NOTE: Reading the post linked immediately below will help you immensely in keeping your place for this post. Plus, if you’ve never been to BloodhoundBlog, it’ll be an added treat.
Michael Cook wrote an elegant piece on BloodhoundBlog the other day. It was a reminder of why Greg Swann recruited him as a contributor in the first place. He’s not only smarter than the average bear, he’s aggressively pursued excellent formal education — and it shows. When you combine superior innate intelligence with high quality formal education, what you get is — Michael Cook.
This is an academic discussion, and should be viewed as such. Though Mike and I are having fun with it, we both honestly, and most importantly, with respect — disagree with each other on some pretty definitive points.
The way I’ve chosen to approach my answer to his above linked post is to tackle what I see as his weaker points.
Whichever way you lean, I promise you’ll know more when we’re both done than before we started.
I’ll begin by agreeing with Mike’s statement about the relative historical ‘returns’ of real estate and stocks. 3% for the former, and 10% for the later — both on an annual basis. Fair enough — history is history.
I also agree either one of us can point to a particular five year period to make our point. Five years does not a fair comparison make. As an investor, you should look 10, 15, 20, even 30 years down the road. Things tend to show their real colors over the long term.
Strengths and weaknesses also are uncovered over long periods of time.
We’ll dive into the deep end of the pool now by bringing up leverage. 
Mike makes the point — …real estate investors might argue that leveraging stock market investments increase the level of risk. This is completely true, but while real estate investments tend to have less risk, they have far more holding and opportunity costs.
Real estate investments tend to have less risk? And I’ll take Babe Ruth over Gomer McGillicutty in the ninth inning, and the game on the line. Real estate doesn’t just have less risk when using leverage — it’s risk level is literally worlds apart from leveraging stocks. This is why massive liquidity is a requirement so much of the time before an investor is even allowed through the door, much less even allowed to start playing with leverage in the stock market.
To compare the relative risk between leveraging real estate and stocks by saying risk is increased when applied to stocks, is at the very least, surprising. To blow off the significantly increased risk involved with stock leveraging by implying (am I inferring?) that there are holding costs with real estate is humorous, at least from where I sit.
Real estate investors don’t look at their properties as ATMs. The point is then made that if the investor wishes to sell a stock, he just gives the order and it’s done. 
Sure — and if it went down that day, or for many previous days, it’ll be for a loss. But he sold it in a few minutes, and that’s a good thing. It is I guess — if convenience is a top priority to a particular investor. Most investors I know, put long term performance, and the enrichment of their bank account a few hundred miles before their convenience.
Transaction costs are then brought up.
Let’s make short work of any potential long-winded discussion of this subject. 
I’ll give you a 50-dollar bill and a 100-dollar bill. They both represent net proceeds from investments, for which it took an initial investment of $10. The $50 came after transaction costs of 25¢. The $100 came after transaction costs of $1Mil. You pick which net proceeds you want — I’ll take the one you left. Moral: Investors bank net proceeds. Each industry has their own transactions costs. I don’t know about your banker, but mine only cares about what I net, not what I grossed.
Show of hands. How many investors care more about the gross profit than the net proceeds they get to keep? Talking about transaction costs gets you looking away from the real issue. In all my years in the biz, I’ve yet to find a stock broker willing to get into this discussion seriously. They know they’ve come to a gunfight with a pocket knife.
Leveraging stocks is not just somewhat riskier than doing it with real estate. It’s orders of magnitude riskier. 
Any discussion to the contrary is superfluous. Swimming with sharks is somewhat riskier than swimming with a school of porpoise. The investment world ocean is a risky place in general. But given the choice, I’ll swim with the cute little porpoise. When was the last time you got a margin call on your duplex? There’s not an appraiser coming to my duplex every 24 hours to ensure it hasn’t gone down a buck below what I paid for it. Furthermore, they don’t ask for a check every time my value dips a bit.
It’s the little things that make the difference, isn’t it.
Next up is saying stocks are liquid and therefore more attractive.
Huh? If we’re taking the long view here, 10-30 years, liquidity, though cool to have, isn’t on my A-list. Safety of my original capital and return on that capital are 1A and 1B on that list. Liquidity in real estate is held in terms of equity, Sominex (Ambien) Accounts, and lines of credit. Liquidity in stocks means if you need cash in a hurry you can sell them quickly, with very little transaction costs — and possibly for a convenient cash producing… loss.
