Real Estate vs. Stocks: Investment Showdown
“The stock market is a wonderfully efficient mechanism for transferring wealth from the impatient to the patient.”
Warren Buffet (Investor & CEO)
Which is the better investment?
If you ever hope to attain financial freedom, you must become an investor. Someone who deploys their capital into productive assets in order to grow their wealth over time. Most people, unfortunately, don’t have the mindset of an “investor”. Some people are “spenders”, who will never get ahead because they spend every dollar they earn. Other people are “savers”, hoarding cash in their bank accounts while inflation eats away at their nest egg. If you’re serious about achieving financial freedom, you need to shed these identities and transform yourself into an investor. If you spend less than you earn and invest the difference, financial freedom is inevitable. But what exactly are you supposed to invest in?
While there tons of different ways to invest, the two most popular asset classes are stocks and real estate. When you purchase a stock, you become part owner of the company, entitled to a share of the profits. When you buy property, you own the land and the physical structure, benefitting from owning a tangible asset. Both have stood the test of time, attracting investors for generations. But which investment holds the upper hand?
Read on as we pit these investments against each other to determine the champion of financial freedom!
Establishing the criteria
In order to determine which investment is superior, we need to outline a clear criteria on which each will be equally assessed. While not exhaustive, the below list outlines some of the key questions we should ask when evaluating the merits of an investment.
📈 Appreciation: How much will the value of this asset increase over time?
💵 Cash Flow: How much cash will this investment generate?
💪 Level of Effort: How much work will be required?
🎢 Volatility: How much will the value of the asset fluctuate over time?
🏦 Leverage: Can I borrow money to purchase this asset?
💦 Liquidity: How easy can I turn this investment into cash?
💸 Tax Benefits: What impact does taxes have on this investment?
While these are all significant questions, the level of significance depends entirely upon the investor and where they are in their financial freedom journey. If you’re someone who wants to quit your W-2 job in 3 years, cash flow is going to be the most important. On the other hand, if you have a long investment time horizon, you might be more focused on appreciation. If you’re someone who is already nearing retirement, you will place the greatest emphasis on investments that are less volatile. This is why financial education is so important. In order to give yourself the best chance of success, you need to develop and implement an investment strategy that aligns to your specific goals and objectives.
Now without further ado, let the investment showdown commence: 📊 Stocks vs. 🏠 Real Estate!
Round 1 - Appreciation 📈
Stocks are famously known for their consistent price appreciation. For the last 30 years, the average annual return for the S&P 500 index was roughly 10%. So if you invested $10,000 into S&P 500 30 years ago, today that investment would be worth $164,494 (assuming you reinvested all dividends). Not too shabby. In the same 30 year time period, the average annual increase in the price of a home was roughly 4%, less than half the returns of the stock market. For comparison purposes, a $10,000 home purchased 30 years ago, would be worth $32,434 today. So stocks are the clear winner, right?
While the data seems rather straight-forward, one massive assumption is being made: that an investor can actually match the returns of the S&P 500. According to this article, 94% of US Fund Managers underperform the average returns of the stock market. So if professionals, whose entire job is focused on beating the market, can’t beat the market, how does the everyday investor like you and me fare? Not very well, I’m afraid.
In this informative episode on The Money With Katie Show, she breaks down a study that shows that most investors typically only achieve half of the returns of the S&P 500. So while the returns for the S&P might be 10% per year, most individuals are only seeing 5%, kind of a bummer. It’s statistics like these that have helped me shift my personal investing strategy from buying & selling individual stocks to focusing solely on dollar-cost averaging into index funds.
Winner: While it ended up being close, Stocks still take round 1! 📊
Round 2 - Cash Flow 💵
While appreciation is a major component of building long-term wealth, cash flow is ultimately what pays the bills. If the income generated by your investments are enough to cover your living expenses, you’ve achieved financial freedom. How much cash flow can you expect from real estate vs. stocks? Let’s break down this comparison with a hypothetical investment of $100K.
As a savvy stock market investor, I know that it’s unwise to try to beat the market. So I take my $100K and I invest it into the S&P 500 through a low-cost ETF (ticker: VOO). Certain stocks & ETFs distribute profit to shareholders in the form of dividends. The amount you can expect to receive as an investor can calculated by multiplying your invested amount by the dividend yield. As of this writing, the dividend yield for VOO was 1.55%. So for a hypothetical investment of $100K, you can expect cash flow of $1,550/year ($100K X 1.55%) or $130/month.
