There is a never-ending debate between real estate versus stocks as a better investment. Currently, ~50% of my net worth is in real estate while ~33% of my net worth is in stocks. Perhaps the main reason why is because I believe real estate is less risky than stocks.
As I’ve gotten older and thankfully wealthier, I had thought I would like stocks more given there is no maintenance required in owning stocks. However, the opposite seems to have happened.
As stock valuations have risen, I’ve become more hesitant in buying stocks. And with interest rates so low, I’ve got little desire to buy bonds. The more capital I have, the LESS I like volatility. And stocks are much more volatile than real estate.
Therefore, my capital has naturally gravitated towards real estate, which is a beneficiary of low interest rates, higher inflationary expectations, and an increased desire for all of us to live better post-pandemic. After all, we are permanently spending more time at home.
Why Real Estate Is Less Risky Than Stocks
Let’s go through some reasons why real estate is less risky than stocks. Ironically, due to lower risk, you could actually end up making much more money from real estate than stocks.
1) The Government Believes So
According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price.
After you buy stock on margin, FINRA requires you to keep at least 25 percent of the total market value of the securities in your margin account at all times. The equity in your account is the value of your securities less how much you owe to your brokerage firm.
The 25 percent is called the “maintenance requirement.” Many brokerage firms have higher maintenance requirements, typically between 30 to 50 percent.
On the other hand, the government is actively encouraging first-time homebuyers to only put between 0% – 3.5% down and borrow the rest through the following types of loans:
- VA loans, which are backed by the Department of Veterans Affairs, offer 0% down payment options for borrowers who qualify.
- USDA loans, backed by the Department of Agriculture, offer 0% down payment options for borrowers who qualify.
- FHA loans, backed by the Federal Housing Administration, allow down payments as low as 3.5%.
2) Financial Institutions Agree
Just like you and me, a financial institution’s goal is to make as much money as possible in a risk-appropriate manner.
Yet I hear absolutely no pushback at all from brokerage firms wishing they could lend at a greater than 50% margin. If brokerage firms thought stocks were less risky, they would lobby hard to expand the margin cap.
After all, a brokerage firm earns a margin interest that pays far more than the interest rate it pays on its client’s cash holdings. But brokerage firms know some of their clients could go broke on margin and won’t have the capacity to repay their margin debt during swift downturns.
Most lenders are gladly lending up to 80% of the value of the real property (20% down payment, 80% LTV). If you’ve got great credit, some lenders will even let you borrow up to 90% of the property’s value (10% down payment, 90% LTV).
If lenders thought real estate was riskier than stocks, lenders would lower the percentage amount a client could borrow. Many of these financial institutions run both a brokerage and a mortgage business. Therefore, they see both sides.
3) The Median Purchase Price For A Home Is Much Greater
In 2021, the median purchase price for a home in America is roughly $340,000. This is clearly much greater than the median purchase price of a stock. The median retirement account balance is under $10,000 in 2021 ($5,000 in 2013).
Yet, despite the median house price being at least 30X greater than the median retirement account balance, real estate investors can borrow up to 100% of a home purchase versus 50% for stock margin buyers.
This fact also signifies that financial institutions believe real estate is less risky than stocks. The greater the purchase price, the more a financial institution has to lose. Therefore, lowering the client borrowing amount would make more sense. Yet, the opposite is true.
4) Average Mortgage Rates Are Lower Than Average Margin Rates
Mortgage rates and margin rates follow the Fed Funds Rate and 10-year bond yield. Mortgage rates and margin rates are also dependent on the brokerage firm and your financial health.
However, overall, the average homebuyer can borrow at a lower rate than the average stock margin buyer. If you check online, you can get a 15-year fixed mortgage for under 2.5%.
For a more like-for-like comparison, you might be able to find a bank that offers a 1/1 ARM that charges 1%. However, the average margin rate is closer to 4 – 6%, Really shop around if you want to go on margin.
Therefore, a lower average borrowing rate for real estate investors also signifies that real estate is less risky than stocks.
Banking 101 states that riskier borrowers buying riskier assets are charged higher interest rates and vice versa. One of the reasons why you should shoot to have over an 800 credit score is so that you can get the lowest interest rate possible.
5) Real Estate Holds Its Value During Stock Market Corrections
When stocks are correcting by 10%+, real estate tends to hold its value or rise in value. The first reason is due capital flight to safety. Capital flees riskier stocks and goes into bonds and tangible assets like real estate. The second reason why real estate tends to hold its value is that interest rates decline as bonds get bid up.
During the March 2020 stock market meltdown, I wrote a detailed article highlighting how real estate gets impacted by a decline in stock prices. It was my way of saying that readers should consider buying real estate. The S&P 500 alone was down ~32% in that month. Some individual stocks were down much more.
It is my belief real estate outperforms stocks the most when the S&P 500 is down about 15% – 20%. It is only when the S&P 500 declines by more than 30% and stays down for longer than six moths that the pull of a recession starts to weigh on real estate prices.
Why Investors Can Make More Money With Real Estate
When an asset class is deemed less risky, the returns are usually lower as well. However, because real estate is less risky than stocks, investors can ironically make a greater absolute amount of money in real estate for two reasons.
The first reason is due to the higher confidence a real estate investor has in investing more money in real estate due to lower risk.
The second reason is due to real estate investors being able to borrow more money to buy a more expensive investment due to lower risk.
How interesting! Let me share a real example to demonstrate.
Making Money With Stocks Is Hard
When Donald Trump got permanently banned from Twitter on January 8, 2021, it made me think more about Twitter as an investment. The stock was lagging many of its peers and I found myself wasting more of my time on the platform.
