By Dr. James M. Dahle, WCI Founder
I've noticed a strange but interesting theme among investors. Real estate investors like to denigrate stock investors as speculators who buy “paper assets” subject to market crashes. Stock investors bash real estate investors as “people who want a second job,” “get rich quick schemers,” and “people who can't accurately calculate a return.” As with most stereotypes, there is some truth to them. Both types of investments have their pluses and minuses. You can do both of them poorly, but done well, both are likely to lead to wealth. I have at times found myself in two separate arguments at the same time, one in which I am defending real estate investing and one in which I am pointing out its flaws. In this post, I'll discuss some of the advantages of each, as well as ways in which they are far more similar than the extremists like to admit.
8 Ways to Compare Real Estate vs. Stocks Investments
#1 Generating Profit from Business Ownership
Real estate investors seem to forget what a stock is. A share of stock is partial ownership of a business. Believe it or not, GE, Exxon, Apple, and Disney all make money. If you own a share of these companies, you share in the profits. These profits come as dividends and as capital gains. A share of stock is not like a piece of gold, where it's value is purely speculative. Future cash flows can be discounted to the present and a real value assigned to the company. While there is a significant speculative component to short-term returns, this cancels out over the long term, leaving the stock investor with a fundamental return derived primarily from how well the business is run. This is far different from buying a barrel of oil or a painting and hoping the value goes up.
Well-run real estate is also a profitable business, with a fundamental return derived primarily from rents. Increased rents, in turn, increase the value of the property. Both investments involve placing your capital into a business that has the expectation of generating a profit on that capital. Those who have done better in real estate like to say real estate has higher returns and vice versa. But as near as I can tell, if you're accurately calculating unleveraged returns and taking into account the value of your time, the returns are very similar with both asset classes over the long run.
Advantage: Tie
#2 Generating Passive Income
Granary Canyon bridge rappel, Moab, UT
Stock investors, particularly buy and hold index fund investors, pride themselves on portfolios that take literally minutes a year to maintain and deride real estate investors for failing to take their time into account when calculating their returns. Some real estate investing, of course, requires so much active input from the investor that it becomes a career. Consider a house-flipper for instance. He spends days searching for a property, hours and hours purchasing it, a few more days fixing it up, and hours and hours selling it for a profit. This investor might be very proud to say “I bought it for $75K cash and sold it for $115K just 3 months later!” That's a 332% annualized return! However, if he includes the $25K he put into it, that return drops to a 63% return and if you include the 120 hours of time he poured into it the return drops to 10% annualized (perhaps 6-7% after tax), and there was significant risk of that return being a lot worse.
Next on the spectrum of passivity is the real estate investor who does his own property management and maintenance. Experts estimate that, on average throughout the rental cycle, each unit you own will require 5 hours a month to manage and maintain. Even if you buy and hold this property for years, and hire a property manager to do most of the management tasks, many hours of work above and beyond what it would take to maintain a portfolio of index funds are required. There are yet more passive ways to invest in real estate. We've discussed real estate syndication on this blog numerous times. There is some initial time required to do due diligence, but after that, there is little ongoing time requirement. The more passive you wish to be, of course, the more ongoing expenses you have. Finally, you can invest in “real estate flavored stock”, such as the Vanguard REIT index. While most experts agree REITs are a separate asset class from the overall stock market, the correlation with an index fund portfolio will be far higher than an investment in an apartment building in your city. Real estate is generally a much more active investment when compared to stock index funds, but there are ways to minimize the active involvement.
A real estate proponent also has the counter-argument that while it is possible to invest in stocks in a very passive manner, there are a whole lot of people out there doing it actively. That ranges from picking actively managed mutual funds and reviewing them from time to time to day trading. The more active your investing, the more you need to take into account the value of your time in calculating returns. For a busy high income professional able to trade time for money at a very high rate, maintaining passivity in his investments is very important.
#3 Generating Income and Capital Gains
Far too many investors fall into the “income investing” trap. Dividend stock investors are the classic example, but real estate investors are even worse. It is important to understand the concept of total return investing to avoid this trap. A dollar spends just the same whether it came from income or from capital gains. Neither is necessarily any better. Both stocks and real estate have both an income and a capital gain component. 10% returns are not unusual for either investment, but with a stock you are much more likely to get 8% from capital gains and 2% from dividends whereas with real estate you are more likely to get 8% from income and 2% from capital gains. If you fall into the income investing trap, you would think that real estate is somehow the better investment because the income is higher, but in reality returns are returns. Real estate investors like to argue that total return stock investors are “eating the goose that laid the golden egg” but in reality the stock goose grows faster and lays smaller eggs when compared to the real estate goose. They both provide the same amount of food in the end.
Real estate investors love to talk about “becoming financially free” and “replacing their income” with the income from their properties. There is nothing magical about real estate in this respect. The money you spend doesn't care where it comes from. Safe withdrawal rate (SWR) studies show that you can take a certain amount of inflation-adjusted money out of a portfolio each year and expect it to last. If you're just spending the income, the portfolio will last forever, but you'll end up with a lower standard of living than you could have had with a total return SWR approach. You can just “spend the income” with both stocks and real estate.
