We’ve got real estate tycoons and we’ve got stock market tycoons. We’ve even got wealthy bond investors such as Bill Gross who pulls in over $100 million a year. Now that the markets have recovered from the financial downturn, I’d like to have an open discussion on which asset class provides the the most amount of wealth over the long run.
It’s important to realize there are no renter or cash tycoons. The return on rent is always -100% every single month. Meanwhile, the return on cash averages a paltry 0.1% nationwide, even after the Fed rate hike. You can certainly be a wealthy renter with tons of cash in the bank. But your wealth was accumulated through other means so don’t get confused. Having a money strength grade of F- is no way to go.
In this article I’ll explain why I have a preference for real estate over stocks (equities). Both have proven worthy of building great wealth over time.
REASONS WHY REAL ESTATE IS BETTER THAN STOCKS
1) You are more in control. Every physical real estate investment you make puts you in charge as CEO. As CEO, you are able to make improvements, cut costs (refinance your mortgage now that rates are back down post now that Trump is disappointing on some of his main promises), raise rents, find better tenants, and market accordingly. Of course you are still at the mercy of the economic cycle, but overall you have much more leeway in making wealth optimizing decisions. When you invest in a public or private company, you are a minority investor who puts his or her faith in management. Sometimes managers commit fraud or blow their companies to smithereens through unwise acquisitions. Nobody cares more about your investment than you.
2) Leverage with other people’s money. Leverage in a rising market is a wonderful thing. Even if real estate only tracks inflation over the long run, a 3% increase on a property where you put 20% down is a 15% cash-on-cash return. In five years you will have more than doubled your equity at this rate. Stocks, on the other hand, generate roughly 7% – 9% a year including dividends. Leverage also kills on the way down, so remember to always run the worst case numbers before purchase.
3) Tax advantageous. Not only can you deduct the interest on up to $750,000 in mortgage indebtedness on your primary home as of 2018, you can also sell your primary home for tax free profits up to $250,000 for singles and $500,000 for married couples if you live in the home for the last two of a five year period. If you are in the 28% or higher tax bracket, it behooves you to own property. All expenses associated with managing your rental properties are also deductible towards your income. Income limits do apply however, so make sure you don’t make much more than ~$166,000 a year total.
4) Tangible asset. Real estate is something you can see, feel, and utilize. Life is about living, and real estate can provide a higher quality of life. Stocks aren’t event pieces of paper anymore, but ticker symbols and numbers. When the world comes to an end, you can seek shelter in your property. Real estate is one of the three pillars for survival, the other two being food and shelter.
5) Easier to analyze and quantify If you can calculate realistic expenses and rental income that’s all you really need when it comes down to valuing a piece of property. If you can borrow at 3% and rent out for a 6%+ yield, you’ve likely found yourself a winner. Real estate is immediately exploitable if you have the financial means to invest. There’s not only the cash flow component but the underlying equity component that helps investors build wealth. Stocks require you to trust what the company reports. There are countless ways for companies to massage their numbers to make things look better than they really are e.g. adjusting accounts receivables, adding one off gains, and using various amortization or depreciation strategies to name a few. Take a look at Zillow for the latest estimates, comparables, and sales history. It’s so easy to do research on real estate compared with researching stocks.
6) Less visible volatility. Your house value could be tanking and you would never know it since there isn’t a daily ticker symbol. During bad times, the utility of your home really helps soften the blow as you enjoy your home and create great memories. During the 2008-2009 downturn, I still got to enjoy my vacation property in Lake Tahoe 15-20 days a year even though its value was plunging. Meanwhile, looking at the TV or computer screen just made me mad. When your investment is less volatile, it’s much easier to stay the course and not sell at the bottom.
7) A source of pride. Making money for money’s sake is a pretty empty feeling after a while. Every time I drive by my rental properties I feel proud to have made the purchases years ago. I know that my money is working as hard as possible so I don’t have to. Real estate is a constant reminder that taking calculated risks over time pays off. There is an indescribable feeling nobody tells you once you’ve closed on your property. Even though the bank probably owns most of it in the beginning, you literally feel like the King or Queen of your castle. When you die, you can pass on your pride to your children or closest companions to let them create their own memories. Further, there is a “step-up” function where your heirs inherit the property based on the value of the property at the time of passing so that the cost basis is higher, which helps lower tax liability if the property is ever sold.
8) More insulated. Real estate is local. If you’ve made a good decision to buy in an economically strong region, you will be more insulated from the national economy or the global economy. Spain blowing up is likely not going to affect the rent you can charge. Brexit actually helped drive mortgage rates lower as foreign investors bought safe US Treasury bonds. Look at prices in superstar cities such as NYC, Hong Kong, Singapore, London, Paris, and San Francisco. They fall the least, recover the soonest and gain the most. Of course, industries in your area could suddenly disappear and leave you broken as well. Of course, it’s also a good idea to diversify into lower cost regions of the country with higher yields. I do this through real estate crowdfunding and focus on real estate projects in Texas, Nebraska, Utah, and Tennessee.
9) The government is on your side. Not only do you get generous mortgage interest tax deductions and tax free profits, you get bailouts if you can’t pay your mortgage. The government also aggressively went after banks to force them to extend loan modifications to bad and good creditors. I even got a free loan mod recently to my surprise. Programs such as HARP 1.0 and HARP 2.0 are allowing folks without hefty downpayments to get in on the action. There are plenty of non-recourse states such as California and Nevada which don’t go after your other assets if you decide to stop paying your mortgage and squat for months. When was the last time the government bailed individual investors out of their stock investments?
