5 Core Concepts in Both Real Estate and Stock Investing—and 5 Key Differences
The study, a joint project between several American and German universities along with the German central bank, found that real estate offered both higher returns and lower risk than stocks. Not surprisingly, returns on bonds and bills lagged far behind both.
I love stocks, don’t get me wrong. In fact, the majority of my investing capital is in stocks.
Over 145 years, developed economies’ stocks returned an average of 6.89 percent per year. They returned even more in the U.S.: 8.4 percent. And if you look at the “modern era” from 1980 to present, stocks averaged 10.7 percent per year.
Across the many industrialized countries analyzed, real estate offered returns averaging 7.05 percent over the last 145 years, beating stocks’ average returns. And perhaps even more importantly, real estate has proven far more stable with less volatility and risk.
In fact, when you take a ratio of return over risk (the “Sharpe ratio” in economics), real estate offered an impressively high 0.7 Sharpe ratio, compared to only 0.27 Sharpe ratio for stocks.
It’s worth mentioning that by “real estate” the study authors specifically mean rental properties, as they are measuring both rental income and appreciation. Similarly, they included both dividend income and appreciation for stocks.
I get frustrated when I hear investors lionize either stocks or real estate alone and dismiss the other. After all, a successful portfolio is a diverse one!
So here are five core concepts that apply to both stocks and real estate, along with five key differences, that all investors should understand.
5 Overlapping Core Concepts
“Similarities” is the wrong word for these; rather, here are investing concepts that apply to both real estate and stocks. They are not identical, but they are analogous.
1. Annual Yield
In stocks, annual yield showcases the dividend income that a stock or fund pays out as a percentage of the stock price. For example, a $100 stock with a 2 percent yield pays $2 per share per year. (More accurately, that’s what they have paid in the past, but as brokers are quick to point out, “Past performance is not indicative of future results!”)
Yield says nothing about potential appreciation. That stock may rise by 10 percent over the next year or drop by 10 percent.
Rental properties follow similar logic. Investors can forecast cashflow based on purchase price, rent, and expenses to come up with the property’s expected annual yield.
For example, a $100,000 property that rents for $1,200 and follows the 50% Rule (ongoing expenses equaling 50 percent of the rent) can expect an annual yield of 7.2 percent. The math breaks down like this:
$1,200 x 50% = $600/month net income
$600 x 12 = $7,200 annual income
$7,200 / $100,000 price = 7.2% annual yield
Again, appreciation will move independently of yield after purchase; the property could appreciate by 5 percent or decline in value, just like a stock.
Annual yield is what percentage of your purchase price you can expect back in the form of annual income.
2. Expense Ratio
Investments usually come with expenses.
When you buy a mutual fund or ETF, you’ll notice a number indicating the expense ratio. That’s how much the fund charges investors to oversee and administrate the fund. In the case of index funds, these are usually very low, such as 0.1 to 0.2 percent. For actively-managed funds, they are much higher, up to 2 percent or more.
This expense ratio is the annual percentage that the fund charges you. If you buy $1,000 in a fund with a 1 percent expense ratio, the fund will charge you $10/year in administrative expenses. (In the real world, that number will fluctuate along with the value of your holdings—if your $1,000 investment rises to $1,100 next year, then next year they’ll charge $11.)
And if expense ratios for equities sound high, expenses for rental properties are much, much higher.
As mentioned above, a common rule of thumb is to estimate costs at 50 percent of the monthly rent. These expenses include repairs, maintenance, vacancy rates, administrative fees, travel expenses, and more.
3. Management Expenses
Real estate and stock portfolios also both need to be managed. Managing stock portfolios means periodically rebalancing to maintain your desired asset allocation and, of course, strategically buying and selling stocks to meet your investing goals.
Some investors outsource this management to a financial advisor for a fee, typically around 1 percent of all investments under management. Thus, if you have a portfolio worth $500,000, you could expect to pay around $5,000 per year in management fees.
Rentals also require labor to manage—and typically a lot more of it compared to stocks. Property managers usually charge 7 to 10 percent of rents to take on the day-to-day headaches of fielding tenant phone calls, overseeing repairs and maintenance, and so on. They often charge additional fees for placing new tenants in the range of half a month’s rent to a full month’s rent.
It’s worth pausing to point out two key differences here:
- First, property managers don’t help you with decisions to buy and sell, market timing, or investing strategy the way that financial advisors do.
- Second, note that property management fees are structured based on income, rather than on portfolio value.
- A rental portfolio worth $500,000 may generate $50,000 in collectable rents in a year. So, if your property management fees (including both ongoing rent collection and new tenant placement) averages 10 percent, then you’re looking at $5,000 in annual property management fees.
In this example, this amounts to the same cost it would be to hire a financial advisor to manage a stock portfolio of similar value. That’s not always the case, but hey, I’m illustrating analogies here, right?
And, of course, you don’t have to pay someone to manage your investments. You can do that labor yourself. However, at a certain portfolio size it makes sense to hire a property manager or financial advisor, because it becomes overly complicated and time-consuming to manage such large investment portfolios yourself.
4. P/E Ratio
Investors can compare the revenue of both companies and rental properties to their respective prices to get a sense of the value.
Investors evaluating stocks use price-earnings ratio, or P/E ratio, to compare share price with revenue. It’s a simple calculation:
Price Per Share / Earnings Per Share
For example, a stock trading at $100 per share with earnings of $7 per share would have a P/E ratio of 14.29 (100/7 = 14.29). Incidentally, that’s in the historically normal range.