However, one benefit of real estate over stocks is that because real estate returns come more from income than capital gains they are less volatile. If you have the same return from a less volatile portfolio, you can have a higher safe withdrawal rate from it. Plus, the process is more automated with real estate. The capital gains component tends to move along at the rate of inflation, automatically increasing income each year with inflation, so you can just take the inflation-adjusted income each year and spend it without any complicated calculations.
Advantage: Real Estate
#4 Tax Advantages
Real estate investors love to talk about the tax advantages of real estate. There are many, but there may be even more with stocks. Real estate investors are able to deduct their expenses, including mortgage interest, from their income. Businesses (stock shares), of course, get to do this too. Real estate investors get to depreciate their assets, but so do businesses. The stock investor may not be as aware of all these benefits, but he is reaping their benefits all the same.
Real estate investors like to point out that they can avoid capital gains taxes by exchanging from one property to another and then at their death the heirs inherit it with a stepped-up basis. However, if you inherit stock shares, you also get a step up in basis. You can also tax loss harvest both assets. Stocks enjoy more favorable tax treatment of their returns. Long-term capital gains and dividends are taxed at a favorable tax rate whereas real estate income (the lion's share of returns) is taxed at your full marginal tax rate. Exchanges do cost stock investors taxes, but not if done within a retirement account. Real estate investors like to point out that they get “paper losses” for the first few years of ownership. Unfortunately, for a high-income investor like a physician, those paper losses can't be used to offset earned income.
Stocks are also easily invested in using retirement accounts. 401Ks and other tax-deferred accounts save taxes with an up-front tax break, tax-protected growth, and a tax-bracket arbitrage at the time of withdrawal. Roth accounts don't provide that up-front tax break but do provide tax-free growth and withdrawals for you and your heirs. Aside from REITs, it can be a big pain to invest in real estate in retirement accounts, and even if you do so, you lose some of the tax benefits, like depreciation, that you would otherwise get.
Advantage: Stocks (Slight)
#5 Ability to Use Leverage
One of the biggest advantages of real estate investing is the ability to use leverage in a safer manner. It is possible to invest in stocks using leverage through a margin account, although most investing experts recommend against it. The main issue, aside from increased volatility and variable interest rates, is margin calls. In a big bear market (which will come as it always does) the investor will be forced to come up with cash to cover the margin call. Mortgages, however, are generally long-term loans, are fixed at low-interest rates, are collateralized with the property itself, and are non-callable. It is possible to use mortgage money to invest in stocks, but you are then putting your home or other property at risk, rather than just the investment. Leverage, of course, works both ways, and there are plenty of real estate investors who were ruined in the recent housing market downturn due to using too much leverage, but as a general rule, it is far safer to use in real estate investing than in stock investing.
Advantage: Real Estate
#6 Liquidity
One of the biggest downsides of traditional real estate investing is that it is highly illiquid. Roundtrip transaction costs may be up to 15% of the value of the property, 5% to buy and 10% to sell. Plus, it may takes months to do so. In contrast, a portfolio of publicly traded stocks can be liquidated under normal conditions in minutes. While there can be some illiquidity issues with stocks in a down market, they pale in comparison to the issues with real estate, where there may be no buyers for a property at any reasonable price for years. It is also far easier to rebalance a more liquid portfolio to maintain an appropriate risk level.
Advantage: Stocks
#7 Efficiency
The publicly traded stock market is highly efficient. It might not be perfectly efficient, but compared to the real estate market it might as well be. There are many opportunities to both outperform and underperform in real estate depending on your skill level. If you are skilled at assessing, purchasing, and selling property and talented at managing it, you will be rewarded with high returns. If you try to manage your own rental property but aren't good at screening tenants and feel badly raising rents to the market rate, your returns will stink. With stock investing, especially using a buy-and-hold static asset allocation of low-cost index funds, your talent and skill will have little effect on your returns, for better and for worse.
Advantage: Real Estate (slight)
#8 Volatility
Nobody gets their rental property assessed every month, much less every minute of every day the markets are open. That doesn't mean the value of the property doesn't fluctuate wildly. The value of a property is whatever someone is willing to pay for it. However, the owner only thinks about the property value on rare occasions; perhaps once a year when the tax assessment comes and when he buys and sells it. Since he isn't confronted with a talking head on CNBC every afternoon screaming “buy buy buy” and “sell sell sell” he is unlikely to sell except when his life circumstances change. Stock investors should also be like that, but who are we kidding. The vast majority struggle to stay the course in market downturns, so much so that they often have to mix stocks with an asset that has a lower expected return (like bonds) to lower volatility to the point they can sleep at night. Stocks are risky investments with high expected returns. Real estate is also a risky investment with high expected returns. Bonds, however, are relatively lower risk with corresponding lower expected returns. The more bonds you have to hold to lower volatility, the lower your return is likely to be over the long term. Real estate's lower volatility, whether real or just perceived, allows investors to tolerate a riskier portfolio, boosting expected returns.
