Is Real Estate A Better Investment Than Stocks?

If you purchased a rental property home in the Easy Bay region of San Francisco Bay Area for $110,000 in 1981 and sold it in 2011 for $400,000 and collected rent would that be better than stocks? (This ignores commissions and closing costs, which are significant). Assuming a gross rent of about 6% of value and a 30% haircut for expenses for an absentee owned rental property this would result in about a 4.2% dividend (averaging roughly $980 monthly over 30 years) assuming no mortgage. This produces an 11.67% annual IRR, assuming dividends were reinvested at the same rate. This study does not consider taxes.

How it would compare

Compare that with the Dow Jones Industrials. If you purchased $110,000 worth in 1981 when the price was 900 points, now worth 12,500 points (which is $1,527,777) with a 2% dividend (averaging $1,222 monthly dividend assuming a median value of $733,700), and assuming no debt was used. This assumes dividends were reinvested at the same rate and ignores taxes. 15.4% IRR.

From a risk-adjusted viewpoint of Sharpe ratio or Information ratio the stock portfolio was far safer since it is diversified and liquid. From a convenience standpoint stocks are more convenient due to their ability to obtain a “no qualification” margin loan of 70% if the purpose of the loan is something not related to securities. This could be useful if someone had a personal problem they could raise cash without having to sell or refinance their rental house. From a tax standpoint the larger amount of capital gains from stocks produce even greater after-tax benefits to stocks than to real estate.

The rental income net profit is taxed at ordinary income rates, but the dividends and capital gains are taxed at the 15% dividend rate. (The rates were higher before 2003, but still favored stocks). The study is a bit simplistic because the dividend reinvestment rate in the 2000-2011 period was certainly not at the long term 30 year IRR of 15.4%, but was more like 3%. The investor would need to have another source of cash to pay taxes in order to create these type of compound returns, and that would create an opportunity cost. Rental real estate has the ability to do a tax-deferred exchange, stocks don’t. But ultimately capital gains have to be paid when assets are sold unless the owner dies and basis is stepped-up.

The study doesn’t consider depreciation deductions on rental real estate, but they last for 27.5 years, and are recaptured when the property is sold and are only on the “improvements” (the building). Since land is what really is a large part of an urban property then depreciation deductions are not that significant and they must be paid back. In this example the depreciation would be about $2,000 a year or about an extra $700 a year in “tax savings” which is repaid to the IRS when the property is sold. One plus for rental real estate is that when rental real estate is sold at a loss, the losses are categorized as a “business loss” and are thus fully deductible; by contrast stock market loss deductions are limited to $3,000 a year.

If someone was afraid that being a renter and owning only stocks would cause him to miss out on the great real estate boom of the past 30 years they could have put some of their stocks into shares of Real Estate Investment Trusts (REIT’s).

If someone says real estate is better than stocks because it allows more leverage, my objections to that are: investment options should be reviewed assuming they somehow could be bought for all cash. That is how it is taught in commercial real estate and the Modigliani-Miller theory in stocks agrees with that indirectly. Further, leverage is dangerous as many overleveraged home owners found out. To be safe a rental property investor should put a down payment (at most times in history) of roughly 40% plus closing costs to get a breakeven cash flow; further he would have to segregate some cash for reserves for future maintenance and vacancies, which does not occur with a passive stock portfolio.

What is interesting is that my study looks at the best 30 years of real estate. The future may be a stagnant market with no appreciation until 2016 or later and then it may only appreciate by the rate of growth in the overall economy, which is now at roughly 2%. Further, my opinion is that real estate’s number one appreciation factor is growth in the personal earned income of the local community. So if earned income stays stagnant with a zero real growth rate then real estate will not appreciate. Add to that a rate increase by the Fed to normal levels and real estate will go down even after the real market has healed!

Another caveat: stocks are overpriced, so to be fair the study should assume they go down about 33% and settle at roughly 8,000 or 9,000 for the Dow. Even then real estate is not as good. Besides real estate still needs to go down a little bit more, perhaps 10 to 20%.

 

Lessons learned from the generational bubble:

Real estate did worse than stocks partly because it is undiversified, and over-leveraged. Its potential tax rewards hypnotized investors and made them too eager to buy, so they overpaid for an asset with a perceived tax shelter value. Its ability to provide a 30 year non-callable loan with leverage of 30 to one (for owner-occupied properties) rather than a callable margin loan on stocks with a 2 to 1 leverage ratio attracted people who wanted leverage and that made buyers too emotional.

This article does not discuss bonds, it is merely a comparison between stocks versus real estate.

About the author

Don Martin, CFP®

2 Comments

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  • Another view: I put 30% down on all my properties, avg. $350 each per month cash flow. Unlike stock the value can go to zero and I still make money every month and have 100% controll. Been retired since I was 42 now, 65.
    Would love to find something else to invest in with good returns and controll such as money lending (tired landloard).

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