Should I Invest in the Stock Market or Buy a Principal Residence
Over the years we have worked with a variety of individuals and every once in a while come across a few who have a good amount of money in the stock market (100k+) and are hesitant to pull that money out to use as a downpayment as they fear they will miss out on some profits. I wanted to write this article not to say they are wrong but to highlight the reality of investing in the stock market and how that compares to instead buying a principal residence to live in or even doing that major renovation you've been contemplating.
Stocks
I want to first start by talking about the stock market and make sure you are aware of the reality and not what is advertised. The average return from the stock market over the last 15 years (2004 - 2018) was 7.04% and 9.06% over the last 30 years (1989 - 2018). That would mean that had you invested 100k in 2004 it would be worth $277,454 in 2018. What the majority of investors don't realize is that 100k did not actually grow to $277,454 due to the volatility of the stock market from year-to-year. That 100k was actually only worth $225,425 (5.6% return compounded annually) due to actual annual returns of the S&P 500. Sure the average was 7.04% but that doesn't mean you actually earned that figure every year you were in the market. The average is not the actual.
Fees
Next up we have fees to talk about. The average expense ratio for actively managed mutual funds is between 0.5% and 1.0% but can go as high as 2.5% or more. The typical ratio for ETFs is about 0.2%. Considering most investors have a blended portfolio of ETFs and mutual funds, let's use a conservative number of 1%/year. after taking out a 1% fee each year that $225,425 is now worth $193,879. Now the average of 7.04% is down to 4.5% compounded annually.
Taxes
We can't forget about taxes. Stock market profit is considered a capital gain so 50% of your profit will be taxable at your personal income tax rate for that year. Profiting $93,879 means $46,939.5 will be taxable income. After-tax your 100k investment in 2004 is now worth $184,638 bringing our compounded annual return down to 4.17%. At a certain point in your financial journey, you need to have your finances diversified and putting your money in the S&P500 if anything will at least keep you above inflation.
Real Estate
Real estate has made more millionaires than any other industry which is a relatively widely known fact and this has to do with a few different factors. There are three ways to make money with real estate:
- Appreciation
- Leverage
- Cash Flow
In a later article, we will review the impact of cash flow on investment returns but for the purpose of this analysis cash flow will not be included as this is a principal residence and you, the homeowner, are responsible for all expenses related to the property.
Single-Family
We're going to use the same $100,000 and look at a principal single-family option in Langley, BC from 2000 - 2015 to keep this as fair as possible. The real estate market took off like crazy in 2016 onwards and I want to keep this relative. I am going to be using a property located on 1 acre in Langley, BC and using the actual assessments for the exact property (Appendix A). The value of the property in 2000 was $314,000 and in 2015 $1,020,000 meaning an average return of 8.17%. Now of course as we know from above, the average isn't the actual. The actual return is about 8.01%. The table covering the 15 year ownership period is included in Appendix B. To keep this as fair and realistic as possible I made sure to include property taxes, utilities, mortgage payments & a $100,000 renovation in 2007 into my calculation.
Leverage
The subject property was bought for $314,000. You put $100,000 into the property and financed the rest. This explains the first wonder of real estate, leverage. Leverage allows for access to more capital than you otherwise would be able to work with. Our subject buyer could have qualified for up to $1M, however, would have to earn an income of about $200,000/year which not everyone with $100,000 in cash has and I want this article to be as relative as possible. The use of leverage to buy property requires payments to repay that debt over the length of the specified term usually by way of monthly instalments. For this subject property, the annual debt service is $11,495. This is comprised of $7,371 in interest and $4,125 towards the principle in the first year. As time goes on a larger portion is paid towards the principal. The annual payment in year 15 is comprised of $4,791 in interest and $6,704 in principal. The principal portion is money that stays with you in the form of equity in the property and the interest is the cost of borrowing that money. Even with interest payments in the amount of $93,393 over the 15 year period, real estate still returns a higher ROI to the investor.
Appreciation
Appreciation and leverage work in conjunction with one another. Your $100,000 was used to buy a $314,000 property and when that property appreciates 5%, you get the lift on the total property value, not just your $100,000 investment. Appreciation is why over 15 years this subject property grew from being worth $314,000 to $1,020,000 at the start of 2015.
Taxes
Principal residences are a beautiful thing in Canada because all of the money made from appreciation is 100% tax-free. That means if you buy your house in 2000 for $1M and 10 years later sell it for $5M you just made $4M tax-free!
Fees & How Much I Walk Away With
With real estate, the only fees you have to be concerned with is when you sell the property. For our example, this property was sold at the end of 2015 and even though it appreciated 14% that year I am going to use the average over the 15 year period, 8.64%, giving us a sale price of $1,108,128. From this $1.1M you would pay $33,813 in real estate fees and about $1,200 in lawyer fees. You would pay off your outstanding mortgage in the amount of $134,421 and be left with a cheque in the amount of $939,772 TAX-FREE BABY!
Conclusion
Investor A put $100,000 in the stock market and 15 years later was left with a cheque for $184,638. Investor B put $100,000 into real estate and 15 years later was left with a cheque for $939,772. The naysayers out there will be saying "oh ya but with stocks investor A only had to put in $100k and nothing else while Investor B had to contribute $14k - $18k/year + a $100,000 renovation)" and while yes this is true, investor A, on the other hand, was renting a home for those 15 years at a cost of $1,200/month or $216,000 over 15 years which he will never see again and investor B only paid $161,995 in money he'll never see again and everything else went towards his investment. If someone is considering to take the wealth they have accumulated and invest it into the stock market vs buying a home for themselves then I hope this article shows you the light at the end of the tunnel real estate holds. Keep an eye out for later articles looking at how the stock market can compare to other forms of real estate investment.
This article was inspired thanks to Michael Blank of Nighthawk Equity. The link to his article comparing the stock market to investing in a real estate syndication can be found below
Appendix A
Appendix B
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