A long while back I published a post discussing the so-called debate, Real Estate VS Stocks as investment vehicles. It’s time to remind folks, as stock tips are flying everywhere again, that the stock market just doesn’t compare, especially for regular folk just looking to ensure the retirement they’ve been planning for years. Of course, this dovetails with what I was talking about the other day — 401(k)’s. They thrive or fail based upon the stock market. If in the last 10 years of your work life, the stock market takes a snooze, so does your retirement. Name the last time real estate took a decade off. Right, not even. 
Since the end of World War II, the next time real estate stays down, or flat for a decade — will be the first time.
Now that the stock market has done a solid imitation of the real estate market, I’m hearing more and more from folks who honestly think there’s a real comparison between their stock portfolio’s potential and their real estate investment plans. The whole, ‘We’ve reached the bottom, and now’s a great time to get into the stock market.’ Before I begin, there’s something I wanna make perfectly clear. You can get very wealthy in the stock market. Over the long haul, you can drag a bunch out of the vault for yourself. That said, you have to know which stocks to pick, when to buy, and who in management might undermine your long term plans. And much of the information on which you will want to base that info is zealously kept from you.
Your real estate portfolio is also subject to outside factors, but not nearly to the extent as the stock market. You can pick where, when, why, how, and in the end, do it all with reasonable confidence that the big picture will show you with an even bigger smile. One area is down, the next isn’t. San Diego is down now, while much of Texas is the real deal. Phoenix is waiting to bounce back, while Kansas City just keeps cooking along.
As I write this the DOW is just at or a touch below 12,000 — a hefty decrease compared to a year ago. Now everyone is trying to figure out if real estate measures up. This is predictable every time the stock market goes bullish o4 bearish in a big way. The mainstream media chimes in with their take on what investors should do. Those without a dog in the fight (read: any real understanding) offer the most humorous reading. The media often takes ignorance to levels air breathing mammals can’t survive.
The journalist usually ends up concluding the investor has to choose what’s better for their particular situation. That’s media-speak for “I had to write a piece on this topic and don’t know what I’m talking about, but it sure sounds good, doesn’t it?” Let’s put this subject to bed once and for all. We’ll put them in the most transparent way possible, side by side so anyone can discern which way is north on the map. Of course I’ve always maintained the media hasn’t ever done their research diligently on this topic, but we’ll give it a shot anyway.
Stocks vs. Real Estate
Here’s how we’ll do it. I contacted my Financial Planner as a source for an historically reliable annual growth rate in the stock market. I decided to use the S&P 500. For the past 55 years or so it has performed at a growth rate of approximately 8% annually. (It’s actually somewhat higher, maybe 8.5%.) Sounds impressive, but of course that’s not every year, just like real estate doesn’t always go up 40% a year. In fact, let’s be honest and say right up front that both real estate and stocks experience downturns from time to time as part of the normal business cycle. Duh. Don’t the current circumstances faced by real estate investors today speak for themselves? Ask your neighbor, the stock investor what he’s thinking about his portfolio these days.
Pick any growth region you want. Go to any 10 year period at random. In San Diego that’s a fun game I play with my new clients. They usually pick the period ending with a real downturn. It doesn’t matter. The rises have, historically speaking, given more than the downturns have taken away — by orders of magnitude almost. Nothing in San Diego has gone up as little as 5% yearly, in any decade you’d choose. It just hasn’t happened. I’m beginning with the year I got in, which was 1969. Almost four decades is long enough to make a point, don’t ya think?
Let’s set the parameters first. I’m going to grant annual growth of 10% for 10 years for the S&P. That’s about 25% over what they done over the last half century. We’ll use $100,000 as our opening capital investment amount. For real estate we’ll use an average annual appreciation rate of only 4%, buying small income properties using 10% down payments. (Note: This isn’t theory, I’ve been executing this exact scenario successfully for decades now, and have done so recently (How’s 14 times in the last few weeks?).)
