With Coronavirus in the news and stocks taking a beating in March, many people are wondering what to do with their money. Should you invest in real estate, stocks, or some other asset? Or should you hold onto your cash?
Will quarantine’s economic impact create new opportunities for investing?
In this article we compare stocks and real estate as investment vehicles.
Table of Contents:
|Real Estate||Stocks||It Depends|
|Which makes more money?||✓|
|Barrier to entry||✓|
|Control and options||✓|
What goals do you want to achieve with your investments?
What is the next big thing you plan on using your money for?
Is it your goal to buy a home in the next year? 5 years?
Buy a boat?
Pay for your kids college?
Financial planning involves answering key questions about what you want your money to do for you.
There is a time and place for each financial product.
Because of the fees and time involved with selling real estate, it should be used as a more long term investment than stocks.
That’s not to say you can’t invest in stocks for the long term. It just means that you shouldn’t invest in real estate if you’re planning on needing the money within a year or two.
There are exceptions to this, like wholesaling or flipping homes. But for most real estate investors, you should plan to hold onto your real estate investment for 5+ years.
Holding on to real estate longer tends to increase your ROI. Transaction fees accumulated from buying and selling real estate could be around 6-8% of the final sales price. The longer you own the property, these transaction fees are offset by the appreciation in the value of the property, homeowner benefits (if it’s a primary residence) and potential cash flow (if it’s an investment property).
Will investing in stocks or real estate make me more money?
We invest to make money. We want our money to work for us.
So, is real estate or stocks better for increasing your wealth? Let’s take a look at some numbers.
Real estate average annual appreciation in Pacific Beach since 2010 (1/1/2010 – 5/1/2020): 6.35%
Average annual stock appreciation in the S&P500 since 2010 (1/1/2010 – 5/1/2020): 10.57%
At a first glance, stocks seem to have a better rate of return, but that’s before we calculate leverage!
There are hundreds of ways to invest in both real estate and stocks. For most people, stocks are bought at full price, and real estate is bought with leverage.
What is leverage and how does it affect investing in real estate?
Approximately 70% of home buyers get a loan when buying a home.
When we calculate the returns on an investment, we use: cash invested vs cash received upon sale.
This creates a huge advantage for real estate investments.
For example (using the appreciation numbers above from 2010 – 2020):
If I invest $100,000 in the stock market, and the market increases 10% each year, in 5 years my stocks will be worth: $161,051. A 61% return on your money!
If I invest $100,000 in real estate, and get a 80% loan (a 20% down payment) to buy a $500,000 house, and that house’s value increases 6% each year, my house will be worth: $669,113. Your original $100,000 investment has now become $100,000 + $169,113 = $269,113. A 169% return on your money.
This doesn’t even include the principal payments you’ve made over the 5 years, which gives you even more equity (we will talk more about this below).
Leverage is how real estate can have a better ROI than stocks even if the annual returns from the stock market shows higher annual appreciation rates.
For the example above, a 10% annual increase (stocks) has a lower return than a 6% annual increase (real estate), because the 6% gain is applied on a number 5 times larger than the original investment.
There are ways to use leverage in the stock market, but it is far less common.
Real estate has tangible value
You need a place to live.
Real estate can solve that problem.
Investing in a home provides you with a stable housing situation. No need to worry about a landlord raising the rent, or selling the property on short notice.
Not only can you live in the property, there’s an element of pride in owning real estate. You can do (almost) whatever you want to it.
Your monthly housing expense becomes an investment.
Renting does nothing towards building wealth, outside of limiting your maintenance liability and giving you some flexibility. It’s a sunk cost, meaning that you’re going to have to pay for housing in some way or another.
Why not optimize a guaranteed monthly expense, your housing expense, into an investment?
Your monthly mortgage payments build wealth by paying down your principal on the mortgage.
For the example above, we did not factor in how much the $400,000 loan balance would have been paid down over the 5 years. So there could be another $40,000 increase in equity on top of the $169,113 appreciation on your initial $100,000 investment. Now the 5 year return is $309,113.