Advantage: Real Estate
Overall Winner
Looking at these eight aspects of investing, I see real estate winning 4, stocks winning 3, and a tie. That is essentially a draw in my mind. The truth, however, is that you don't have to choose between these two great asset classes. You can have both. I have a large percentage of my net worth invested in stocks. I also have a significant percentage tied up in real estate, including my principal residence, a rental property, shares of the LLC that owns the building housing my business office, and REITs. Both assets provide great returns and diversify each other. You may favor one asset class over the other in your portfolio, and that's fine, but you can reap big benefits by avoiding an extreme position in this debate.
What do you think? Stocks? Real Estate? Both? Sound off in the comments section!
I like this post.
I’d add “ease of diversification” as another category in which stocks have the advantage. Sort of the converse of efficiency
Of course various advantages will be more or less important to different investors. I’d rather add on an extra 1/2 day seeing patients a month than manage an investment property, but I can see why other docs would prefer the reverse.
I include real estate as part of my overall portfolio allocation but am lucky to have access to the TIAA-CREF real estate portfolio in one of my retirement accounts, which I use for the majority. As David Swensen details in his Unconventional Success book, it is a great way to gain diversified exposure to real estate without paying exorbitant fees.
Thanks for the great article and well written summary. I respectfully must disagree with your analysis on taxes. Real estate is far superior to stocks or mutual funds when it comes to taxes. If you sell a stock that you have owned for more than a year, then you will have to pay capital gains tax. If you want to avoid this, you will have to put your money into a retirement account, as you mention. However, in return, you must wait until you are 59.5 years old to access that money. Sure there are some exemptions but not for those who want to retire early and live off of their portfolio. When you do access that money, you will have taxes to pay. If you want to access it early, you will have taxes and penalties to pay.
As you mention, real estate is already so tax advantaged that putting real estate into one of these retirement accounts actually makes the investment less tax advantaged. That fact alone should tell you which has better tax advantages.
You mention that real estate income cannot be used to offset earned income for high earning physicians. However, active investors who qualify for real estate professional status can do just that. As for passive investors, they may not be able to use it to offset their earned income, but they can use it to offset their passive income from their property. In direct fractional real estate investing, it is the norm to get a K1 at the end of the year that reflects a negative number even though the investors made actual money. That phantom loss comes from depreciation and accelerated depreciation and can result in tax-free passive income.
In summary, I believe that real estate is far more tax advantaged because the investor can reap the rewards of tax-free income, tax-free equity harvesting through refinances, tax-deferred 1031 exchanges when selling a property and they can do all of this now WITHOUT having to wait for a late retirement age of 59.5 years old and a future tax burden that comes when you are forced to take mandatory withdrawals from those retirement accounts.
I know you disagree with me on this point Dennis, but I think you’re wrong. You haven’t mentioned a single tax advantage that real estate has that stocks don’t have. Just like your real estate business can depreciate its building and equipment, so can the company whose stock you own. It’s the same tax deduction. It just shows up differently. It shows up as additional profit for the company (a larger dividend or more capital gains) instead of on a K-1. The reason you get to count a “phantom loss” in real estate investing (or business) is because that building really does lose value over time. It requires a new roof, new siding, a new driveway and eventually, the whole thing gets bulldozed and you start over. It will eventually be a real loss, that’s why the government allows you to depreciate it. Depreciation is recaptured if you sell the property prior to death anyway. Either you lose that tax break or you elect to be a real estate investor even into your 80s and 90s.
Age 59 1/2 isn’t considered a late retirement, especially for a physician who may not start his career until his mid 30s. Even Social Security “early retirement” is 62. Besides, as you mention, there are so many exceptions that allow you to access retirement money penalty-free prior to retirement that it’s almost a non-issue. I’ve detailed these here: https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
Yes, you pay tax when you withdraw money from tax-deferred retirement accounts. You also pay tax when you receive rent checks from your income property. That’s exactly the same. There’s a very real tax advantage to using retirement accounts, and you don’t get it when you invest in real estate outside of a retirement account. If your stocks aren’t in a retirement account, you actually get to pay tax at a lower rate on the qualified dividends/capital gains distributions. These two tax advantages are much larger than the ability to depreciate a rental property and write off its expenses.
I think are a number if advantages to real estate.
1. You mention in the comments that sticks take advantage of appreciation, but it is not the same as a rental property. A rental property can depreciate the full amount of the building over 27 years and that is a direct income reduction to the owner each year. You mention the building loses value each and must be repaired. Well each repair and maintenance item is deductible or added to the depreciation and becomes a tax benefit as well. Most likely value is being added and you are getting a tax benefit as well.
Yes with stocks the stock holder may get the benefit of depreciation as well, but my nearly to the extent of the RE investor. First the company is most likely not going to hold as high a percentage of real estate unless it is a REIT. Second that depreciation is being shared by thousands of other stock holders and is virtually negligible once you factor in all the stockholders and less real estate held. Plus the stock is valued based on depreciation being part of the overall profit. Real estate may not be if it is single family and not currently used as a rental. Huge advantage to real estate.