So how does real estate stack up from a cash flow perspective? Let’s say I decided to invest in the Midwest and I purchased a nice 3 bed 2 bath home in a solid working class neighborhood for $100K cash (yes these homes exist). Since I’ve been doing my real estate investing homework, I made sure that this property would rent out for at least $1,000/mo (satisfying the 1% Rule) before purchasing the deal. So this property will generate $12K in annual income which is awesome, but we need to factor in our expenses. Without getting too in the weeds (see: blog post on how to analyze a rental property), a good rule of thumb is that a rental property will have a 50% operating expense ratio (for property taxes, management, repairs, etc). After subtracting 50%, for operating expenses, this property will be generating $6K/year or $500/mo, and since we bought this property in cash (don’t have debt service), this will be our net cash flow. To put it in stock terms, this house has a 6% yield (in real estate this is referred to as Cash-on-Cash return), which blows the 1.55% yield of VOO out of the water.
To be fair, sophisticated stock market investors can implement strategies to optimize for a much higher dividend yields (see: dividend investing), but in general, (good) rental properties will produce much stronger cash flow when compared to stocks. The demand for housing in the US also continues to push rents higher, improving rental property profitability over time.
Winner: Real estate bounces back to clinch Round 2! 🏠
Round 3 - Level of Effort 💪
Chances are, you have a lot going on. As you try to execute the never ending balancing act that is life, it’s important to ask yourself how much time do you have to allocate to investing? How much work are you willing to put in? Investing requires effort, but the level of effort can vary significantly between stocks and real estate.
Technology has made investing in the stock market extremely accessible. You can download an app and with a few clicks of a button, you’re a bonafide stock market investor. It also doesn’t require a lot of money to get started. With as a little as $1, you can invest in any company or ETF that is publicly traded. You can then automate your investing, pulling money from your banks accounts on a set schedule and investing it, removing yourself from the process entirely. Simply put, stock market investing is almost completely passive. You will spend some time researching companies and rebalancing your portfolio, but overall the work required will be minimal.
Real estate, on the other hand, will require more involvement. For starters, the barrier to entry is much higher. Most banks will require you to put 20% to 25% down to acquire a property. Even for a $100K property, that is $20K to $25K that an investor will be required to have in cash (not including closing costs, repairs, etc). Even if you do have the money, buying a property is not straight forward. The vast majority of real estate properties listed on Redfin or Zillow wouldn’t make good investments, and even if you do identify one that will cash flow, that property will likely have multiple offers from other investors. After you are able to successfully acquire a property, the work doesn’t stop there. You will need to make sure the property is filled with tenants and well-maintained, and while a property manager helps with this, you will still need to manage your manager and approve decisions. Needless to say, real estate requires a lot more effort than stocks.
To clarify, I’m referring to the work required to acquire and manage rental properties. There are several different ways to invest in real estate that would be as passive investing in stocks (see: syndications, REITs, crowdfunding). As investors, however, we should think critically about why things are the way that they are. Investing in the stock market can be done with a few clicks of the button, but what are the implications of that? Real estate investing is certainly more difficult, but might that mean there is more opportunity? With that being said, stocks are the clear winner of this round.
Winner: This one wasn’t even close, Stocks blitz in Round 3! 📊
Round 4 - Volatility 🎢
Volatility refers to the degree of variation in an investment’s price over time. While everyone’s appetite for risk is different, it’s generally better for an investment to be stable rather than volatile. Seeing the value of your investments rapidly increase and fall over time can feel like a roller coaster and can lead to suboptimal decision making. Are stocks or real estate the more volatile investment?
In the previous round, we identified that it’s fairly easy to buy and sell stocks. While that attribute helped it win last round, it’s going against stocks in this round. Stocks are notorious for their volatility. Market sentiment, economic data, company news, and a myriad of other factors can cause stock prices to swing dramatically in short periods.
As mentioned previously, it’s actually quite difficult to buy and sell real estate. While seeing a stock dip 10% might trigger someone to sell their position, someone might not be so quick to sell their home because of the work required (clean the property, make repairs, list it with an agent, etc). The friction of real estate transactions in this case is positive, and what results is much more stable price movements relative to stocks.
