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Why Real Estate Returns Are Higher than Stocks, Bonds and Mutual Funds

by McKellar Newsom on September 29, 2012 · 9 comments

  
ice cream sundae

Investing in rental property is like eating a hot fudge sundae. Buying stocks, bonds and mutual funds is like eating hot fudge with the occasional spoonful of ice cream.

With real estate rentals, your returns include:

1. Cash Flow from Monthly Rental Income – A Huge Scoop of Your Favorite Ice Cream
2. Buying Money – A Second Scoop
3. Tax Free Refinancing – A Third Scoop
4. Appreciation – Hot Fudge on Top
5. Write Offs – Extra Peanuts
6. Depreciation -The Cherry on Top

With typical stocks, bonds or mutual funds, your returns include:

1. Appreciation (Capital Gains) – Hot Fudge
2. Cash Flow from Quarterly Dividend – A Quarterly Scoop of the Ice Cream

Investing is all about getting your money to make you money. But the money can come in many forms. With real estate the money comes from cash flow, buying money, appreciation, tax free refinancing, write offs and depreciation. For typical securities, your money comes in from capital gains and dividend cash flow. So when you read an article that touts historical high returns for stocks over real estate, you need to make sure the real estate returns include all the parts of the “hot fudge sundae.”

Marlys Harris, the Money Magazine senior editor, wrote:

“Housing delivered a solid but unimpressive annualized return of 8.6%. Commercial property did better at 9.5%. The S&P, however, delivered a crushing 13.4%.”

Selena Maranjian of the Motley Fool penned:

“The long-term average annual growth rate for real estate is around 5%. Per data from Ibbotson, the stock market (as measured by the S&P 500) has averaged 9.7% annually between 1926 and August 2010, while long-term government bonds averaged just 5.6%.”

What part of the hot fudge sundae are Harris and Maranjian talking about with their “8.6%” and “5%” returns? Though they don’t specifically state what they were measuring, I’d guess they are comparing the real estate hot fudge (appreciation) to the stocks hot fudge (appreciation/capital gains) and stocks quarterly scoop of ice cream (dividends). I’m assuming Harris and Maranjian’s figures left out the most important aspect of rental returns – the cash flow, as well as the rest of the hot fudge sundae. When you really want to calculate your real estate returns, you need to factor in all the ways the money comes in.

So, what about the rest of the real estate sundae?

Cash Flow from Monthly Rental Income

A Huge Scoop of Your Favorite Ice Cream

I love to focus on the cash flow. If I were a stock or mutual funds investor, I’d buy dividend funds for the cash flow. But I prefer to make my own dividends, my own cash flow, from monthly rental income. I believe the analysts’ figures skip over the returns from rental income, but I bet they have included stock dividend income in their numbers. If you buy rentals right, you should produce rental income at a “crushing 13.4%” or better or at least “9.7% annually.” And that’s with the rental income alone.

Buying Money

A Second Scoop

If I buy one share of a stock, I get only one share. If I buy a rental unit, I want to buy one and half shares for the cost of one share. Or better yet, I can buy two shares or more for the cost of one share. I like to buy money, to buy equity.

I refinanced a property this month. Here are the numbers:

Initial price: 23K
Rehab cost: 19K
Total cost: 42K
Rent: 798/month
ARV and Appraised Value after 6 months of Seasoning: 79K
79K minus 42K = 37K

So you could say I essentially “bought” 37K in equity. Now 37K of the initial 42K investment is an 88% gain that took only a six month’s seasoning. I’ll take the 88% gain in 6 months any day.

The thing is – I can fairly accurately predict what my new ARV will be before I buy a property. Give me a genie or a magic 8 ball to predict which stock is going to let you “buy money” in six months.

Tax Free Refinancing

A Third Scoop

Let’s say you want to pull out some money from your stocks. Well, that would be a taxable event. If I refi and pull out my equity, I’m not taxed. Can anyone say “halleluiah?”

Appreciation

Hot Fudge on Top

Appreciation (capital gains) is the main way stocks get their ROI. For rentals, appreciation – which I don’t even factor into my returns -is the added bonus, the “hot fudge on top.”

Write Offs

Extra Peanuts

Your write offs from stock investments are extremely limited. I believe you can write off your annual fees and possibly more. With real estate, you can write off much more of your spending that relates to your properties.

Depreciation

The Cherry on Top

Depreciation is a gift from the government. If I were musical, I’d write a song about depreciation. Make sure your tax accountant knows all about depreciation and contents depreciation. Can you depreciate your stocks, bonds and mutual funds?

With stocks, most analysts are looking at returns based on price and dividends together to give the “crushing 13.4%” or the “9.7% annually.” But with real estate, your return is based on a lot more. Imagine that the “8.6%” and “5%” mentioned in the quotes above are only the appreciation returns. Now add buying equity, tax free refinancing, write offs and depreciation gains. And the best part of all – add in the cash flow from monthly rental income. With real estate rentals, investors get to eat the entire hot fudge sundae.

Photo: Kirti Poddar

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{ 9 comments… read them below or add one }

Jeff Brown September 29, 2012 at 9:30 am

Hey McKellar — Excellent. Allow me to pile on?

After writing a particularly scathing comparison of the stock market vs real estate investing several years ago, I was challenged to a public debate. It was fall down funny. We were to both begin with $250,000 and predict the retirement outcome 30 years later. She did what you so accurately outlined in your post. When it was my turn, all I said was, “My guy’s gonna buy a million bucks in income property. It’s gonna generate 5-10% cash on cash return. It’s NEVER gonna appreciate, ever. It’ll pay off it’s own debt, and more quickly than scheduled. When he retires, his NOI will not have risen a dime, yet he’ll have over $6,000 a month on which to live. ‘Course, this assumes he’s a complete idiot and never once took advantage of any further opportunities that came his way in the real estate market for 30 long years, without adding another dime of his own capital. If all he does is make two moves in 30 years at the right times, his net worth at retirement would be at least $2 million and his income easily five figures monthly in retirement. And all this without an inch of appreciation or increase in NOI, ever.”

