Should I Invest in Real Estate or the Stock Market?
By, Soumyadipta Basu
Once you are on track with your primary financial goals such as retirement contributions and being debt free, (except for your home mortgage) it’s time to embark on your next journey in the world of personal finance. Next, it’s time to think about about growing your wealth. While there are a few options of doing so, investing in real estate vs stock markets are the both popular and offer high rates of return.
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For an investor, trying to figure out which is a better investment option-real estate or stocks-is like asking my kids whether they want chocolate or vanilla ice cream. Both will vet their taste buds but, ultimately, the choice comes to personality, preference, and style. My son always prefers chocolate while my daughter opts for vanilla. In the same way, there is no clear winner between real estate versus stock market and in the end, it all comes down to the specifics.
So in this article, I will try to bring out the pros and cons of each investment and then leave it to you, to choose. Let’s first start by understanding the two different types of investments.
Real estate vs stock market, what’s involved?
Real Estate Investing
When you are investing in real estate, you are typically buying physical land or property. Some real estate costs you money every month you hold it — think of a vacant parcel of land that you hope to sell to a developer someday but must come up with cash out-of-pocket for taxes and maintenance. Another type of real estate is cash generating — think of an apartment building, rental houses, or a strip mall where the tenants are sending you checks each month. You pay the expenses and keep the difference as the profit. For simplicity in this study, we will look at real estate as pure rental income coming from a single-family home where you are the sole owner of the property.
Stock Market Investing
When you buy shares of stock, you are buying a piece of a company. Whether that company makes ice cream cones, sells furniture, manufacturers motorcycles, creates video games, or provides tax services, you are entitled to a fraction of the profit, if any, for every share you own. If a company has 1,000,000 shares outstanding and you own 10,000 shares, you own 1% of the company. The company’s Board of Directors, who are elected by stockholders just like you to watch over the management, decides how much of the profit each year gets reinvested in expansion and how much gets paid out as cash dividends. You can invest either in single company stocks or in a basket of stocks called mutual funds or exchange traded funds (ETFs).
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Without getting into the tax details, for stocks as well as real estate, the total return on your investment involves an appreciation of property/stocks plus the dividends/rental income minus the expenses.
An important term is the return on investment (ROI). ROI measures the profit made on an investment as a fraction of the cost of investment. Before making any investment it is extremely critical for an individual to look at the ROI on that investment. Let us first compare real estate and stocks from ROI on an invested amount of $100,000 at the end of 1 year. The numbers for ROI calculation don’t relate to any specific example but have been selected just for understanding the differences between the investments.
For stocks, let us say that $100,000 grew to $105,000 with 2% annual dividend and you had an expense ratio of 0.2%. Lets also assume that you pay 20% taxes annually on the dividends.
At the end of the year, your ROI will be 6.4% or 0.064:
Now let’s look at ROI on a typical real estate property for the same initial investment of $100,000 at the end of the first year. At the outset, it must be mentioned that ROI calculation for real estate investment has more variables than stocks hence not is as straightforward. With real estate a number of variables, including repair/maintenance expenses, and methods of figuring leverage – the amount of money borrowed (with interest) to make the initial investment – come into play, which can affect ROI numbers. When purchasing a property, the terms of financing will greatly impact ROI.
Let’s say if you buy a property worth $100,000 right away without any financing. In this case, let’s make the following assumptions:
Closing costs were $1000 and remodeling costs totaled $9000 which brings the total investment to $110,000. At the same time, you earned $550 in rent every month. Also, let’s say that there were utility expenses, taxes, and insurance totaling to $2000 for a year. At the same time, let’s say the property appreciated by 2%. At the end of 1 year, your ROI will be roughly 6.6% and is similar to that we calculated for stocks:
Now let’s stir the pot a little, let’s say you purchased the same rental property but instead of paying cash, you took out a 30-year mortgage of $80,000 at the rate of 4%. In this case the down payment is $20,000, the closing cost is higher on financed properties and let’s assume equals to $2000. Let’s assume the same value for utilities and miscellaneous expenses as in the previous example of $2000 for a year and at the same time 2% appreciation of the property. At the end of the first year, your ROI will be approximately 6.5%, again similar to the previous returns.
Notice this is only the return at the end of the first year. Over time, the ROI calculations are more involved since taxes play an important part in real estate. For a more accurate estimate of real estate ROI, you need to consult a tax consultant or use ROI calculators. Over a substantial period, inflation also needs to be accounted for both stocks and real estate.
The objective of doing this exercise was to emphasize that real estate and stocks could give you a similar rate of return, depending upon the rents and stock price appreciation and both will typically provide better returns than a money market account. A look at the formula that I used to calculate the ROI will help you understand the risks and rewards of the two investments which are discussed next.