Winner: Real estate takes Round 4 and we are tied 2-2! 🏠
Round 5 - Leverage 🏦
In the world of investing, leverage refers to borrowing money in order to control (own) an asset. When used properly, leverage can amplify returns. When used irresponsibly, however, leverage can generate huge losses for an investor. Let’s break down the use of leverage in both stocks vs. real estate.
In the stock market, leveraging involves trading on margin, essentially borrowing money from your brokerage to buy (more) stocks. While it’s possible to do this successfully, it’s more of an advanced strategy reserved for experienced investors. Given the volatile nature of the stock market, an investor trading on margin runs the risk of their account falling below the requirements set forth by the brokerage, and their loan being called due (see: margin call).
In real estate, the use of leverage is more commonplace. For example, a bank is typically willing to loan up to 80% of the value of the home (with the investor putting 20% down). In comparison, a brokerage is only willing to lend up to 50% in the case of margin trading. Why are banks willing to lend so much when it comes to real estate? That’s because banks view real estate as incredibly safe investments. At the end of the day, they have high confidence that they will make money from the transaction (even if they need to foreclose on a property and sell it themselves). The same confidence isn’t held in stocks, which is why the requirements for margin trading are much higher.
As an real estate investor, taking out a loan/mortgage to purchase real estate is often referred to as “good debt”. How can debt be good you might ask? What makes real estate debt “good” is the fact that the underlying asset is generating enough cash flow to service the debt. If the rent you are charging your tenants is enough to cover the mortgage payments, your loan is being paid for by the asset itself. This isn’t the case when borrowing against your stock portfolio where you are almost entirely dependent on the asset increasing in value.
All that being said, leverage is something to use carefully and responsibly regardless of the asset class!
Winner: Real estate takes Round 5! 🏠
Round 6 - Liquidity 💦
Liquidity refers to how easily an investment can be converted into cash without significantly affecting its price. This aspect is crucial, as it dictates how quickly you can access your funds when needed.
Stocks excel in terms of liquidity. In today's digital age, buying or selling stocks can be done in a matter of seconds. The stock market operates with high trading volume, ensuring that there's a ready market for shares at almost any time. This liquidity provides flexibility, allowing investors to adjust their portfolios swiftly based on changing circumstances. So for all intensive purposes, stocks are almost as good as cash.
Real estate, on the other hand, is relatively illiquid. Selling a property involves a more prolonged process, including finding a buyer, negotiation, inspections, and legal procedures. It can take weeks or even months to finalize a real estate transaction.
Winner: Stocks take Round 6 and we’re tied 3-3 going into the final round! 📊
Round 7 - Tax Benefits 💸
(disclaimer: I’m not a CPA or tax professional, and this is not tax advice)
If you live in the US, taxes will likely be the largest expense you incur in your lifetime. Taxes significantly impact your investment returns and when it comes to stocks vs. real estate, this one isn’t even close.
In most cases, stocks are subject to capital gains taxes when sold. The rate depends on how long you've held the investment. Short-term gains (held for less than a year) are usually taxed at your regular income tax rate, while long-term gains (held for over a year) often enjoy lower tax rates. Dividend income received is also subject to taxes.
When the wealthy say “they don’t pay taxes”, it’s most likely because they are investing in real estate. I went into this in more detail in my last blog post, but in summary, the tax code is highly favorable to real estate investors and there are a variety of ways to minimize the tax liability on income generated through real estate because of things like depreciation, 1031 exchanges, mortgage interest deductions, etc. As always, make sure to seek the professional counsel of a CPA or Tax professional before attempting to leverage the tax benefits of real estate.
Winner: Real estate takes the 7th and final round ands edges out stocks 4-3! 🏠
Wrap Up
As the investment showdown comes to a close, let’s recap which rounds each investment won.
📊 Stocks: Appreciation, Level of Effort, Liquidity
🏠 Real Estate: Cash Flow, Volatility, Leverage, and Tax Benefits
While Real Estate won more rounds, how important each round is depends entirely on you as an investor. We all have to do the critical work to iron out our financial goals and devise an investment strategy that propels us toward those goals. Some might prefer to stick to one asset exclusively, whether that be stocks or real estate. Others, like myself, might prefer to build a balanced portfolio thats consists of both stocks & real estate, capitalizing on the strengths of each asset class to mitigate the downsides of the other.
There is no one right answer. Everyone’s path to financial freedom will be unique to them. In the end, the true winner is the investor who gets educated, takes action, and makes incremental progress against their goals each and everyday.
Stay committed to the journey, my friend. Your future self will thank you.