2. Real estate is an inefficient market. I like to think of this as buying properties below market value. You can buy Reo, short sales, estate sales or off market properties and get deep discounts. I have 8 rentals and 6 fix and flips right now. All were bought at least 25% below market value. Then I can make repairs and increase value even more! On all my rentals I put 20% down, purchased around 80k to 115k, put 5k to 20k in repairs into them and they are worth $155k to $180k now and cash flow $500 a month. I bought them all in the last three years and part of that increase was appreciation, but most of it was value added and buying below market.
You can’t do that with stocks. You can’t buy below market because it is an efficient market and you can’t fix up a stock. You can buy possible undervalued stocks, but your still buying at market value. You would need millions or billions to buy the company and add value yourself.
3. I have constant cash flow that nets me 20% plus a year without factoring in tax advantages, equity pay down or appreciation. If values go down, it doesn’t matter because I am bringing in cash flow and not selling property. My retirement calculator is not factoring in how long I think I’ll live so I don’t run out of money and principal when I’m 85. I figure I’m shortening my retirement age by about 20 years by investing in real estate instead of stocks.
1. Yes, that’s an advantage. But depreciation is also recaptured if you don’t exchange/die. Also, maintenance is deductible, but it isn’t added to the basis (although additions/upgrades can be). The depreciation that a company/stock isn’t diluted any more than a real estate investment owned by multiple people would be. I agree that a larger portion of the assets of a real estate company/investment is probably depreciable than a non-real estate company. Good point on the fact that many buyers of real estate aren’t investors, but also keep in mind those folks also often bid up real estate to values far higher than the rent would justify. That’s a huge disadvantage to real estate.
2. I agree, real estate is inefficient. That means you can get a good deal much easier. It also means you can get a bad deal much easier. See, when I go to buy real estate, I’m now competing against experienced folks like you and I’m at a severe disadvantage. Inefficient markets go both ways. An efficient market is an advantage if you don’t have much time/expertise.
3. You can shorten your retirement age by many years by working two jobs instead of one. Why is that a surprise? 🙂 You and I could have retired earlier by going into real estate investing right out of high school instead of going to medical school too.
You have also made some particularly good real estate investments. Buying properties at 25% below market value isn’t as easy as your paragraph makes it sound. That’s good for you, but do you really believe that ALL real estate investors can buy their properties for 25% less than the value? Sounds like Lake Wobegon to me. It is much more common to see houses being sold at Cap Rates of 3-5. You have to put a lot of cash down to be cash flow positive in those situations, even at today’s low interest rates. Your 20% return is a little bit unbelievable. I would suspect you aren’t factoring in your time, which is really a “second job” effect. A cash flow return of 20% requires a very good price. Take a $100K house. Let’s say you put $25K down. You’re saying you have a positive cash flow of $5K a year (20%). Let’s assume you financed this house at 5% over 30 years. That makes for annual P&I payments of $4646 per year. Using the 55% rule (45% of gross rents goes to expenses, vacancies, taxes and other non-financing expenses) and adding your financing cost of $4646, that means you’re getting a rent of $13,737 per year, or $1145 per month. That’s a cap rate of 13.7%. Everything I look at has a cap rate of 3-5%, with an occasional 6%. Yet you seem to find properties with a 13-14% cap rate. That’s awesome for you, but not exactly easily reproducible.
Thank you for the response!
You make some great points. Yes you would have to recapture when you sell, but why sell if your making money off the properties unless you want a huge payoff in the end when properties are paid off. By that time inflation would make the recapture much less than the tax savings earned in today’s dollars.
My typical property rents for $1100 to $1,400 and I bought it for $80,000 to $115,000. Taxes in Colorado are .05% and very low. I put 20% down and have 8 of them so far. If I went to MLS and bought whatever was there then I wouldn’t find those deals. I have to be patient and jump on the good ones. That’s the best part of real estate is the good deals do come along. Yes it takes time, but so does figuring out an IRA, 401k, which stocks and mutual funds to pick. Is that time calculated into returns? You can pay a pro but that takes fees and lessens returns even more. I would agree it may take more time to find great deals for rentals. I guess the question is if it is worth the increased returns.
Cash flow is the big kicker for me. It will keep going up with inflation and drastically go up when properties are paid off.
I disagree that the time commitment to figuring out how an IRA and picking stocks is anywhere comparable to seeking out good real estate deals, much less purchasing them, managing them, selling them etc. Give me a break. Just buy all the stocks in 30 seconds at Vanguard. You can’t do that with real estate.
If all you want is cash flow, then just put 100% down. You’ll have great cash flow!
I am an real estate investor in Maryland, and I’m sorry but stocs can not compete with my market. I buy my homes usually at around $80k and rent for $1400/month. Which is $16,800 yr. a return of 21%.
But now let’s deduct expenses. Tax range = $700 – $900/ yr.
This reduces my return to 20%. Now white Coat investors says subtract vacancies. I Haven’t had a vacancy in this property in 12yrs. So that’s $0
Now white says subtract for the taxes you will have to pay on that profit.
Which is also 0. I’ve relieved tax returns every yr. creative write off strategies for me eliminates it.
So you have no expenses on this property? No insurance? No management costs? No maintenance? No interest costs? Really? Pretty awesome property. I’d love a few of those.
