Real Estate Vs. The Stock Market - The Unending Debate
I firmly believe in the benefits of having real estate play an important role in a well-crafted investment portfolio. Real estate takes advantage of multiple wealth-building principles – namely cash flow, appreciation, tax benefits and mortgage paydown. Real estate is relatively easy to leverage due to having lower volatility when compared to equity markets which allows relatively low net-worth individuals to get started. However, after listening to a recent BiggerPockets Money Podcast with guest Ramit Sethi talk about a tendency of real estate investors to be overweight in this one asset class, it got me to thinking.
I think he has a point about a number of “Mom and Pop” investors being overweight in this asset class – and since they do not have a true competitive advantage or the hustle to really find solid deals and maximize management efficiency, they are unable to achieve the maximum returns. In most cases, the money will work harder in an index fund than it will in an underperforming real estate asset.
How does real estate compare to other asset classes?
In an entirely efficient marketplace, an investments return should only improve with increased risk. In broad strokes, this is true. However, real estate investors are constantly seeking some sort of distress that encourages a seller to dispose of his or her asset at a discount to what it is worth. Human emotions distort the efficiencies of the market in this instance. This same emotional buying and selling is well documented in the stock market. Seasoned investors buy when everyone else is selling if they see value in the underlying asset because they know it is like buying that new down jacket at 70% off from a store going out of business – just because it is cheaper doesn’t necessarily mean it is any less valuable.
The math involved in determining the actual ROI is a bit more complicated in real estate. In the stock world, ROI is basically the dividends plus the capital gains minus any tax (minimized in a tax advantaged account, maximized in a mutual fund not held in a tax advantaged account where there is regular buying and selling). In real estate, you have to look at the monthly cash flow, the appreciation in property price (whether it is forced or inflation based appreciation), debt paydown, and then take out a much lower tax bill than most other activities that produce a similar cashflow.
What does this mean for real estate?
Real estate typically appreciates at significantly slower than the average stock market appreciation rate. A number of very local factors play into this rate of appreciation, but if supply and demand are in equilibrium a home should appreciate roughly with inflation. Why would anyone want to get into an investment that keeps pace with inflation? Well thank goodness appreciation is just one of the factors that goes into the overall return. In many places – especially areas with slightly slower appreciation – rents are strong. Snagging a 1% rule property should, under most financing scenarios, allow for strong cash flow, while depreciation can jack up paper expenses associated with the property creating a scenario where the overall return on a house are very strong – at least initially.
Financing allows for outsized returns. Putting down less money now and securing a loan at a relatively low interest rate (when compared to most other loans) allows investors to get a significantly larger cash-on-cash return. As the loan is paid down and more capital is tied up in equity, the overall return on investment begins to decrease. Once the loan is paid off, the cash flow is the strongest but the overall return on investment is the weakest. Depending on what your objectives are (cash flow for retirement or trying to grow your net worth as quickly as possible) will determine whether you keep the paid off property or trade up/refinance and put that equity to work somewhere else.
We should be careful not to put all of our eggs in one basket. For a well-balanced approach to personal finance, we at least need to be aware that real estate provides amazing opportunities, but it isn’t the only vehicle available that features these tax advantages and strong opportunities for long term growth. However, if you have a significant advantage in one area, don’t over-diversify yourself to mediocre returns. If, instead of looking at the much disparaged “mom and pop” landlord we now examine a professional investor, we will see that his or her ability to structure a deal to produce maximum return has a better chance of forcing their money to work harder than it would in the stock market.
What does this mean?
Real estate is not a “passive” investing strategy. Lazy investors should stay away from real estate as it requires more homework and more discipline to achieve better than average returns. If you want to park money somewhere, an index fund will give you those average returns. Fire and forget real estate usually doesn’t work out.