see a repeat of 1929-1945, 1966-1982, 2000-2013…..3 periods where bonds outperformed stocks.
I also think a higher percentage of people can learn to invest profitably in real estate vs. someone who attempts to market time and trades stocks. Of course long term broad market index funds are the simplest of all. But once anyone gets into any type of stock trading, the bar is very, very high to achieve alpha and time & education commitment very high IMO. And that is IF any retail traders can beat the market over the long term at all…..something I am not convinced of since active fund manager & hedge fund managers who are professionals an do it full time cannot generate alpha over the long term.
Yes, but it’s simple to NOT actively trade or pay someone else to actively trade stocks. You just buy an index fund. That doesn’t exist for anything but the largest properties in the country (publicly traded REIT holdings). So you have to take on manager risk with real estate.
On the flip side, if you really want to put a lot of time and effort into your investments, doing so in real estate is far more likely to pay dividends.
I agree. Inefficient markets allow for easier over and underperformance and transaction costs are a big deal.
I got the real estate bug two years ago. I was going to purchase, renovate, and rent tax foreclosure houses. I created a LLC, got lists of houses, visited them, did extensive analysis of them, and waited for the day of the auction. 30 minutes before the beginning of the auction 10 of the remaining 12 houses on my list were suddenly paid off. The other 2 houses had a rapid bidding frenzy in the last 5 minutes of the auction (which extended the auction), and ended up going for far above what I considered profitable. The bidding soon went well above the Zillow values for well built houses, and these homes still needed extensive renovations. I saw the same thing on 2 other auctions I tried. Somehow the taxes were being paid off the morning of. And people are paying very high prices for the remaining properties that cannot possibly make enough rent to make them profitable. Clearly I was missing something. The real estate bug has since left me and I invest in something I understand better and takes far less time, stocks and bonds.
The winner’s curse! It’s a big issue with an auction. If you win, it means you think it’s worth more than anyone else on the planet.
Impromtu……trying to buy properties at tax sales is a extremely time intensive process. I tried it once and had the same experience as you. You get the list going to sale, spend a lot of time researching the properties, narrow down your list, go drive them….only to find most are canceled or bid up by newbies. And all that is left are slivers are unbuildable land on steep inclines that have IRS liens you take subject to! Tax sales are THE OPPOSITE of passive. Very risky, very time consuming. Wild goose chases.
I found that it was another area of investing that mostly the people selling courses and coaching make the easy money.
Stocks and bonds for more than 99% of people are investments; management of the underlying businesses is delegated to others. And for many who own real estate, they are also investors. But real estate for others is also a business, where they play a varying role in management. That can be an extra source of profit or loss.
I wanted to compliment Dr. Kim on a excellent blog post. Very well written, very informative. Stocks vs. RE is a very good topic for discussion! Thank you!
As best I can tell, studies of whether the real estate market is efficient or as efficient as the stock market have been inconclusive.
Isn’t this beside the point? For many of the real estate investors who comment here, their goals are income producing properties, not to earn excess returns by speculating on the prices of the properties.
If you own an apartment building or commercial real estate you can make profits by running a business. If the market is efficient, that has no effect on how well your business runs.
?
It’s not even close. You don’t need to study it. Just walk around and look at your local real estate market. It’s not even close to being as efficient a market as the stock market.
Just as it was obvious that seasoned professionals, devoting their waking hours to studying stocks, would outperform the market as a whole. So obvious that the pros laughed at the absurdity of index funds.
Whether a market is efficient is a question of fact. Answers derived from data, not subjective impressions from walking around.
When I get home I will post some data.
As I said, the conclusion is not net settled. Maybe real estate markets are less efficient than the stock market. Maybe not.
It’s settled in my mind, but you can study it if you like. Let me know when you find an index fund for SFH investments. I’d be interested.
“It’s settled in my mind, but you can study it if you like.”
Is that a quote from an active stock manager dismissing the idea of index funds as obviously wrong? Being were sure they were right did not make them right.
Being sure something is right without caring what the data show is not a route to reliable decision making. On the other hand, testing hypotheses and then acting on the results of those tests is the way to make progress.
A few references that themselves have many more.