I think real estate can be a great investment, but to take an honest look at it you have to include ALL the numbers. Yes, there are ways to minimize the income taxes due on it. Primarily that means sheltering the income with depreciation and then exchanging to a bigger property when the depreciation can no longer shelter the income. Not sure what you mean by “creative”. A deduction is either legit or fraudulent. I’m all for the legit ones.
“I know you disagree with me on this point Dennis, but I think you’re wrong. You haven’t mentioned a single tax advantage that real estate has that stocks don’t have. Just like your real estate business can depreciate its building and equipment, so can the company whose stock you own. It’s the same tax deduction. It just shows up differently. It shows up as additional profit for the company (a larger dividend or more capital gains) instead of on a K-1.”
I hate to disagree with you here, Jim, but I do think you have to give this point to Real Estate, but not for the reason Dennis thinks.
The difference is that Stocks have a disadvantage here not because the have a different method of DEPRECIATION but because they have a different method of TAXATION. As you point out most real estate income is taxed via a K-1 because most Real Estate ownership entities are pass-through entities (LLC’s, partnerships, etc.) that thereby avoid corporate level taxation. The reason Real Estate has a tax advantage is that it generally avoids corporate taxes and is taxed only once not twice.
The depreciation losses are minor these days since you cannot pass those losses through to your active income. Yes, Dennis can. On the other hand he gets hit for ordinary income rates rather than capital gains when he sells because he is a “dealer” in real estate. But Dennis is not your typical MD who has a lot more ordinary income than passive income outside of his retirement accounts.
But that 35% additional corporate tax rate is a real bite. Easy for you to ignore it because you don’t write the check but it’s there and that money that goes to Uncle Sam doesn’t come to you as either a dividend or a capital gain– it is pure friction against the corporate earnings.
Yes, many companies have become adept at avoiding this burden but even avoidance has costs.
Great post and summary of benefits/drawbacks of each. I agree with the healthy mix of both. I like commercial real estate as part of my portfolio for the very reasons that WCI pointed out. I like to use leverage of real estate to boost the overall return while I am young/working and do not need/want the income from the property, but then as I get closer to retirement, then the real estate de-leverages itself with the loan paydown, turning it from a higher risk/higher return asset when I am younger to a lower-risk/lower-return asset as I am older and am less tolerant of asset volatility and want the income. Often as people age, they reduce the volatility of a stock portfolio by adding low yielding bonds, but with real estate that has paid off it’s mortgage, I believe (hope) to get a more stable, income producing return–more similar to bonds, but with hopefully, a higher return (cap rate of 7% or so plus appreciation of property value/rents vs 3-5% with bonds). Also, as WCI pointed out, it has some inflation-hedge built into it. Obviously, there are still all the downsides of real estate as pointed out by WCI, but these can still be mitigated by having the equities portion of your portfolio along with diversification of several different real estate properties. I prefer office-warehouse for its lower maintenance, lower concern for aging of building, etc. I am not a big fan of syndication or REITS for this specific purpose as I feel that the fees take out too much of the upside. I do think REITS (and less so for syndications) have their place for asset diversification, but not for the reasons I’ve listed.
I agree that it is important to consider fees. Every fee you pay on an investment is less money that you get to keep. Having said that, I believe that net returns after fees are more important. I would rather pay 20% in fees for an investment that will make me 15% per year than pay zero in fees for an investment that will make me 4% per year.
The risks associated with leverage decrease, but other risks associated with a real estate investment still exist after the loan is paid off. It can drop in value, you can have significant vacancy, serious maintenance expenses show up etc.
In addition unless that leverage has a relative short term (10 to 15 years, not 20 to 30)there are a whole other set of “lifetime” risks.
Risk of deferred maintenance
Risk of building component failure
Risk of functional obsolescence
Risk of location deterioration
Risk of property tax restructuring affecting values
Risk of demographic shift
etc. etc.
On the typical 20 to 30 year timeline there is significant likelihood of one or more of these factors becoming significant.
On the other hand real estate has generally been a great hedge against inflation and with all the quantitative easing the Fed has been up to I think inflationary pressures are likely to continue for the next 20 to 30 years and may offset any of the risks above.
Which brings us to a stock market concern. Seems to me that the trillion dollars or so which the Fed has pumped into the economy over the last year has gone to to “pump up” the stock market with a lot of air. As the Fed “tapers” off does anybody think a 16,000 point DOW is sustainable? While I agree that the market cannot be timed in the short run (say three weeks to a year) it looks pretty Bubble-like to me in the middle term (say one to three years).
Agreed, however, to get that higher return with high fees, the asset needs to take on a significant more amount of risk in order to get a high rate of return and pay high fees. Also, with syndication, you lose the ability to control/time the leveraging, purchase, sale, pay down loan vs take out the cash, etc.
“Real estate investors like to point out that they get “paper losses” for the first few years of ownership.”
Could you go into more detail about the above statement?
Two points that I would like to make. Divisibility is better with stocks than real estate: it is usually easier to sell 10% of your stocks than 10% of your real estate. Also, there is considerable implicit leverage in stocks. Stocks are a levered claim on corporate assets; about 50% of corporate assets are paid with borrowed money on average. If I remember correctly from an interview with Ray Dalio, he stated that without that implicit leverage, stocks would have similar returns and volatility as bonds.