As stated above, we’ll use an annual appreciation rate of only 4%. I’ll assume the stock’s annual return will be able to maintain a 10% annual growth by selling and buying different stocks as the professionals see fit. I’m also assuming the real estate investor will do one tax deferred exchange at the end of the fifth year. Though I won’t impute any costs to the buying and selling of stocks, I will burden the real estate investor with a selling cost of 8% when he exchanges.
Let’s see what happens.
After 10 years (rounding to the nearest $100) the stock investor has $259,400 — a profit of $159,400 over the 10 year period. A 10% annual growth rate on the originally invested capital.
Real estate has ended up with $458,000 – a profit of $358,000 for the same 10 year period. A 16.435% annual growth rate on the originally invested capital.
We gave stocks the benefit of 2.5 times the growth rate we gave real estate.
This still doesn’t take into account the benefits received from the real estate that don’t exist with stocks.
- Any income derived over that period generated by the real estate would not be taxable because of depreciation.
- All excess depreciation would then be allotted to the ordinary income (salary from job) of the investor, resulting in thousands of dollars in taxes not paid.
- On the other hand any dividends derived from stocks are taxable. With rare exceptions the only way the stock market investor gains any tax shelter is when he loses his money, which is far more likely in stocks than in real estate, especially over the long haul.
Now imagine what this same $100,000 could have done for you, if you’d been pressing the right buttons for the last decade with your real estate investment portfolio. In my experience, even with some bumps along the way, 10 years of prudent and Purposeful Planning, (using the Flywheel Principle) almost always results in multiplying your original capital 5-20 times, depending upon the region, your timing, (sometimes lucky is good) and how vertical the rises were in that particular 10 year period. The immediate decade past would have resulted in your $100,000 turning into at least $1.5-2MIL — if you were paying attention and exchanging when it made sense.
Note: It’s my very strong belief the next decade or so will not bring us any huge run-ups in real estate. I think even the normally high appreciation regions probably won’t experience any significant upward spikes.
What’s really cool about real estate is the ability to buy based upon regional performance. For instance, if you bought investment property in Ohio in 1997 vs buying in San Diego, you’d have been very disappointed. Real estate is local, whereas stocks are, well, stocks. By understanding the fundamentals of different regions, an investor can more intelligently place his capital. A great example of this is when we took our clients out of San Diego five years ago, and exchanged them into other, lower priced growth regions. Many of them can now look back with 20/20 hindsight and see how their capital growth rate was significantly higher outside of San Diego. This doesn’t take into account the relatively lower prices, and the far superior price to rent ratios they enjoyed elsewhere. Their cash flow, if that’s what they wanted, was easily superior when the properties were not in San Diego, or areas like it (Palo Alto?).
Before anyone jumps in to defend stocks, don’t bother. You can make a lot of money with them. But the bottom line is, you can’t use leverage without going over the top with risk. Your weak dividends are taxable. You provide no tax shelter during the holding period. If you picked one industry leader over another, you might have made it big — unless of course, you picked wrong. Folks don’t need a crystal ball with real estate — plus they have prudent leverage.
Ah, leverage. Real estate without leverage, is like — buying stocks. It’s the difference maker.
This is why folks like Ben Stein, a man for whom I have almost unlimited respect, avoids any mention of leverage when he compares the two investments. (And he made himself wealthy almost exclusively through stocks.) He knows if he did, stocks would be embarrassingly left behind. Even conservative leverage puts the regular investor way ahead. Leverage is the unfair advantage we have. And we allow it to move Heaven and earth for us, until we arrive at our magnificently abundant retirement.
Then we bask in the glow of the life we’ve earned — through real estate.
Let all this percolate for awhile. Then ask yourself whether or not you should begin taking your retirement a lot more seriously. Contact me — I’m easy to talk to.
Related posts:
- Stocks vs. Real Estate: A Debate? Really?
- Is Your Real Estate Investment Broker Like a Nordstrom’s Sales Guy?