As someone who is not a fan of social media, I thought perhaps engagement might be going way up given I was being drawn more to the platform. When engagement goes up, advertising revenue and profits tend to go up. Therefore, I decided to buy an initial 220 shares at $47.08/share worth $10,357.69 on January 20, 2021. See below.
My ultimate goal was to buy a $50,000 position for this particular investment portfolio (normal exposure size). However, the stock began to move higher soon after. I wanted to wait for a better entry point. But it never came.
Twitter stock kept going up after it reported solid results and gave a clear profit target for the first time. Now that the stock is in the $70s. I have no interest in buying more after a 56%+ increase in under 40 days.
A 56% increase so quickly is great. However, being up $5,849.71 does not move the needle in terms of the portfolio or my net worth.
I should have bought $50,000 of Twitter stock all at once. But I lacked the confidence to buy more, let alone to go all-in plus margin. A $25,000+ gain would feel so much better to go revenge spend on fun things.
Update June 2021: Twitter stock tanked after its earnings results. As a result, Twitter is now trading around $55/share. Just like that, Twitter lost 30% of its value in a couple months. Yet, real estate continues to do very well. I’m buying more Twitter in the low $50s, but I don’t have huge conviction like I do with real estate.
Making Money With A House Is Easier
Now let’s compare a house I bought in 2019. One day, a larger house in my favorite San Francisco neighborhood with panoramic ocean views became available for purchase. I thought it was a good investment so I haggled and paid cash.
Today, the house is supposedly worth 19% more according to Redfin. A 19% return over two years is ho-hum compared to a 56% return over 40 days in Twitter stock. If only I had bought with a mortgage. I could have earned a higher return. Oh well.
However, a 19% gain equals about $340,000, which is 58X more than the $5,849 Twitter paper profit. Further, after inviting four sets of real estate agents over for a valuation assessment, the consensus is the property is worth 10% more.
I was fine with investing 169X more in a house than in my initial Twitter stock purchase. The simple reason is I felt real estate was less risky. The house had a significant purpose: to shelter my growing family. I planned to own the house for years, fix it up, and maybe sell it. Today, it is a healthy rental.
Granted, I would have had more courage investing more money in the S&P 500 than in a single stock. That said, I probably would have only invested at most one third the amount in the S&P 500 as I did in the house. Further, I would have bought in multiple tranches.
Also, I realize this is a simplistic comparison in paper gross profits between a stock investment and a house investment. I’ve purposefully kept the comparison simple to illustrate a point.
If you want to go more into the nitty gritty, you can read: The Return On Rent Is Always Negative 100%. As an investor, it’s important to face facts and remove as much emotion as possible.
Updating Real Estate Valuation Algorithms
What I’m really excited about is the likelihood Redfin and Zillow will be updating their valuation algorithms. They must to catch up with the robust price movement of single-family homes all around the country.
I’ve been closely following sale prices for 3 – 5-bedroom homes since the pandemic began. The number of homes sold for above Redfin’s estimate is rising. Therefore, it sure seems like the online pricing algorithms need to get revised upwards.
Here is an example of a single-family home that sold in February 2021 for $337,925 above Redfin’s estimate. These occurrences are now much more common.
No Confidence, No Invest, No Make Money
If you do not have enough confidence to invest in a risk asset, then you either won’t invest or invest enough to make a difference.
Since starting Financial Samurai in 2009, I’ve come across plenty of people who let their savings pile up in a savings account. The reason is because they were too afraid to invest in the stock market.
I was one of them when I left a good-paying job in 2012. Instead of investing directly in the S&P 500, I invested in a structured note with downside protection. The price for this protection was liquidity and giving up most of the dividend for five years. Hoarding cash is a suboptimal reality that is completely understandable after the Global Financial Crisis.
Sure, there are examples where some investors went all-in on their favorite multi-bagger growth stock. But for the average American without a trust fund and who has a family to support, buying a property that provides a purpose is an easier, safer way to build wealth.
So long as you can afford the home, even if your home is declining in value, it’s nice you aren’t being constantly reminded about its depreciation. Instead, you’re hopefully enjoying the utility your home provides while making wonderful memories as well. This utility is what will make a potential real estate investment loss much more bearable.
When it comes to stocks, no amount of ownership joy will make up for a stock loss. Stocks simply provide zero utility. And funny enough, Twitter is now below where I initially bought it for. What a waste of time. The hardest thing about buying stocks is timing both the purchase and the sale correctly.
You Can Make More With Real Estate
Given real estate is less risky than stocks, it is ironic the average person can make much more money from real estate. We have the government’s support to partially thank for this anomaly. But we can also thank our ability to courageously take more calculated risks for potential financial glory!
Personally, I’m going to maintain my current asset allocation of stocks and real estate into the future. However, I’ve become more partial to private real estate syndication deals to diversify my investments. I also want to dampen volatility and earn income passively.
Check out my two favorite platforms.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eREIT. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the best way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. They also potentially have higher growth due to positive job and demographic trends. If you have more capital, you can build your own select fund.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects. My goal is to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Refinance Before Mortgage Rates Go Higher
Finally, as the economy opens back up, mortgage rates are rising due to higher inflation exceptions. Therefore, you may want to refinance now before rates potentially go even higher. Check out Credible, my favorite mortgage marketplace where lenders compete for your business. Get free, no-obligation quotes in minutes.
Why Real Estate Is Less Risky Than Stocks is a Financial Samurai original post. You can make much more money investing in real estate, even though it is considered lower risk.