Thanks to depreciation, you may have a loss according to the IRS, when in actuality you made money on the investment.
Right on about Divisibility and that is a key advantage. But maybe its related to Liquidity somehow.
From WhyNotUs on the Bogleheads forum:
I own rental and index funds and am bemused by the ongoing attempts to compare such incomparable subjects. There are many (most?) for whom rental RE will not have any interest, regardless of the anecdotes about the guy who “retired” at 50 by renting 7 sfhs. Indexes make sense for just about everyone that has the ability to invest while rental real estate is for a particular group of people. One circle is much larger than the other, if you, like me, own rental real estate with some success then I would give serious consideration about diversifying some of the proceeds into index funds so that the circle overlap.
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=89908&p=1898224#p1898224
Jim,
What a thoughtful article! One of the reasons I really like your website. Most of the debate on this topic lacks clarity of thought and degrades over time to platitudes.
Allow me to agree with you on most of this and make a number of small points of disagreement.
Re: Stocks are pieces of a Business: I agree, of course, but in light of concerns expressed elsewhere in this post and on this site you should point out that because of multiple levels of management (and taxation) in the stock business the “paper assets” argument, while usually badly framed, is not without some merit.
Re: Passivity. Basically I agree but there are a lot of extremely passive RE investments out there: NNN leases, mortgages (making them, not borrowing money). Most of these tend to perform like bonds and have limited upside beyond the fixed rate of return but its hard to beat 20 year NNN leases with 20 year options to renew for a “forget about it” investment vehicle. Also very few stock investors seem to be taking anything near the “few hours a year” kind of approach you favor.
Re: Tax advantages. I agree that depreciation as a tax advantage is WAY overrated after the Tax Reform Act of 1986. That people continue to repeat this canard shows how little real thought goes into these debates.
On the other hand, your argument that it is easier to do stocks in IRA’s and other tax advantaged vehicles is, I think, also simply wrong. Self Directed IRA’s are cheap enough and the processing easy enough that this “advantage: stock” is actually “advantage: none”
RE: Leverage and Liquidity. I think that these are a see-saw that actually cancels each other out. As you have pointed out many times your portfolio has way more liquidity than it needs so Liquidity is only a very minor advantage and may actually be a disadvantage. Likewise Leverage: most real estate investors use way more leverage than is healthy. In each case the “advantage” is a potential booby trap (and is usually an actual trap– few investors have the discipline to turn down a 30 year mortgage or ride out a bear market). Also unless that debt is non-recourse (rare) it also increases risk giving away most of the Liquidity advantage of real estate.
Re: Inefficiency and Volatility: I think these are reverse sides of the same coin. Giving the advantage to real estate on both of these is probably too generous.
Anyway, the “both” option is, of course absolutely correct. I am always surprised at how many people actually invest to any real degree in both markets. Probably it comes down to psychology– some “fit” better in one place than the other– but I’ve never been able to figure out what psychological factors are the key.
Both can be volatile investments. The key is to keep researching the market, maintain a diverse portfolio and try to stay ahead of the game so you can move your money around accordingly.
Late post, but a major difference is barrier to entry, which I am not sure if you covered. You can start investing with Vanguard with $3000 at a young age and take advantage of the time value. That is the only way that many people who are working 40-60 hour weeks can invest. So if we were running a scientific experiment, I would wager stocks win over a lifetime, because of the time value. In real estate, there is also high barrier to entry because it is so geographically constricted. Being an amateur real estate investor in Northern California is a much riskier proposition than in suburban Utah. If a key principle is staying diversified, I don’t see how real estate could figure into a portfolio unless you already have amassed a large amount of wealth or have inherited it. I suspect most of the pro-real estate folks are older and started when they had substantial wealth.
I agree that is an issue for most folks, however, many physicians will be able to come up with $50K to put down on a $250K property once a year. After 10 or 15 years, you have some diversification. Private real estate opportunities can be as low as $5K. Most real estate investments definitely fall into the “put all your eggs in one basket and watch that basket very closely” category.
I happened to find this post again. In respond to increasing cash flow by buying with all cash. I actually make more cash flow buying three properties with 20% down than I would paying all cash for one.
I have ten rentals now and I have about $5,000 a month in cash flow coming in. I include vacancies and capital expenses in that figure. My average rent is up and I now clear about $900 a month in rent more than my mortgage payment.
As far as people who retire early with rentals; it happens all the time. i know many people locally and on forums that started small and ended up quitting ther day job Because of the income from rentals.
Yes it takes more time to invest in rentals than stocks, but its a lot more fun! I would much rather take the time to control my investment than hope the market does well.
I paid off my first rental the start of this year using cash flow from my other rentals. It felt awesome to have a free and clear property.
To each their own with regards to fun, but I’d much rather spend time mountain biking, skiing, canyoneering or even farting around on the internet than trying to collect rent, buying and selling properties, and doing repairs. Buying with all cash does improve your cash flow on the property you buy- obviously if you put down 100% you’re going to make more total money on the property than if you put down 20% (although your cash on cash rate of return may be lower due to the effects of leverage). I don’t disagree that you may clear more using $100K to buy 5 $100K properties instead of one, depending on your skill at buying and managing properties.