- How To Get Your San Diego Real Estate Equity Growing Again — Get Outa Dodge Now
- Real Estate Investors: If You Had To Retire In 2017 Would You Be Happy Or Anxious?
- Retirement Through Real Estate Investment — Constructing The Plan
About BawldGuy
Can I urge you to give yourself a Bawldy?
Thanks Chris, you’re too kind. Modesty prohibits following your suggestion.
You have a great point in the relative benefit of investing in real estate over the stock market. In general, even a well-balanced stock portfolio (which very few people enjoy)rarely provides as consistent returns as a well-planned real estate investment.
You can enjoy leverage in both the stock market and real estate. However, only in real estate can you structure your financing to maximize your return on investment.
-4MySales
I don’t think ‘enjoying’ would be the word for leverage used in the purchase of stocks. Buying on margin is not only incredibly risky, but calls for MORE money, when things go south.
Thanks for stopping by.
Jeff;
Typically lurk without commenting (my father said that even a fool, if he remains silent, may appear wise. =0) Given the subject and the eloquence with which it was presented, I wanted to give KUDOS. Nice article, nicely done, with all due respect given to stocks. Enjoy your work.
Michael
http://www.KansasCityInvestors.com
Thank you Michael – and I like your father’s advice. i try to follow it whenever possible.
Great post, I’m currently helping people who are sitting at the crossroads between these two mainstream strategies. I could really only give my own experience and note that it was purely up to their own preference. Maybe they will follow my preferred strategy after I send them this post.
Jeff,
I very much enjoy your blog, approach to investing and the other thinkers you expose your readership to.
Regarding this post, I understand that for pure growth, real estate wins vs. stocks. But what does the comparison look like when you take into account the carrying costs (interest expense and taxes) of real estate? Seems to me that going through IRR analysis would provide more of an apples-to-apples comparison. Perhaps this is the subject of a separate post.
Your thoughts, please.
Thanks!
Geoff
Great Post… this should be required reading for all young people
Geoff,
If you have a helment, you might want to put it on.
INCOMING!
Geoff — You’re right, an after tax cash flow analysis arriving at IRR’s for both investments would be enlightening. It would also show that my numbers were more than lenient on the stock side of the comparion! The difference would be even greater when everything is included.
To create the apples/apples comparison you’d simply take out the cash flows for both sides and assign them a ‘discounted’ after tax yield, then come up with a yield which would indeed be apples and apples.
Real estate just has too many advantages over stocks, and when they’re amplified over time, the gap grows even larger.
As far as the ‘carrying costs’ go, the examples used in the post paid for themselves, before tax. After tax they would’ve been generating positive cash flow through tax savings each year. After a few years the property itself would no doubt have begun throwing off pre-tax cash flow due to rising rents — 100% of which would have been untaxed. (depreciation)
Also, since tax deferred exchanges are available, paying capital gains taxes isn’t a part of life for most real estate investors. This begs the question too, about how some folks are able to take a straight cash sale WITHOUT paying taxes due to accumulated/unused depreciation.
And the beat goes on.
Come back Geoff — great question, thanks.
Thanks Chris – you consistently crack me up.
Scoreboard – Thanks so much for your kind words.
Readers – take a minute and get over to Scoreboard’s site. It’s interesting.
I don’t know if I how to use trackback well:
Things Suze Orman Forgets to Tell You But Jeff Brown Will
http://delmar.typepad.com/world_wide_wealth_advisor/2007/07/things-suze-orm.html
Jeff,
I am going to go out on a limb and disagree with you here. First, I dont think you are comparing apples to apples. If I decide to buy a stock, that transaction is done. If I decide to buy an investment property, I have a headache. While I certainly enjoy that headache, not everyone does. Over the course of 10 years, that certainly might be worth a different return.
I also dont think it is fair to leverage real estate, then not leverage stock investments. You imply that it makes investment more risky, but it also significantly increases the stock return. By your same example, a leveraged stock investment would signficantly outperform your real estate example.