“Journal of Economic Research 20 (2015) 117{168 117
Informational efficiency of the real estate market:
A meta-analysis
Shanaka Herath1
UNSW, Australia
Gunther Maier2
WU-Vienna University of Economics and Business, Austria
Abstract
The growing empirical literature testing informational efficiency of
real estate markets uses data from various contexts and at different
levels of aggregation. The results of these studies are mixed. We use
a distinctive meta-analysis to examine whether some of these study
characteristics and contexts lead to a significantly higher chance for
identification of an efficient real estate market. The results generated
through meta-regression suggest that use of stock market data
and individual level data, rather than aggregate data, significantly
improves the probability of a study concluding efficiency. Additionally,
the findings neither provide support for the suspicion that the
view of market efficiency has significantly changed over the years
nor do they indicate a publication bias resulting from such a view.
The statistical insignificance of other study characteristics suggests
that the outcome concerning efficiency is a context-specific random
manifestation for the most part.
Evidence for Weak-Form Market Efficiency in Hotel Real Estate Markets
Seonghee Oak, William P. AndrewFirst
Journal of Hospitality & Tourism Research First Published November 1, 2003 Research Article
https://doi.org/10.1177/10963480030274004
The purpose of this study is to test for evidence of weak-form market efficiency in hotel real estate markets by measuring how rapidly price changes diffuse in geographically proximal areas. Using autocorrelation and cross-correlation analysis, we found that there is little evidence that past hotel prices predict future hotel prices in the same city as well as neigh- boring cities. In addition, buy-and-sell trading strategies based on the information in past hotel prices did not earn higher returns than buy-and-hold strategies. The results of this study are supportive of the existence of weak-form market efficiency in the pricing of hotel real estate.
Evaluating Market Efficiency of the US Forest Industry
By:La, L (La, Le)[ 1 ] ; Mei, B (Mei, Bin)[ 1 ]
FOREST PRODUCTS JOURNAL
Volume: 63 Issue: 7-8 Pages: 232-237
DOI: 10.13073/FPJ-D-13-00072
Published: 2013
Abstract
The market efficiency of the US forest industry had evolved over the past decade. In this study, the entropy measurement, an econophysic approach, was applied to quantify the informational efficiency of timber real estate investment trusts (REITs), wood, furniture, and paper markets in the United States during the period from 1999 to 2012. In a relative context, indices on Treasury bonds were used to proxy the risk-free rate of returns, while Standard & Poor’s (S&P) 500 stock returns were used as a yardstick for risky investments. The analysis indicated that the forest markets were considerably more informationally efficient than the Treasury market. Furthermore, most markets were marginally more efficient compared with the S&P 500 index, with the exception of REIT returns. Therefore, better arbitrage opportunities were present in REIT investments.”
Have fun with this argument. I’m going rafting. Let me know when you figure out whether my local real estate market is efficient or not.
Ditto for the stock market. It is obviously inefficient. No amount of data on the subject is even interesting.
At least, so the dwindling group of active managers would have it.
If people read the literature, they stop paying for active management. So managers try to convince them not to read the literature.
How would someone determine whether a market is efficient without testing it? How would one even define the question?
When you say the market is obviously inefficient, what does that mean? When you say it is so obvious that no tests are necessary what does that mean?
I think the real estate markets are MUCH MORE INefficient than the stock market. The stock market may not be perfectly efficient, but almost nobody can exploit those inefficiencies over the long term. Especially retail mom and pop investors like us. That’s why for me personally if I am in stocks at all, I am in total market index funds with money I do not need for 15+ years.
No way in hell I want the brain damage of trying to figure out how to time when to buy and sell stocks, sector etf’s, commodities, options, etc… I have much better things to do with my time. And even I did spend the massive amounts of time and energy trying to figure out how to exploit inefficiencies in publicly traded markets…..the odds are I would not be successful. And it would be a total waste of my precious time on earth. I’m humble enough to know I am not Jim Simmons at Renaissance!
While I agree with most of the article, not so much the statement that the tax benefits are “not a loophole.” Many of those were put in place by lobbying from those heavy into real estate. Getting a tax cut for depreciation on an asset that increased in value makes no logical sense, but its a great deal for those who lobbied to get that into the tax code. Also, for the past 5 to 8 years first time home buyers have been struggling to get into the market. Part of the reason is that after 2009 so many people bought up distressed homes and turned them into rentals, so now supply is very low making prices go through the roof. Having a business renting is great for the home owner and I’m not against it, but don’t fool yourself into thinking the government is encouraging you to do it for the greater good when the side effect is actually decreasing home ownership because first time buyers are getting priced out.
PICU doc…..I think you may have some what of a point on single family homes. Investors buying all the homes up for rentals reduces supply and drives up prices for families want to buy their first home.