A principal residence can be sold after 2 years without paying any taxes. That alone makes real estate ALWAYS superior. Also in CA you have prop 13 which guarantees your property taxes will remain below inflation. Furthermore, on a second property you can rent it 14 days tax free. Around Xmas and Thanksgiving this can be 5-10K in tax free income for a decent rental.
Real estate is not always superior. That’s a bizarre argument to make. I assure you my real estate investment in 2006 is not superior to the stock investments I made in 2006.
My comment about not paying taxes after 2 years on a primary residence is more a point for those who think it’s better to rent a house and invest in stocks. I think that’s ludicrous. Primary residences are the #1 wealth creator for Americans. Period.
While I agree that primary residences make up a large percentage of the net worth of Americans, that is primarily a consumption decision, not an investing one. They have to pay their mortgage, but they don’t have to save for retirement.
At any rate, I don’t see a primary residence as being relevant to the discussion in this post. It’s about what to do with your extra money AFTER you’ve paid your rent or mortgage. Should it be invested in real estate, stocks, or both.
I compared real estate market 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.
You can read my entire analysis here: http://wp.me/p6V9kv-6e
About what % of wealth would you recommend in real estate vs. stocks? Controversial, I know. Was thinking of focusing on real estate with post tax account and majority stock in tax deferred. So maybe around 50-50 eventually.
No right answer. Personally, I think a portfolio should include stocks, bonds, and real estate so I’d put the lower limit for real estate at 5% and the upper limit at perhaps 75% for those who are really into it. 50/50 is fine.
Real Estate vs Stock where should you invest in 2020
Real estate is an excellent way to invest your hard-earned money. If you are looking for a long term investment, you should definitely go for real estate.
reit of reits like vgslx allow you to vercome many of the disadvantages of real estate to an extent. of course it also comes with less returns but i personally like 25% large cap, 25% mid cap, 25% small cap value and 25% vgslx. rebalance every year or so if stuff is off by 5% or more.
its very helpful. i got nice info from this post. thanks for sharing
Managing 10 rental homes while being a full time physician? Sheesh, what a mess. My time would be much better spent picking up an additional few shifts at work and investing the proceeds.
I still don’t see anything wrong with investing it all in VOO or VTI and letting it ride for decades (or add in 10-20% BND if “volatility” really bothers you). I have almost instant liquidity, transaction costs are nil, will have better long term growth potential, no liability potential with tenants, and no one ever calls me at 3am because the toilets are broken. Heck, I can even get a margin loan against my portfolio balance at interest rates RE investors would kill for…
Like WCI says, total return is all that matters. RE may kick off higher “dividends” in the form of rents, but home values appreciate more slowly than VTI will. Businesses that buy back shares rather than issue dividends are still returning value to shareholders, just through increased capital appreciation rather than a dividend payment (which is taxed).
Simply your life. I’m much rather spend my weekends hiking or snowboarding than demoing a kitchen or fixing broken toilets…
I wonder how much of the perceived benefits of real estate is due to recency bias? Leverage aside (which also very substantially increases risk by greatly accentuating volatility) it seems that real estate returns are actually much lower than stock market returns, especially if you look beyond the very abnormally hot prior decade.
Also, any thoughts on whether the historically high recent rates of return on real estate make it more likely to underperform? I know people think that real estate isn’t a very efficient market, however, living in a hot real estate market, it feels very efficient to me (but could be my particular situation), and now with over 30% of properties being bought by investors, it seems that could limit returns and make it more efficient? What’s to stop hedge funds etc from capitalizing on this inefficient market? Have they already? Is it though that the market is too large and complex for them to get into? It seems they are primed to be better at this than physicians and no one loves a good risk-adjusted return more. With so much attention on real estate from lay people of late, I worry that this could be a recipe for poor future returns.
I am trying to weight benefits of getting more into real estate, but I worry it’s primed for disappointing returns.
Would be interested to hear thoughts on this.
Thank you!
Yes, hedge funds are already moving into single family homes in a major way. That probably will make things more efficient.
But keep in mind when blaming recency bias that stocks have also had fantastic recent returns over the last decade. I suspect stocks, bond, and real estate are all likely to have much worse returns in the 2020s than in the 2010s.
That’s a good point. It does seem like real estate returns historically have been 3-4% and stock returns more like 10% historically so I worry low returns for both might mean lower than this which could put real estate appreciation quite low. Especially with mortgage interest rates coming up, this may result in quite a disappointment for many investors. Leverage may end up being more of a problem than a benefit.
I know some feel the housing shortage could counter some of these factors and increase returns.
I do wonder if the time where jumping into real estate heavily leveraged makes sense has passed.
I guess my question in all of this is- does rental real estate investing make sense with 0-3% expected appreciation (income and tax benefits outweigh?) ? How much of one’s portfolio would make sense to devote to this asset class under those expectations?
Depends on the alternatives.
Maybe better way to put it: If you felt that real estate would appreciate 0-3% per year how much of your portfolio would you put in said investment when alternatives are things like all ETFs.