Look at REIT returns compared to S&P500 returns and you get a more accurate picture. I think you do your naive readers a disservice with this comparision because you really dont take into account the implied assumptions you are making with a real estate investment. Finding an easy to manage $1 million property yielding a 4% appreciation year over year is not as simple as investing in a stock.(at least not where I am from).
I enjoy your posts and think you have great investment ideas, but I must respectfully disagree with your presentation here. If you really want to wow me, compare your example to a 130/30 hedge fund (not even close to as much leverage as your real estate example) yielding an average of 16% or better. Tell me how that compares to your example.
Readers – Before I address Michael’s comment, you should all know how cool it is for him to even drop by and comment. He’s one of the big-hitters on BloodhoundBlog, and is massively qualified to speak on this subject. Mike is not only highly educated (MBA from Cornell) but just plain stand-alone brilliant. I almost always either agree with his takes or at least don’t disagree. If you want to read some great thoughts in writing, go to Bloodhound and look up his stuff. You won’t be disappointed.
Mike has done me an incredible favor here, and inspired another post on the subject. We do indeed respectfully disagree.
Thanks again for coming Mike – you raise the level of academic discussion – never a bad thing.
As a note, I did not mean to imply that all of your readers were naive. Looking back on that comment, it seems harsher than I intended. I meant to refer to the readers with very little experience buying or owning investment properties as naive about all the work it entails. Before I did it, I was quite naive and would have not had any beef comparing the two. Once I became a property owner the story was very different, even with a management company. I really hope you or your readers were not offended there.
Thanks for all the compliments, but you have far more experience in this area than I do. I have spent a lot of time tackling this very issue, however. My second year of school I managed quite a bit of money ($10 million) in a market neutral hedge fund. Year over year we were returning on average 12-15% and we were just a bunch of students. We were about 50% leverage and our risk profile was surprisingly low.
If I was an investor, without a specific passion for real estate, I might consider long/short hedge funds or mutual funds with leverage before I took the plunge into real estate. I will be writing a post on Monday at Bloodhound on this very subject. I would love to hear your thoughts. Again, great site and a great discussion.
This can only be fruitful Mike. And, readers, if you know Mike, you know he absolutely didn’t mean anything at all negative by his ‘naive’ remark. This is demonstrated clearly with this latest comment. He’s one of the good guys.
Your Bloodhound post will be something my audience will surely want to read. This is an outstanding subject for academic discussion, as most folks would love to read what you have to say.
It appears we’ll have dueling blog posts – and everyone will benefit.
If I may weigh in here while trying to get these new listings in the computer…
Mike – you bring up good points. But there are points to ponder. I’m sure Jeff will touch on those.
One of the things you said…
** My second year of school I managed quite a bit of money ($10 million) in a market neutral hedge fund. Year over year we were returning on average 12-15% and we were just a bunch of students. We were about 50% leverage and our risk profile was surprisingly low. **
That is terrific. But there are an aweful lot of people out there with less than $10,000,000 floating around.
Real estate lets Average Joe’s like myself begin to build wealth. I was never, repeat, never going to be able to get enough money together to make a splash in the stock market, hedge funds, etc. Leveraged or otherwise.
But I was able to buy my first property on a contract for deed that I sold a few years later for $25,000 to move to other properties.
I didn’t take your comment harshly, either. In fact, I love a good discussion. It should be intersting to see where Jeff will take this. But I just thought I’d throw that in, as well.
All good points Chris.
I’ll not comment either way as I’m now sensitive to giving too much of a preview of my upcoming post.
It’s my bet you’re even money to end up with $10Mil by the way.
Chris,
My job was to manage the money, which came from many individual investors much like yourself. Anyone with a few thousand dollars and an Etrade account can get into these funds. Granted the best funds are reserved for the heavy hitters, which start at $1 million to get in the door. There are still plenty of funds out their, with no load fees that are open to the average investor. Like Jeff, I wont go too far, but I definitely feel like any investor can do as good in the stock market.
