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What Offers the Best Return on Investment? 145 Years of Real Estate vs. Stocks

What Offers the Best Return on Investment? 145 Years of Real Estate vs. Stocks

9 min read
G. Brian Davis

G. Brian Davis is a landlord, personal finance expert, and financial independence retire early (FIRE) enthusiast, whose mission is to help everyday people create enough rental income to cover their living expenses.

Experience
Through his company at SparkRental.com, he offers free rental tools such as a rental income calculator, free landlord software (including a free online rental application and tenant screening), and free masterclasses on rental investing and passive income.

He’s been obsessed with early retirement since the early 2000s (before it was “a thing”).

Besides owning dozens of properties over nearly two decades, Brian has written as a real estate and personal finance expert for publishers including Money Crashers, RETipster, Think Save Retire, 1500 Days, Lending Home, Coach Carson, and countless others.

Here’s to financial independence with real estate!

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Choosing the ideal investment for you has been a long-heated debate that’s come to a head recently as retail stock market investors find themselves pitted against larger hedge funds. And there’s a strong argument to be made for investing in both real estate and stocks—a diversified portfolio is never a bad thing.

But that doesn’t mean we can’t pit the two investments against each other. Which earns the best return on investment: real estate vs. stocks? And while we’re asking this grandiose question, which option is safer?

Related: Tired of Market Manipulation? Skip Robinhood—Invest in Real Estate Instead

You probably have an opinion already as to the answer to both of these questions. But opinions are never as useful as facts—and here, we’ve got the facts.

A team of economists from the University of California, Davis, the University of Bonn, and the German central bank set out to answer these questions by analyzing a stunning amount of data collected over a 145-year period of time.

The best investments to make Money: the numbers

The lead authors of the study—Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor—reported the findings of their massive study in a paper entitled “The Rate of Return on Everything, 1870-2015.” In it, researchers looked at 16 advanced economies over the past 145 years to find what offers the best return on investment. They compared returns on several asset classes, including equities, residential real estate, short-term treasury bills, and longer-term treasury bonds.

To better compare apples to apples, with each asset type, they adjusted for inflation and included all returns, not just appreciation. Dividend income was included for equities, and rental income was included for residential real estate.

Their findings, in short: Residential real estate was the better investment, averaging over seven percent per annum. Equities weren’t far behind, at just under seven percent.

Then came bonds and bills, each with a far lower rate of return—surprising no one.

Related: 5 Ways the Next Recession Can Make You Rich

stocksvre1

Real estate vs. stocks: average ROI

Rental income proved an important factor—roughly half of the returns on real estate investments came from rental income, while the other half came from appreciation.

Stock investments and investment property each performed differently in various countries, of course. Here’s a comparison of each of the 16 countries:

stocksvre2

Keep in mind, these are long-term return averages over the course of many decades. In real time, these returns bounced up, down, sideways, and in circles.

Here’s a curious little chestnut for you: From 1980 to 2015, the stock market, on average, performed significantly better than real estate investments. Across the 16 countries studied, stock investments earned an average annual rate of return of 10.7 percent, decisively beating the real estate market’s stolid 6.4 percent.

Should we all sell our rental property and move our money into a Vanguard account?

Of course not. But the reasons are multiple and a bit nuanced.

First, a few outlier countries threw off the average return on investment from the time period between 1980 and 2015. Japan saw its real estate markets collapse as its population aged. And in Germany, residential real estate has been stuck in the slow lane for decades.

Meanwhile, stock investments in Scandinavia have exploded.

But the most interesting case for real estate investing lies in its risk-reward ratio.

Related: Why Real Estate Beats Stocks During a Recession

Risk by asset class

Let’s do a quick stereotype check-in, shall we?

Treasury bonds are low-risk, low-return. I don’t think anyone’s prepared to challenge that stereotype—after all, stereotypes exist for a reason, right?

Stock investments are high-risk, high-return. This one gets a little more interesting, but a quick look at how stock markets have gyrated for the last century—up 29 percent one year and down 18 percent the next—should disabuse anyone of the notion that stock investing doesn’t come with high volatility and risk.