What wasn’t countered in any way, shape, or form, was that well researched, well located real estate, when leveraged prudently, out performs stocks when viewed over the long haul — period. Anyone who invests in both stocks and real estate knows this to be true.
It’s almost axiomatic for Heaven’s sake.
Over the years I’ve literally had dozens and dozens of people in my office complain about the difference in long term returns between their stocks and their real estate. 
The vast majority came into my office in order to successfully transfer their Wall Street money to real estate. Their experiences demonstrated clearly and inarguably they were losing money by having so much tied up in the stock market. And understand — they weren’t complaining of actual losses. They were complaining about the money they were leaving on the table by not investing in real estate.
Now don’t take that statement out of context, and start saying the Bawldguy said investing in stocks is a losing proposition. You can make millions in the stock market. In fact, I expect that Mike will become a multi-millionaire in part by doing just that. He’ll make a lot more money in real estate though, which is why he pays so much attention to real estate in the first place.
Saying, with a straight face, that real estate has the ability to compete with stock market returns is like saying Michael Jordon had the ability to compete in the NBA. To make more sense, it should have been stated the other way around. And even then it would be a questionable statement. I suspect Mike put it that way to have a little fun with me.
Bottom line?
If the investor is consistently able to prudently leverage real estate, while making upward moves to more real estate when the timing is right, he’ll not only out-perform his stock investing buddies, but they’ll tire of his bragging at the backyard BBQ — finally breaking down to ask him how he’s doing it.
Proponents of stocks just can’t won’t yield the main point: Given equal initial investment amounts, the leverage factor in real estate is not only almost infinitely less risky than stock leveraging, it’s incredibly more profitable. There’s no believable argument (sans huge risk) that says anything different. The reason is, they don’t have a viable alternative that matches risk level, tax treatment, (including tax shelter, tax deferred gains, or the ability at times to simply sell without paying taxes), and profits. Marry this to the fact regular folks are now finding these things out by the thousands across the country, and you can see their dilemma.
The argument from the stock side complaining about all the added ‘work’ involved with real estate is informative. I work a little harder, and spend more time watching over my real estate, and am rewarded with far more profits than buying a stock and grabbing a beer. My experience as a real estate investment broker/advisor has shown me that folks don’t mind delaying that beer if they’re gonna make $10 instead of a much lesser amount.
- They discovered they still get the beer.
- Michael, in the end, is certainly right about this being a matter of investor preference.
- Most investors I know prefer to make more money rather than less.
- They prefer the option of avoiding capital gains taxes.
- They prefer writing off some of their job income.
- They really prefer being able, at times, to sell a property, reaping significant gains — while paying little or no taxes whatsoever.
He and I agree — it certainly is a matter of preference.
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About BawldGuy
I think both options can make you money, just the X factor tends to be skill. Something the general public generally lacks.
-Athol
You’re right of course – which is exactly what has been our most consistent discovery while on the road. The number one comment from regular folks is that they’d like to invest, they just don’t know an expert who is both experienced and honest.
It’s my opinion most would go in either direction if they thought the advisor was an honest and straightforward individual.
You have the uncanny ability to hit the nail on the head quickly, Athol.
LOL maybe “honest” is the real X factor at work. That’s the hardest thing to find I think. Everyone seems to be trying to play a business suit version of 3 card Monte. I think convincing people you’re honest is the biggest step.
I mean who would you invest your money with? The A+ guy who makes your skin crawl a bit, or the B- guy who is honest.
Now if you can be A+ guy AND be honest, well that’s just the fudge sundae isn’t it.
-Athol
We find when we’re asked a question for which we either don’t know the answer, or aren’t sure – we say so – loudly and clearly – drawing attention to the fact that – we can’t possibly have all the answers. Nobody does.
We discourage thoughts of getting ‘rich quick’. In fact, we laugh at the thought.
We often tell folks to slow way down. Or that they should absolutely NOT sell something. (did that the other day)
It’s small little give and take conversations like these that often result in the trust level rising naturally. People don’t expect their advisors to be perfect – they expect them to be pros with a clear sense of right and wrong, and an concrete sense of integrity.