I loved the article but I really don’t understand the math.
I’m just learning to use my hp-12c calculator, so please bear with me if I screw up.
Using 10% down, $100K would buy $1M in real estate.
Future Value in 10 years $1,491,000
Less remaining bal. after 10 yrs $772,000
Gross equity $719,000
Less 8% of future value $119,000
Net Equity $599,000
$100K growing to $599K in 10 years is 18.4%
Take Care!
Allen — I’ll accept your future value.
On your 12C do the following:
10 n -100,000 PV 0 PMT 599,000 FV Hit i
19.6% is what my 12C comes up with three times running.
Thanks! The number just keeps getting better!
So, do you know off-hand the numbers (n,i,pv,etc) that resulted in you ending up with $458,000? Just curious…
Also, if you have to put 25% things do not look that much better for real estate (neglecting the benefits of depreciation).
I was wondering…can 10% get you break-even or better on cash flow?
Thanks again and take care!
Allen — Yer welcome.
That number was hit by doing exchanges along the way, if memory serves. I didn’t just invest and hold for the entire period. Does that help?
Even if you put 25% down, Allen, look what has to happen with your stock investments just to stay EVEN.
Example: If you RE investment appreciates at 4%/yr that means your stocks must appreicate 16%/yr to remain even. Though that happens sometimes, it’s not likely to maintain that level for a decade. It’s merely the benefits of using leverage. Using leverage in the stock market is orders of magnitude riskier than in real estate.
10% can indeed get you a break-even or cash flow. The problem with that is Murphy. (Hence the Sominex Account) Even if the investor is visited by Uncle Murph, the AFTER TAX cash flow will no doubt be positive. Try that with the stock market. Of course the stock guy will cite dividends as positive before AND after cash flow.
That argument is too weak to spend time addressing. Suffice to say if yer happy with the relatively reduced returns of the stock market, and their embarrassingly low and TAXABLE dividends, go for it.
I prefer prudent leverage backed by solid research, and a generous cash reserve.
Great discussion.
Hate to get too technical, but to get to a true apples to apples analytical tradeoff, it seems like that in addition to considering after tax cash flows with equal leverage(including all transaction costs and the tax benefits of rental property write offs), we need to include something like a Sharpe ratio that accounts for the respective historic volatility differences that are discussed above. This is the only way I can think of to account for different expected volatilities.
Has anyone seen an analysis that takes all of the above into account?
Mark — You can do that if you wish.
However, take any 10, 20, or even 30 year period and compare dollars in to dollars out — while factoring in after tax cash flow.
The S & P has for its first 55 years averaged less than 8.5% annual return.
The volatility is already included in any time period you wish to measure. Dollars in vs dollars out. Pick an historical time period. Stocks lose every time. Regardless of the period, as long as it’s at least a decade or so, volatility doesn’t change the results.
Sometimes RE rules, sometimes it’s stocks. Sometimes their both simultaneously up or down.
Nothing changes over the long haul. RE wins.
Leverage is applied to real estate with almost infinitely more safety and prudence than the stock market. Buying stocks on margin isn’t even in the same galaxy as leverage in real estate.
Game — set — match.
Hi Jeff, I can’t seem to find the follow up post to this in response to Michael Cook’s post:
http://www.bloodhoundrealty.com/BloodhoundBlog/?p=1685
Can you point me to it?
Thanks!
I frankly don’t remember if it’s at BHB, or here myself. Sorry.
I’ll try to find it during the week.
Your real estate portfolio is also subject to outside factors, but not nearly to the extent as the stock market. You can pick where, when, why, how, and in the end, do it all with reasonable confidence that the big picture will show you with an even bigger smile. One area is down, the next isn’t. San Diego is down now, while much of Texas is the real deal. Phoenix is waiting to bounce back, while Kansas City just keeps cooking along.
========================
Best Stocks and Shares ISA