REASONS WHY STOCKS ARE BETTER THAN REAL ESTATE
1) Higher rate of return. Stocks have historically returned ~7-9% a year compared to 2-4% for real estate over the past 60 years. You can also go on margin to boost your returns, however, I don’t recommend this strategy given your brokerage account will force you to liquidate holdings to come up with cash when things go the other way. Your bank can’t force you to come up with cash or move out so long as you are paying your mortgage.
2) Much more liquid. If you don’t like a stock or need immediate cash, you can easily sell your stock holdings. If you need to cash out of real estate you could potentially take out a home equity line of credit, but it’s costly and takes at least a month.
3) Lower transaction costs. Online transaction costs are under $10 a trade no matter how much you have to buy or sell. The real estate industry is still an oligopoly which still fixes commissions at a ridiculously high level of 5-6%. You would think the invention of Zillow would lower transaction costs, but unfortunately they’ve done very little to help lower expenses. They are in cahoots with the National Association of Realtors because they are their source of advertising revenue.
4) Less work. Real estate takes constant managing due to maintenance, conflicts with neighbors, and tenant rotation. Stocks can literally be left alone forever and pay out dividends to investors. Without maintenance you’re able to focus your attention elsewhere such as spending time with family, your business, or traveling the world. You can easily pay a mutual fund manager 0.5% a year to pick stocks for you or hire a financial advisor at 1% a year. Or you can just manage and track your portfolio yourself due to so many free financial tools online.
5) More variety. Unless you are super rich, you can’t own properties in Honolulu, San Francisco, Rio, Amsterdam and all the other great cities of the world. With stocks you can not only invest in different countries, you can also invest in various sectors. A well diversified stock portfolio could very well be less volatile than a property portfolio.
6) Invest in what you use. One of the most fun aspects about the stock market is that you can invest in what you use. Let’s say you are a huge fan of Apple products, McDonald’s cheeseburgers, and Lululemon yoga pants. You can simply buy AAPL, MCD, and LULU. It’s a great feeling to not only use the products you invest in, but make money off your investments.
7) Tax benefits. Long term capital gains and dividend income are taxed at lower rates (15% and 20%) than the top four W2 income rates (28%, 33%, 35%, 39.6%). If you can build your financial nut large enough so that the majority of your income comes from dividends, you could lower your marginal tax rate by as much as 20% or so, depending on the current legislation.
8) Hedging is easier. You can protect your real estate investments through insurance. If disaster strikes, it’s often a pain to get your insurance company to pay for damages because the burden is on you to prove your claim. With stocks, you can easily short stocks or buy inverse ETFs to protect your portfolio from downside risk.
9) Potentially less ongoing taxes and fees. Holding property requires paying property taxes usually equal to 1-2% of the value of the property each year. Then there’s maintenance costs, insurance costs, and property management costs. You can build your own portfolio of individual stocks and bonds for just $5 a trade. Or you can have a digital wealth advisor like Wealthfront build and maintain your investment portfolio for just 0.25% a year in assets under management after the first $15,000. They use their research and algorithms based off modern portfolio theory to best manage your money based off your inputted risk tolerance.
CHARACTERISTICS MOST SUITABLE FOR REAL ESTATE AND STOCKS
* Believe wealth is made up of real assets not paper.
* Know where you want to live for at least five years.
* Do not do well in volatile environments.
* Easily spooked by downturns.
* Tend to buy and sell too often. High transaction costs ironically keep you from trading too often.
* Enjoy interacting with people.
* Takes pride in ownership.
* Likes to feel more in control.
* Happy to give up control to those who should know better.
* Can stomach volatility.
* Have tremendous discipline not to chase rallies and sell when things are imploding.
* Likes to trade.
* Enjoy studying economics, politics, and researching stocks.
* Don’t want to be tied down.
* Have a limited amount of capital to invest.
NO BAD CHOICES IN A BULL MARKET
The choice between investing in real estate or stocks is like choosing between eating a chocolate cake or a hot fudge sundae. Both are good provided that you don’t go overboard. When you are younger, investing in stocks is easier and makes more sense since you have less money and are more mobile. As you get older you probably want to set some roots so owning at least your primary residence is beneficial.
With stocks, it’s terrific to see portfolios go up. But after a while, it becomes unsatisfying to see more money accumulate in your brokerage account. Money needs to be spent on something, otherwise, what’s the point of saving and investing?
Whatever you do, don’t own nothing. Inflation will rob you of your financial happiness when you are older and less willing or able to work. Own assets that rise with inflation such as stocks and real estate. There is no reason why you can’t invest in both.
* Look into real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property or don’t want to tie up your liquidity in physical real estate, take a look at RealtyShares, one of the largest real estate crowdsourcing companies today. Real estate is a key component of a diversified portfolio. If you study the asset allocation mix of college endowment funds and high net worth individuals, you’ll see real estate weightings of anywhere between 10% -25%. Real estate crowdsourcing also allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 4% – 5% in San Francisco, but over 10% in the Midwest and South if you’re looking for strictly investing income returns.
* Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
* Manage Your Finances In One Place: The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month.
The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! They also recently launched the best Retirement Planning Calculator around, using your real data to run thousands of algorithms to see what your probability is for retirement success. Once you register, simply click the Advisor Tolls and Investing tab on the top right and then click Retirement Planner. There’s no better free tool online to help you track your net worth, minimize investment expenses, and manage your wealth. Why gamble with your future?
About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $175,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2018 and beyond.