From time to time, investors need to pause the game and ask themselves: “Is this the best use of my money and time?” I’ve met people who are so focused on one investment that they rule out other possibilities.
(No, I don’t know why we’re in a cave.)
Since I’m doing real estate full time now, it seems an ideal opportunity to give myself a sanity check. I thought I’d share my process with the nice folks here on BiggerPockets.
To figure out if real estate is the best use of my money and time, I first had to pick something to compare it to. Why not stocks? To simplify things, I looked at the S&P 500 (a stock index used as a baseline by many hedge funds).
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S&P Versus Home Prices
Want to see something scary? Assume you invested $100 in both the S&P 500 and a “typical” house in 1975. How much would each of them be worth in 2013?
Note: Throughout this article, I’m going to be referencing the Home Price Index (HPI). This index is tracked by the FHFA and loosely follows changes in the typical home price (clever name, isn’t it?).
Wowzers! Not only is the $100 invested in the S&P worth more, it’s worth triple! Even during the two recent crashes, it was worth double.
The result is clear: say screw it and dump your money in the stock market.
Hold on a second Speedy, we’ve left out a few variables.
Dividends vs. Real Estate
Many companies in the S&P 500 issue dividends: they give you money every so often for being a faithful shareholder. So, we should add those to our chart, right?
We could, but it’ll just make matters worse. Is there income from your real estate investments we can include?
You’re not buying a home hoping for appreciation, are you? You’re making money every year on the real estate you own. Maybe you’re a landlord, maybe you’re a flipper, or maybe you grow weed in the basement (don’t do this). Either way, you’re getting an annual return on your investment. Let’s toss this in to offset the S&P’s head start.
The two things we’re going to add are:
- S&P Historical Dividends
- Annual cash flow from our real estate investment.
How much annual cash flow? Well, how much do we need to “match” the S&P 500?
Can you make 14% every year? Perhaps for a while. For 40 years? Unlikely. Hedge fund managers would kill for consistent 14% returns. Heck, the fourth richest man in the world, Warren Buffet, managed 20% a year for the 40 years he’s been investing.
However, there is one more thing we can include to help real estate compete with stocks.
Reinvestment of Stocks vs. Real Estate
Up to this point I assumed you invested $100 back in 1975 and never added more to it. You used the dividends/distributions to do things like, I don’t know, live.
What if instead you reinvested every penny you received. Does this make a difference? What annual returns on your real estate investment did you need to match the S&P 500?
Just over 6% a year.
Side Bar: I want to take a moment and draw your attention to that scale on the left. It doubled. That $100 is now worth $4,500. Remember how your math teacher went on and on about the power of compounding? Here’s a real life example.
Whether you decide to invest in stocks, real estate, or stamps, the most important thing to do is START.
Back to the lecture at hand. Over the last 40 years you needed 6% annual real estate cash flow for your to break even with the S&P 500 returns. 6% is more doable than 14%; however, you must to be diligent to reinvest those proceeds.
Factoring in Time
So our goal is to beat 6% return a year. Let’s get to it!
Not so fast. We want to see if it’s worth our money and time.
Assume the average numbers we’ve been looking at are correct for this year (they won’t be). If you put your money in the S&P 500 this is the equivalent of investing in real estate with a 6% distribution. (That statement isn’t strictly speaking accurate, but I don’t want to complicate this simple example with more math).
Now let’s say you invest $50,000 in real estate, then you bust your hump and get 10% annual cash flow for the year. How much extra money did you get?
Profit from hard work (Real estate – 10%) – $5,000
Profit from no work (S&P 500 – 6%) – $3,000
Extra cash earned – $2,000
Is that worth your time? Would you be ahead to get a part time job and invest more in the stock market? Would it change if you had $100,000 to invest? $200,000? If your return was 15%? 20%? How much extra risk are you willing to take?
The answers to these questions depend on your situation; I can’t help you out.
I’ve argued this before, but I’ll say it again: investing in real estate makes sense if you are large. Economies of scale are a wonderful thing. If you’re just starting out, it takes time and effort and there are other avenues which pay you more per hour. If you get larger and want to get into real estate, find someone who has an established track record and invest along with them.
Wrap It Up
I started this article by asking “Is this the best use of my money and time?” So what’s my answer?
For me, right now, yes, it is. **phew** We’re getting a high return and invested enough to make it worthwhile.
Remember, this can change faster than you can say “seller’s market.” If I were back in the 1980’s when government debt yielded 15% a year I would be shocked if I arrived at the same conclusion.
I know I’m risking the ire of BiggerPocketers with this post. Let’s preempt a few of the criticisms.
You forgot that you can borrow money to buy homes.
It’s much easier and cheaper to borrow money on stocks than real estate: lower loan origination fees, no appraisals, less time commitment, etc. If anything, including margin will make investing in real estate look worse.
Don’t forget you pay commission every time you buy a stock.
Real estate transactions cost much more than stock transactions. You can buy a stock for under $5. If you enroll in a DRIP program to automatically reinvest your dividends, there is no purchase cost.
Kenny, you chose the wrong dates! You should have started in the year XXXX.
You could be right. I chose these dates because it gives me enough data and includes a number of volatile environments.
That and it was the easiest data to find.
Drop me a line and I’ll be more than happy to send you my raw analysis.
Real estate is great for taxes. Shouldn’t you be factoring that in?
Very astute. I’ve even written articles discussing how good real estate tax benefits are. However, long term dividends are taxed at 15%, which isn’t light years better than what you get with real estate. Not to mention if you invest in stocks through a 401(k) the first $17,500 (for 2013) is tax free. I figured I’d leave it as an exercise for the reader.
Well…that and figuring out historical tax rules and a reasonable investor bracket sounded time consuming and boring.
I invest in area XYZ and it has much higher appreciation than this HPI thing shows.
You can make a similar argument about picking penny stocks. Or slot machines. Once appreciation becomes a factor in your “investment” criteria, it stops being an investment and starts being a gamble. Buy something if you’ll make money without the price going up. Profits above that are just gravy.
Photo: Nathan Siemers