And that brings us to an economic assumption that dates back to, well, the beginning of economic theory. Economists have long held as a given that risk and returns are highly correlated, and that “the invisible hand” of the market will ensure that remains the case.

Why? Because if an asset were low-risk, high-return, everyone and their mother would fling so much money at it that the rate of return would dry up faster than Lindsay Lohan’s acting career.

Except that assumption hasn’t held true for residential rental properties.

Rental properties: low-risk, high-return

Throughout modern history, residential real estate investors may actually boast the best return on investment, thanks to its extremely high rate of return with low risk. Take a look at volatility for real estate versus stock for the past 145 years:

stocksvre3

Brighter economic minds than mine are scratching their heads as to why that is. But since I can’t resist offering a (you guessed it!) opinion, here are a few thoughts as to why.

First, real estate investing is expensive. Until the past 10 years, with the advent of crowdfunding, you couldn’t invest your extra $100 a month in a tangible asset (unlike the negligible purchase price of some stock shares).

Even if you leverage to the hilt and borrow the maximum mortgage allowed at a low interest rate, that still usually puts you at 20 percent down payment, plus thousands of dollars in closing costs. Which says nothing of credit requirements, income requirements, and/or lenders’ requirements for investing experience.

In other words, real estate investing has a high barrier to entry.

It’s also difficult to diversify your investment portfolio for those very same reasons. If each asset requires $20,000 in cash to purchase it, then it takes a lot of money to build a broad, diverse real estate portfolio.

Investment property is also notoriously illiquid. You can’t buy it and sell it on a whim—either process typically takes months.

There’s also, of course, the risk of tenants. Many forms of real estate require pinning your assets on another person. If a tenant damages your property, or you’re not receiving rents from several apartments in a multifamily, it can damage your cash flow. But ultimately these risks are low, and have an even lower impact on your return on investment.

Additionally, rental properties offer a number of tax breaks and deductions. If you live in the property—let’s say you’re house-hacking—you can write off mortgage interest and exclude up to $250,000 of net proceeds. You can also deduct depreciation on your investment portfolio and use 1031 exchanges to avoid taxes on the sale of any rental-only properties. If you’re investing through real estate investment trusts (REITs), you may avoid corporate taxes because they often pay out income as dividends.

There are a number of ways to invest in real estate and maintain a diverse portfolio. That’s precisely why this investment strategy is so much more stable than stock investing.

Related: Stocks vs. Real Estate: Which One Wins?

Measuring risk vs. return to find the best return on investment

How do you measure an investment’s risk against its rate of return?

It turns out, there’s a simple way to determine the best return on investment: a literal risk-reward ratio. It’s called the Sharpe ratio after its creator, William Sharpe.

You start with an asset’s return, and subtract out the return of the going with a short-term, risk-free alternative (like U.S. Treasury bills). That gives you a “risk premium”—the extra return the asset delivers over a risk-free investment.

Then you simply divide that “risk premium” over the asset’s volatility, as measured by its annual standard deviation in value:

Risk premium / average annual standard deviation

If the math is giving you a headache, don’t worry about it. Just think of it as return divided by risk. A higher ratio indicates a better investment—greater return on investment, relative to the risk. Here’s the breakdown:

  • Treasury bonds: Their Sharpe ratio of around 0.2 is weak sauce.
  • Stock investments: Not much better, at 0.27. Sure, their returns were strong, but they’re more volatile than plutonium in a mad scientist’s lab.
  • Residential real estate: The average Sharpe ratio of 0.7 is great.

The Sharpe ratio for real estate has only grown stronger over time. Since 1950, the Sharp ratio for real estate has averaged an impressive 0.8.

Another way of looking at it is return per unit of risk—here’s how stock investments have compared to real estate in each of the 16 countries studied:

stocksvre4

Rate of return and GDP

Advanced economies tend to have slow economic growth over any given period of time, right? So how have returns done so much better than the GDP growth in these countries? Aside from the obvious issue that these economies looked very different in 1870 than they do today, there’s an interesting answer to this query.