Since I eliminated appreciation and NOI increases, she was left with nothing to attack except for a lame, condescending attempt at disparaging the prudent (25% down) leverage used. The audience literally sneered. They then laughed out loud and applauded when I asked her about the stock market’s version of leverage. Game, set, match. :)

One of my fondest memories.

Reply

McKellar Newsom October 1, 2012 at 4:41 pm

Hi Jeff,

Great pile on!!

Interesting public debate challenge. I wish I could’ve been there to see the debate.

Thanks for pointing out 2 additional “sundae toppings”: 1. using leverage in general and 2. increasing your equity by having tenants pay off your debt.

I just love rentals. mck

Reply

Dale Osborn September 29, 2012 at 1:03 pm

Great article – there may be some who make it in stocks or bonds, but everyone I know who has become financially independent did so by the way of real estate investing. The main reason is by the use of OPM through leverage. If you want to live paycheck to paycheck – keep your JOB. If you want to risk your money at the whim of “the Market” throw it away on stocks, bonds, mutual funds or annuities. If you are looking for financial freedom – put your money into real estate investments.

Reply

McKellar Newsom October 1, 2012 at 4:47 pm

Hi Dale,

I know experts who have the ability to do more extensive analysis and due diligence on companies can do really well with securities. But for us regular folks, I believe money is more easily made through real estate.

Great “sundae topping” addition: using OPM. I know for stocks if you want to use OPM, you need to have a good chunk of change. You can do an owner finance or a “subject to” and not have to have as much initial capital to use OPM.

I like the concept of using the JOB, the investment income or the windfall to invest in the passive income. I agree that real estate is the road to financial freedom. mck

Reply

Kevin Yeats October 3, 2012 at 11:35 am

Tax Free Refinancing

A Third Scoop

Let’s say you want to pull out some money from your stocks. Well, that would be a taxable event. If I refi and pull out my equity, I’m not taxed. Can anyone say “halleluiah?”

* * * * *
Apples and oranges … or chocolate and vanilla

In your example, the investor is SELLING the stocks … certainly a taxable event (assuming the sales price is greater than the purchase price).

But with your real estate, you are only refinancing. The taxable event happens when you sell the real estate.

To be equivalent, I could margin my stock holdings (using them as collateral for a loan) and do the same thing as with real estate … Guess what? NO taxes due.

* * * *
Yes real estate is given lots of advantages. The downside with those advantages is the loss of liquidity, as I mentioned previously. If an investor needs liquidity, stocks and bonds have the advantage AND can also offer both appreciation and cash flow.

Reply

McKellar Newsom October 11, 2012 at 6:40 pm

Hi Kevin,
Can you margin your stocks and take out the money to pay for your kids’ school? Or can you only margin your stocks to buy more investments?

I agree real estate lacks liquidity but if you really want cash back, it’s fairly quick to refi. If you have a really great deal, you can sell it in a day. I wrote an answer to you in my next blog post.

Thanks for your comment, Kevin! Sorry it took me awhile to respond. I was out of town for a bit. mck

Reply

William Buffett October 8, 2012 at 7:57 pm

This article is exactly the reason you need to diversify and not choose an “either or” strategy when it comes to making money though investing. The writer obviously has a bias, I suspect, based on her own business interests. Stock brokers do the same. Same thing with commodities brokers including those emotionally laden commercials for gold, silver et al. The fact is that you need a broad based portfolio of at least a dozen or more categories to be invested in. It needs to be long term and it needs to be managed to rebalance the portfolio on a regular basis to maintain diversification of assets due to the inevitable swings in markets. Real Estate is great, but not in the light that is being presented here. There are also many downsides including physical responsibilities involved. Its never as straight forward as people feel the need to present.

Reply

McKellar Newsom October 11, 2012 at 6:54 pm

Hi William,
Thanks for your comments. You are correct in that I have a bias. I love my real estate investments.

I know many people like to be diversified. I, however, like to understand one area and excel in that area rather than be diversified. If I focus in on one area, such as rental property, I can know a lot more about how to make predictions and acquire knowledge. I just can’t see the average investor being able to understand all the different “diverse” areas. I want to be able to predict the swings before they happen in my markets versus having a lot of different investments in case one doesn’t do well. The way I diversify a bit is to invest in a number of different markets.

Please elaborate more on the “light that is being presented”. Do you mean not diversifying?

The downside to real estate over securities are: increased liability and more paperwork.

William, sorry to have been so late responding. I’ve been out of town. Thanks for your patience. mck

Reply

Cole February 20, 2013 at 7:02 pm

Surely it depends on location?

In the DC suburbs, a small one bedroom apt can be rented for around 800/mo, while a one-BR house costs almost 200k.

If I had 200k and put it all into equities, I’d be getting as a long term average a return of about 9% above inflation, which is 18k/year or 1500/month . [Of course I don't have anywhere near this much wealth, in reality, I'm just a low-income grad student, but we can always use the hypothetical for illustration.]

If I had 200k and bought the house and rented it out, I’d net less than 500/month after expenses because property taxes are super high on the east coast. Maintenance and repair are also very costly due to the antiquated power and plumbing.

Adjusted for inflation, appreciation of rental property OVER THE LONG RUN is nearly zero, as it has been over the last 100+ years .

So why should I [if I had it] put 200k into real estate and earn 500/mo when I could put it into equities instead and earn 1500/mo ????

Reply

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