I’ll bet your clients stick with you because of your way of disarming them with naked candor. I would if I were them.
A little stream of conciousness writing…
“This is why massive liquidity is a requirement so much of the time before an investor is even allowed through the door, much less even allowed to start playing with leverage in the stock market.”
This statement is not true. Anyone with an online stock account can short stocks, thereby employing a leveraged strategy. While does add more risk, I wouldnt go as far as comparing it to Babe Ruth and Gomer. Many subprime borrowers and interest only borrowers, would probably agree with me on that front. In fact shorting stocks can actually make your portfolio less risky if done properly. The downside protection of shorting can decrease the volatility and increase the overall return.
“The $100 came after transaction costs of $1Mil. You pick which net proceeds you want — I’ll take the one you left. Moral: Investors bank net proceeds. Each industry has their own transactions costs. I don’t know about your banker, but mine only cares about what I net, not what I grossed.”
This very statement is surprisingly outrageous (I mean that in the nicest way, really). The level of funds at risk for $100 vs. $50 is significant. It speaks to how easy it is to get into the game. Right out of college, who has the money to play in the real estate market? Heck, I still dont have your “$1 million.” Interestingly enough, I did find a quarter on the street the other day, so it looks like I can get into the stock market.
Neither investment has promised returns, so transaction costs are important. Flexibility may not be paramount, but it should not be neglected. If an investors gets into a pinch, it will certainly become more important than the profitability. Ask anyone who has lost a job or simply stretched themselves too thin. Tapping investment property for cash is very expensive and much harder to do than selling stocks, which if held for a period of 3-5 years would probably be at a significant gain, contrary to your above statements.
Overall, Jeff, I think you are selling stocks too short, pardon the pun. You really do over exaggerate the risk of stocks, down play the risk of a commercial real estate investment,and do not give credit to a prudent leverage stock investment strategy. Risk is simply the volitality of investment returns. I have seen many good market neutral funds that employ leverage at fairly low risk levels. While still higher than the risk of real estate’s unleveraged returns, competitive. Leverage real estate returns by contrast show significantly increased volatility. You constitently talk about prudent real estate portfolio’s, but fail to give stocks that same benefit of the doubt.
Looking at the subprime lending market and the resulting defaults shows a hint of what can happen with over leveraged real estate. Give this situation another year and my case will be even stronger.
I was not sold on your rebuttal here, but I did see some good points. Going out for a beer seems like a good idea.
Mike – First of all, we can agree on one thing for sure – a beer together whenever the opportunity presents itself.
When I spoke of massive liquidity requirements, I was addressing your post’s mention of certain hedge funds. We both know, some of the leveraging in the stock market absolutely requires the level of liquidity of which I spoke. That said, you made an excellent point about the average guy being able to put himself in harm’s way while at home in front of his computer – sans any real liquidity.
That still doesn’t address, head-on my real point. I speak for myself here, but I’m sure you’ll agree – I’m not having this discussion with rank amateurs in mind. The point I was making is how much higher, relatively speaking, leverage in stocks is than real estate.
Comparing that indisputable fact, to interest only an sub-prime abuses by amateur investors doesn’t change the fact itself.
You missed the point I was making re: net proceeds. I was merely pointing out, using what I thought would be amply transparent hyperbole, that a $100 net is preferred over a $50 dollar net. It was not in any way making a statement about transaction costs as a topic in and of itself. It was merely saying investors tend to be ‘bottom line’ people.
Flexibility – I preach flexibility to the nth degree when talking about Purposeful Planning. We absolutely agree there. Tapping investment property for cash has its costs, true. However, because RE investors can tap leveraged property without endangering their position, which is way less likely with leveraged stocks, their flexibility offers, I think you’ll agree, less risk.
I’ll plead guilty to some exaggeration when talking about the risk factor in stock investments. I go out of my way however, and the empirical evidence is all over my blog and Bloodhound, that investing in real estate, residential, or commercial, is definitely not for amateurs or wannabes.
Look, you and I probably agree on the following:
Both stock and RE investment can result in a two comma net worth.
Leveraging RE is easily safer than doing the same with stocks.
Leveraging stocks is, relatively speaking, far more sophisticated that the same approach in RE.
The relative tax treatments of the two investments favorite real estate by orders of magnitude.
Having a beer together trumps all the above.