But I’m not sure I agree with on commercial real estate like apartment buildings, etc… Investors take very big risks with their capital to develop say a 500u apartment building because of rewards that come with those risks . Some of those rewards are the tax advantages to take depreciation to write off income and tax deferred exchanges. We already have a housing shortage and need more housing. Who is going to take the massive risk to develop a new apartment buildings if you take away these incentives from investors?
You raise a good point. There are a lot of single family home rentals in my area so that was my focus, but I agree with you that an apartment building should be treated differently.
I’ll still argue some of the tax breaks are loopholes. The most ridiculous one was the one I mentioned before where you can claim a tax break for depreciation on an asset that has increased in value (this is particularly true if you can double dip and also claim repairs as business expenses). However, I agree with you that investing in an apartment building should be encouraged given the housing crisis.
One man’s loophole is another man’s tax break. I could argue the standard deduction is a ridiculous loophole for instance, but 90%+ of Americans really like that deduction.
I don’t see how you can make any sort of logical argument that a six door apartment building should be treated differently than a single family home as far as depreciation.
“one mans loophole is another man’s tax break” is a cop out. Thats just another way of saying you have no logical argument as to why someone should get to claim a loss of value on a property that actually increased in value (other than special interests lobbying of course).
As far as the apartment vs single family home argument I do think there is logic there. In theory congress gives tax benefits to things that are in the best interest of the public (again if you ignore the effect of lobbying). If you build a 100 unit apartment building you can argue at least that it is in the public interest. It increases housing availability. If you buy a single family home and rent it out, that’s not in the public interest. It does not increase housing availability if you buy an already constructed home, and even if you’re building it new it barely increases housing (1 unit compared to a 100 unit apartment). There are a ton of single family homes out there for rent right now. That only decreases the home inventory for sale which drives up prices.
The government states wants to support a path to home ownership for americans, but encouraging this type of rental through tax breaks only makes it harder for first time home buyers. These first time home buyers are then stuck renting because they are priced out of buying. I’m not against renting single family homes, but I think the depreciation tax break on it is absolutely a loop hole. It does not serve the public good and it has no logical sense as to why you should be able to claim a loss on an item that actually gained value (particularly in a year like this one where real estate prices went nuts).
I know the next argument is going to be where do you draw the line? How many units should you have before it’s considered in the public good? I’m not sure, but I know it’s not one.
If you want to argue about depreciation, we can do that. Let’s start with a non-real estate business like WCI. Let’s say I buy furniture for our conference room. It’s not worth as much next year as it was at the time I bought it. It is worth less. It has depreciated. IRS rules may require it to be depreciated over a number of years.
Now, consider a real estate business. It buys a building that sits on land. Next year, the land is worth more, but that building is worth less. The siding, brick, carpet, paint etc is all now worth less compared to a brand new building. Why shouldn’t it be depreciated just like that office furniture? Seems plenty logical to me. You can’t depreciate the land of course.
If you want to argue something isn’t logical, your argument should be against 1031 exchanges. That’s the big real estate benefit, not the depreciation.
Your argument against SFH depreciation is illogical though. How is it different if I provide 100 SFHs for rent vs 1 big apartment building for 100 families? It’s not and shouldn’t be treated differently.
I agree that government subsidization of housing raising housing prices, just like education and health care.
The existence of index funds has nothing to do with whether a market is efficient. Index funds were created in response to the finding that securities markets were efficient, not the other way around.
Note that “markets are efficient” does not mean “no one can earn profits in this business”. Vanguard became an enormous company, BlackRock, Fidelity, Goldman Sachs and many others generate billions in profits running businesses in efficient markets.
If one says that the real estate market is “inefficient”, what does that mean? What evidence is one brining to arrive at that statement?
With neither a definition nor systematic study, how could one come to a meaningful conclusion of whether a market has a particular property?
Having watched and listened carefully to many other physicians who invested in real estate, whether residential apartments, single family home or business rentals, they all shared one common denominator: they were all a hassle overall. This was whether they took care of issues or had paid manager take care of issues.
As we get older, especially after a busy clinical practice, we want to keep our life simple, easy and as uncomplicated as possible and enjoy the fruits of our labor. I think this involves a portfolio of traditional equity, fixed income and small portion of REIT. Dividends and short and long term capital gains are deposited into your “spending account” monthly…….what could be easier and hassle free?
There’s no doubt that there are additional hassles with real estate. For instance, here it is May 14th and I’m filing tax extensions because I’m still missing 3 K-1s for Funds/syndications. Tax extensions in multiple states.