It turns out, the best return on investment for a country isn’t tied in a 1:1 relationship with its GDP. Over time, returns on these asset classes tend to grow on average around double the speed of the country’s economy as a whole, measured by GDP.

stocksvre5

If anything, that “returns average double GDP growth” summary is skewed low, because it includes the weak return on investment of bonds and bills. On average, the stock market and real estate market perform several times better than GDP growth.

This helps explain why income inequality tends to expand over time in advanced economies. The average Joe does not own stock investments, and if he owns any real estate, it’s his primary residence—a single-family home that he probably only earns appreciation on with no rental income (and remember, rental income makes up half of real estate investment returns!).

So, how does average Joe improve his finances? Only through a raise. His raise is tied to how his employer is doing, which, in turn, is tied to how the economy is doing.

In other words, average Joe’s finances are tied to GDP growth.

But wealth-wise Wendy, who’s not nearly so average as Joe, invests as much money as she can in the stock market and rental real estate. She builds a portfolio of passive income that earns money even while she sleeps. That income is based on the rate of return of her investments, not based on the economy.

Coupled with the impressive tax benefits enjoyed by those with investment property? Wendy’s financial advisor undoubtedly sings her praises.

Conservatives and liberals can argue all they want about how much to redistribute wealth. But as an individual, you want to be like Wendy, not Joe. You want your wealth and income tied to the returns of the stock market and real estate investments, not tied to GDP.

Why real estate investments crush bonds

Bonds are boring.

No, really. We already talked about how they’re low-risk, low-return. Why bother with this asset class if you can invest in rental properties, which are low-risk, high-return?

A common opinion I hear people say is, “Bonds may not have performed well over the past 15 years, but that’s abnormal! Just look at how well they did in the ’80s!”

Interestingly, this new study disproves that notion. The high bond yields of the 1980s were actually the anomaly—in fact, if you look at bond returns over the past 145 years, there were many periods where they earned negative returns.

Want a few reasons why rental real estate offers the best return on investment compared to bonds?

Here’s a simple one: bonds expire. They pay out for a specific term, then they stop paying. Rental properties keep paying forever.

And not only do they keep paying indefinitely, they pay more over time. With every year that goes by, fixed bond payments become less valuable in real purchasing power due to inflation. But rental income and property value rise right alongside inflation.

It’s actually your fixed mortgage payment that goes down over time in inflation-adjusted dollars! Then one day that mortgage payment disappears, and your rental cash flow explodes.

OK—yes, government bonds offer stability compared to index funds, individual stocks, and even rental property. Bonds pay the same amount every month. They never call you (or hopefully your property manager) about a leaky roof or stop sending payments because they spent too much on cigarettes and Bud Light that month.

But at what cost in returns?

If retirement looms on the horizon for you, familiarize yourself with sequence risk and how owning rental property affects the 4 percent rule so you don’t necessarily have to resort to bonds.

Should I stop investing in the stock market and just buy rental properties?

Stocks may be a roller coaster, but in the long run, the good times outweigh the bad. And ultimately, finding the best return on investment requires a diversified portfolio. Stocks balance rental properties well. And when equities go down, residential real estate almost always goes up.

Real estate is illiquid compared to equities. You can buy and sell mutual funds, ETFs, etc. at a moment’s notice. Investment property isn’t quite so easy to get in and out of.

Stock investing also offers truly passive income. Ultimately, rental income can never be as passive as dividend income (even with property management handling general upkeep).

It’s much easier to diversify your investment portfolio with stocks, as well. You can spread $500 across thousands of companies, in every region of the world, in every industry, at every market cap. You’d be lucky to get away with only putting down $5,000 on a single rental property!

Is there a place for equities in my portfolio?

Residential real estate offers excellent returns with low volatility and huge tax advantages. I love rental properties. But that doesn’t mean there’s no place for equities in your portfolio.

If you invest well, rental real estate will start performing for you immediately. Equities will take longer; the stocks you buy today won’t produce significant income for you until 10, 20, 30 years from now. But the long-term returns will grow in value for you at prodigious rates.

Historical Stock Market Returns
Per: Visual Capitalist

Build up your retirement account with passive income from rentals and dividends, and when your peers are still working in a decade or two, their incomes tied to GDP growth, you can offer sympathetic words.

And then you can go back to playing golf and relaxing with your children, having reached financial independence.

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