While the calculation is different for real estate, a similar principal applies. Investors can compare the expected net rental revenue to the purchase price—often calculated through cap rates—to compare two prospective investment properties.
As a quick recap, cap rates are calculated by dividing:
Annual Net Rental Income / Purchase Price
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Thus, just like the example above, a $100,000 property with $7,200 annual net rental income would have a cap rate of 7.2%.
Note that even though they happened to be the same in this example, and cap rate and annual yield are similar concepts and calculations, they are not identical. Annual yield is calculated based on your own invested cash, and in this simplified example, I assumed a cash purchase with no loan or leverage.
Investors can leverage other people’s money to buy more of both stocks and real estate than their current cash holdings would allow otherwise.
Everyone’s familiar with this concept in real estate, which involves mortgages or hard money loans. You put down 20 percent (or 30 percent, or 10 percent, or whatever) of your own money and a lender provides the rest.
The concept is less widely understood in stocks, but the principle is similar.
Investors can borrow money from their brokers to invest with, which is called buying on margin. You have $50,000 and want to buy $100,000 worth of a stock or mutual fund, so you borrow the money from your broker to buy on margin.
And, just like with real estate loans, investment brokers charge interest. The longer you keep a loan, the more the interest racks up!
5 Key Differences
Investing in stocks and real estate is not as different as many investors think… but there are some crucial differences. We already touched on volatility, but the differences don’t end there.
Here’s what investors need to know about those differences before investing in a new asset class.
Wait, didn’t I just say leverage was a similarity?
The concept applies to both stocks and real estate, but in the details lie some crucial differences.
The first is loan-to-value ratio (LTV). Stocks being more volatile than real estate, brokers only lend up to 50 percent or so of the purchase price to buy stocks on margin. That's a far cry from the 80 percent that many real estate investors expect from lenders.
Second, brokers have the right to demand more money from stock investors who buy on margin, if the stock or fund drops in value. This is known as a margin call, and brokers will invoke a margin call if the underlying value of the stock or fund drops below a certain threshold.
Mortgage companies almost never call their loans—and certainly not for being underwater. The last thing a mortgage lender wants is to force a loss realization, as long as their borrowers are paying on time.
Finally, it’s worth noting that buying on margin works best for quick trades, rather than long-term investing, because the interest racks up quickly on margins. That’s not true for real estate; in fact, the longer you hold a 30-year fixed mortgage, the more of your payment goes toward principal, even as your property (likely) appreciates!
One of the greatest downsides of real estate investing is its difficulty to liquidate.
To sell at normal market value takes months and costs a lot of money in the form of realtor fees and settlement charges. The equity you have in a piece of real estate is largely theoretical. Essentially, it exists on paper based on a rough estimate of what a stranger would be willing to pay for your property.
For stocks, equity is real and immediate. If your cost basis for a stock was $120, and it’s now worth $200, you have $80 in equity. That means you can sell it right now and realize that $80 profit. Pass “Go,” and collect $200!
I touched on this above: it’s a lot more work to manage rental properties than it is to manage a stock portfolio.
Your stocks won’t call you at 3 a.m. to complain that a light bulb went out. Your tenants might.
The same situation would apply for major repairs, vacancies, turnovers, etc.
I buy index funds and promptly forget about them. There’s no need for me to watch the S&P 500 every day. I know that even if it falls today, five years from now, it will be higher. Instead, I set it and forget it with no headaches.
But my rental properties have definitely caused me plenty of migraines over the years.
4. Predictability of Returns
Rental properties aren’t all headaches though. One glorious perk? I can predict my returns with excellent accuracy.
That’s because I invest for cash flow, rather than appreciation. And I can measure cash flow based on today’s purchase price and today’s rents, knowing that rents rarely fall in fundamentally sound cities. Plus, when they do, it’s not by much and not for long.
Appreciation is a nice bonus, as my properties grow in value over time. It’s not guaranteed, however.
But even though stocks do offer income in the form of dividends, that’s not where stocks’ strength lie. Most of the returns from stocks come from growth, appreciation. Which is just not very predictable, at least in the short- to medium-term.
5. Control Over Returns
Another benefit to rental properties is that I have a great deal of control over my own returns.
In contrast, I have zero control over whether the S&P 500 goes up or down or in circles. I have exactly two things I can do: buy or sell.
The flipside to having more labor with rental properties is that you also have more control of their performance and returns.
Real estate feels more intuitive than stocks, which is what draws so many investors to real estate in the first place. It’s also how so many real estate investors get burned, thinking that they understand it better than they actually do.
I’ve made money in real estate, and I’ve made money in stocks. I’ve also lost money in both—a lot of money. But as alien as stock investing feels to new investors, the simplest level of stock investing (buying and holding index funds) is fairly easy. It takes about 20 minutes to learn the fundamentals and invest relatively safely.
Direct real estate investing takes months to learn properly. Sure, you can buy a REIT or invest in a crowdfunding website as indirect real estate investments, but you won’t see the benefits outlined above. Buying rental properties to take advantage of those high returns seen over the last 145 years requires knowledge, skill, and work.
It’s worth it, and I highly recommend it to anyone with a genuine interest. You can earn incredible returns with lower risk compared to stocks. But beware that the minimum learning curve is steeper for real estate than for stocks.
Before you invest money in either stocks or real estate, do your homework and learn how to avoid the most common mistakes and pitfalls.
What does your investing portfolio and strategy look like?
Leave your comments below!