The Pros and Cons of Real Estate vs Stock Investing
Control: With real estate, you are more in control of your investment since you pick your tenant, and the specific property. In case of stock, when investing in a company your money is at the mercy of decisions made by the board of directors that run the company. Many times, I have invested in companies in particular sector with a proven track record and stable dividends. However, with some geopolitical effects, that particular sector sinks and the companies are forced to slash dividends and prices fall. Obviously being in the stock market for the long run I will wait for the market to recover which eventually it will, but in the short term, I will incur losses if I were to sell my stocks.
Although market factors can impact real estate prices as well, but you’re less likely to sell real estate in a panic during a real estate market drop than you might be when a stock price falls. Clearly in the real estate vs stock discussion, you have more control when you own real estate.
Stability: In general, real estate is more stable and less risky compared to stock market. Stocks are at the mercy of a lot of geopolitical factors and can go through wild swings. The stock market is not for the fainthearted and you need to have an un-emotional view of the stock market. Real estate, on the other hand, real estate prices are less volatile. Once you purchase a property, it’s less likely to decline in value.
If you paid cash for the property then you will be in cruise control since the monthly rental will take care of any expenses and eventually become a cash cow for you.
If you financed your mortgage then you might be concerned with rental occupancy since part of the rental income is used to paying your mortgage.
Involvement: Real estate requires personal involvement due to maintenance, property management, conflicts with neighbors, tenant rotation, taxes, HOA and more. Stocks can literally be left alone forever while you receive dividend payments. Without maintenance, you’re able to focus your attention elsewhere such as spending time with family, your business, or traveling the world.
Personally, I pay my financial advisor 0.5% of my portfolio value annually to manage my investments. I don’t have any stock position calling me in the middle of the night with a broken water heater. Or, if you prefer, invest the easy way with a low fee robo-advisor to manage your money.
In fact, in all the ROI calculations of real estate investing, what is often not accounted is the hassle of maintaining an aging property in terms of your personal time and effort. In the real estate vs stock conversation, stocks win with less involvement.
Diversification: When you invest in real estate typically you will buy properties in the same neighborhood where the median income is similar to yours. In other words, for a typical middle-class family guy living in Oklahoma, it is highly unlikely to buy rental properties in San Francisco or Honolulu. However, the same middle-class person can buy 100 stocks of Apple, the most valuable company in the world. At the same time, he can also buy a global index fund ETF for stock exposure to the entire world. That is the beauty of investing, it’s easy to diversify!
Tangible assets: Real estate is more tangible than stocks since you can feel a house of bricks and mortar built on a piece of earth. Stocks, on the other hand, are a ticker symbol on a website.
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Tax advantages: Typically real estate provides greater tax advantages over stocks. Not only can you deduct your mortgage interest you can all sell your primary home for tax-free profits up to $500,000 for married couples if you have lived in the home for the last two of a five year period. Besides all expenses associated with managing your rental properties can be counted as deductible towards your income. And tax deductible depreciation on rental property adds a greater financial benefit.
On the other hand, for stocks, when you sell you pay either short term or long term capital gains tax whether you hold on to the position for less or more than a year. Unless you own the stocks in a retirement account, in which case you can defer or eliminate tax payments altogether.
Initial investment: If you look at the prior ROI calculation, you’ll notice that the ROI on rental properties changes based on your initial investment. In order to avoid paying private mortgage insurance, you must have a 20% minimum downpayment at closing. This explains why it is very costly to buy a rental property in San Francisco where the median real estate prices are a million dollars or more. Even when you pay 20% upfront, you are taking on a big debt. In the world of personal finance, this is called leveraging other people’s money. But for stocks, you can get invest with little money, which is a significant advantage over real estate. Typically people have to wait much longer and need a bigger pool of money before they can buy a rental property compared to stocks.
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Liquidity: Stocks are much more liquid than real estate which means that you have easier access to your funds. I have diversified my stock positions so that I can quickly sell if I need funds for an emergency. Within a few hours or at max a day I have access to the money. Although, due to stock price volatility it’s best to use the buy and hold stock market invetment approach.
With real estate, if you have a renter on contract then you have to wait for his lease to expire before you can ask him to vacate your property and then put the property up for sale. It can take a long time to access your cash.
Although, for the lazy investor, seeking real estate exposure, there are many real estate investment trusts or REITS in which to invest. You get real estate investment benefits with the liquidity of the stock market.
Ultimately, there isn’t a clear choice between real estate vs stocks as a better investment. Ideally, you should have both for a more balanced portfolio. In the end, as I mentioned in the beginning, it is really a choice between chocolate and vanilla ice cream. Or, to remain diversified, why not choose one scoop of each, and invest in both stocks and real estate.
Soumyadipta Basu, an engineer by trade, has 10+ years of experience in personal finance, cost evaluation and investing. He offers easy, no hassle effective strategies for busy families to cut costs and build wealth for themselves and their kids.