You’ve more than tripled your money!
Real estate has great tax benefits
Taxes can have a huge effect on the net gain of an investment. You might not notice it until you sell the investment, but it’s best to prepare yourself before making the investment.
The mortgage interest for real estate is tax deductible
You are usually able to use the interest paid on your mortgage as a tax deduction. So if you have $10,000 worth of interest, each year you will save ($10,000) * (your tax bracket). This could mean saving $2,500 – $4,000 each year.
Primary residence capital gains tax exclusion
On top of the above benefits, if the property you are selling is your primary residence you can exclude up to $250,000 ($500,000 if married) of capital gains when you sell your home!
For the example above, the $169,113 increase in your home’s value over 5 years would be tax free gains if the home is your primary residence.
This is a big deal!
The $61,051 increase in stocks would be taxed at the long term capital gains rate which could be 15%.
Investment property tax deductions
The exclusion of capital gains for selling a primary residence is huge, but does not apply to investment properties. However, investment properties offer other advantages, including cash flow and tax deductions.
You can write off interest payments, property management fees, maintenance expenses, and depreciate the building’s value as a deduction against the rental income.
Investment properties offer amazing passive income potential. Especially multi-unit properties which have better rental income : purchase price ratios.
Calculating the right downpayment and monthly expenses in order to make your property cash flow positive is important.
If you finance the purchase of your investment property and calculate the monthly expenses to match the rent, your tenants will be paying for your housing expenses for the life of the loan .
After the property is paid off, you will gain value from the appreciation in the value of the property, plus make rental income minus property expenses.
Stocks have tax deference and tax-free gain options
There are a ton of different investment vehicles that you can put stocks into.
With a traditional IRA, your invested amount can be deducted from your income, to lower your taxable income for that year.
With a Roth IRA, you don’t get any tax deductions in the year of investment, but your money will grow tax free. So when you take money out of your Roth IRA, it’s tax free.
Both IRA’s are long term investments and you’ll be penalized if you want to use the money before you turn 59 and a half years old, with some exceptions.
There are other ways to invest in stocks to avoid taxed gains, like a 529 account for your kids college education, but they are restrictive on how you use the money.
Real estate is harder than stocks to invest in, and has more fees.
If you have access to a bank account, investing in stocks is easy.
There are virtual real estate investment funds that are similar to stocks, but for the most part, real estate requires quite a bit more to get started.
The barrier to entry, including fees and time, is much higher for real estate.
Do you have less than $20,000 to invest?
If you have less than $20,000 to invest, you should invest in stocks.
Now, I can already hear the people who will think of exceptions to try and prove me wrong.
I know that there are some situations out there, where someone can buy a home with a VA loan, or a down payment assistance program, with $0 down. There are financing programs, or markets outside of San Diego, where you can purchase a home with less than $20,000.
In my opinion, that is a bad idea.
If you don’t have $20,000, I encourage you to invest in stocks, to build that pile up to at least $20,000 before investing in real estate.
Buying real estate typically has transaction fees that can range from $5,000 – $10,000. Lender, title and escrow fees are the big ones. Then you have inspections, appraisals and other smaller fees. Along with these, you will need a downpayment for a home and some cash set aside for moving, transitioning and repairing the property.
Buyers can negotiate to have these fees paid by the seller or lender, but typically they are out of pocket expenses.
On top of fees, real estate has some additional risk with the maintenance of the property. You don’t want to spend all of your cash on the home and then find out there’s an emergency repair needed.
In most cases, buyers will need substantially more than $20,000 to get into real estate. You can talk with a lender to find out what types of financing are available to you.
Save for real estate by investing in stocks
Stocks are a great way to start saving up for a downpayment to get into real estate. You can invest monthly into stocks and watch them grow into what could be your future down payment.
Stocks are faster and more liquid than real estate
Stocks can be bought and sold within seconds. Real estate can take months to sell and get your money out. Depending on the type of real estate and market conditions, it could take over a year to sell a property.