Maybe you don’t have an opinion, just curious if you think appreciation is a large part of the equation when determining real estate allocation.
20%. Which is what I have in there and have for years.
My success does not depend on my ability to predict the future. I spread my bets widely and am very patient.
You realize that when real estate returns look crummy that usually means stock and bond and crypto and everything else also looks crummy, right?
Frankly, I never thought real estate would appreciate faster than 3% a year in the long run anyway. That’s perfectly fine to reach my goals. 6% of income, 3% of appreciation, a few tax benefits, a little debt paydown. Add a little leverage and that’s a great investment in my book.
20% , thanks
I know one can’t predict the future accurately, but your 20% allocation is taking into account expected returns and risk, so you are attempting to predict the future to some degree (as is everyone who invests and chooses a specific allocation – otherwise why not randomly select an asset allocation?).
I do find it difficult to not account for interest rates and recent returns in setting an allocation %, especially if using a loan to get leverage. One could say recent returns have been high for all asset classes, fine. But the cost of leverage is now above historic returns so i think its a valid question to better understand more precisely how the tax benefits and rental income outweigh these other factors.
I will continue my search.
Thanks.
There is a certain amount of randomness in choosing an asset allocation. Which is fine. The important thing isn’t the exact allocation, but sticking with it over time as all of these assets will have their day in the sun.
If you want to avoid leverage, you can do that. That’s totally separate from the asset allocation decision.
Alternatives being other standard investment options…
With all due respect, i don’t see how cost leverage and asset allocation are not related here . To reap any benefits of leverage (listed in your article as one of the major benefits of real estate investing) and including single family home as a subcategory of real estate, the cost of leverage is absolutely integral to the asset allocation discussion. For some with a big enough portfolio, leverage is only a potential benefit and not a necessity, I suppose
Fine, i can buy REITs, but my question centers more around how much can I expect to benefit from having a portion of my asset allocation in single family homes, which requires a loan for me.
Isn’t this a valid question?
Do REIT and single family homes deserve some separate attention in asset allocation determination ? they aren’t exactly the same right? Maybe you see them as the same.
I see today 30 year mortgage rates are almost 7%. In the past they were well over 10%.
Does the cost of a loan not affect asset allocation? I don’t see how it couldn’t. Would you just push forward with having a fixed percentage of your assets allocated toward single family residence if you needed to take out a loan of 7+, 10+ or 15+% . That wouldn’t be a deterrent at all?
My point is that I believe that loan rates seem to reasonably influence the asset allocation of that subcategory of real estate.
I think loan rates are getting high enough that the whole conversation is becoming less relevant to me because its clear loans are becoming too expensive, but I would like to develop a conceptual framework to determine the threshold loan rate that would make it worth it to take one out and be able to reap the benefits of leverage (“one of the biggest advantages of real estate investing “). Which, I agree with.
I think its very attractive to have kind of a stoic approach to asset allocation, but it seems you have to adjust to the costs, even if you assume there is no way to predict appreciation.
So I think a little bit of nuance is needed here. But, I appreciate your insight that I believe i missed earlier. So far I have:
Benefits:
Real estate appreciation: 3-4% annually (but highly variable, but if we’re going with asset allocation based on historical data – ie what I believe you and others like you and I do, then lets go 3-4% which seems totally reasonable to me)
Rental income: 6% (per your prior response that I missed)
Tax benefits: ? % (Will continue my quest to find an estimate here)
Costs:
Cost of a loan: 7% right now
Right now seems unlikely to be a great investment if a loan is needed. But as you say, maybe stock returns will be zero and the 2% in real estate will prove to be helpful though risky when leveraged. But, if loan interest rates are >10% I would say certain no go.
7%? I don’t think it’s quite gone there yet.
You can buy a REIT that only invests in SFHs if you just want exposure to the asset class. You can leverage it up as much as you like. You don’t have to put all your money in a single property just to invest in SFHs. It really depends on how involved and in control you want to be with the investment.
I concur even though I’m a commercial real estate banker and a real estate broker.
I was thinking about buying a Walgreens building. The return is somewhere between 4% and 5% depending on the # of years of lease term remaining (20yrs remaining 4%, 5yrs remaining 5%). Note those returns don’t include transaction costs.
Today, I can buy Walgreens stock with a dividend yield of nearly 5.00%. And MUCH lower transaction costs and much less time.
With Walgreens real estate investment, I would own one store in one market.
With Walgreens stock, I am more diversified and I assume Walgreens keeps/buys the best performing stores and leases the remaining stores.
With Walgreens real estate investment, return is fixed for remainder of lease term.
With Walgreens stock, the dividend is likely superior. Chance for it to increase with inflation and doesn’t have a “maturity” date.
Walgreens stock is “leveraged” return because it has corporate debt but the stock still feels like less risky than buying one (or even 10) Walgreens stores.
And what leverage would I have when negotiating with Walgreens when the renewal comes up? None because it probably has fixed renewals and even so, Walgreens could offer less (say we won’t renew unless you agree to lower the rent) and how would I honestly respond other than “yes sir, can I have another”?
Interesting comparison.