If you want to invest in something and get your money out within the next few years, stocks are the better option.
You have more control over real estate investments than stocks
Outside of picking the index, fund or particular stock, equities are pretty “hands off” investments.
This is great for some people.
You can switch stocks easily and shift your portfolio allocation within minutes.
With real estate, you can choose to manage an investment property yourself, or hire a property manager.
You can choose short term tenants or long term tenants.
You can decide if you want to upgrade the property to increase the value of the property and rental income.
You could flip properties, develop properties or leave them alone and collect rent.
You can also negotiate the price.
Stocks are sold at market price. You can try and wait until the stock price is the price you are targeting, but for the most part you are going to pay the listed price.
With real estate, you can negotiate the price and any repairs on both sides of the sale.
The higher barrier to entry for real estate creates fewer transactions than stocks.
In order to more frequently match a buyer and a seller, the market price of real estate is more negotiable than stocks.
This creates additional opportunities.
Cash flow from stocks vs real estate
Rental properties will generate monthly cashflow even when the market is going down.
There is some risk of tenants not paying rent. However, if you screen your tenants and communicate well you should minimize this risk.
Some stocks pay dividends, so you can receive dividend income. Dividend payment amounts are determined by the company, but in general are consistent or increase each year.
Dividends are usually calculated as a percentage of the company’s profit shared between shareholders. So if the company has a bad year, dividends could go down, or be $0.
Dividends are usually paid out by companies who have been around for a while. Although stable, the consistency of these companies limit the upside for rapid growth that some younger companies might offer.
When comparing real estate to stocks for cash flow, short term rentals will generate the highest cash flow. Vacation rentals require more work and have some additional risk (higher frequency of tenants means increased chances of getting a bad one, increased maintenance, and higher vacancy rates).
Long term rentals will usually generate higher passive income than stock dividends, but exceptions can be found. The profit from rental income will depend on the property expenses.
Real estate cash flow vs stocks for fixed income
There are many options for passive income. You can talk with a financial adviser to learn about insurance products, annuities and other forms of fixed income products.
Stocks will provide some passive income with minimal work.
If you invest in real estate, there will be more work involved but also more potential for fixed income.
Both stocks and real estate have risk
Both real estate and stocks can go down in value if more sellers enter the market and fewer buyers are buying.
We discussed liquidity earlier. If the market is going down, it may be easier and faster to sell stocks than real estate.
Stock prices change faster than real estate because of the time it takes to complete a transaction. Liquidity and tangibility cause the prices of real estate to be more stable than stocks.
This makes real estate safer than stocks.
Some financial insurance products can be set up to have a maximum amount of loss allowed from stocks, but these also restrict your gains.
Real estate does not have a product (that I know of) that can put a max on any potential losses. There are insurance products for real estate in case something bad happens, like property insurance, but nothing restricting depreciation of your properties value, or rental decreases.
Real estate has other risks, like maintenance liability or vacancy from tenants, but these are typically accounted for upon investment.
The time commitment for real estate is higher than for stocks
Buying, managing, maintaining and selling real estate takes considerable time and energy.
You could spend a couple of minutes buying and selling stocks each year.
Real estate will most likely take up hours, if not days of your year.
Is it a good time to invest in real estate or stocks?
Most professionals advise against trying to time the market. Continue to invest whenever you can, and over time, you should be able to achieve your financial goals.
It’s currently a seller’s market in Pacific Beach due to low inventory.
If you are in a position to make an investment, real estate can be a great way to diversify your investments and also generate positive cash flow.
There’s no universal answer when choosing between real estate or stocks.
It depends on your situation.
Stocks have more liquidity, flexibility and are easier to start with.
Real estate can turn a sunk cost (rent) into an investment. It provides security and a sense of pride for owning your own home. Real estate can turn into a business with positive monthly cashflow, which can also appreciate in value.
If you’re interested in talking with a real estate agent about investing, call us today.