Real estate vs. the stock market, which is better?
Many of my colleagues express an interest in real estate investing. In fact, desire to invest in real estate appears to be far more common than desire to invest in stocks. I suspect that the main reason for this is not necessarily due to higher returns from real estate (which is debatable), but rather from apprehension of stocks and the stock market. I’ve talked to more than one colleague who voiced concerns that stock investments can “go to zero” (spoiler: they will not). In contrast, there is something tangible, familiar, and seemingly more accessible about real estate, even for someone who has no experience with any kind of investing.
Real estate is a fine investment. Many people have made fortunes with real estate, and some have called real estate the greatest investment in the world. But real estate is not without its downsides, and for many people, these downsides outweigh the benefits. Note that broadly speaking, there are two types of real estate investors: those who rent out real estate as landlords, and those who buy cheap, usually distressed properties and “flip” them for a profit, usually after some repairs and renovations. In this article I’ll focus on rental properties, as this style of real estate investing is more more passive, more scalable, and most closely resembles long-term stock investing.
What are the benefits of investing in real estate?
In my view, there are four main benefits to traditional real estate investing, where you actually go and buy rental properties.
Leverage. Leverage is investing with borrowed capital. Real estate has easily accessible leverage through mortgages. This allows an investor to pay a fraction of the cost of an investment upfront (i.e., 20% down), but still reap the full benefits of investment (i.e., rent). In fact, a common strategy in real estate investing is to take out mortgages for rental properties, and use rent to cover the mortgage payments. In this manner, a real estate investor can rapidly scale up their portfolio. The use of leverage allows an investor to receive greater returns than normal. While there are ways to leverage the stock market (for example, margin trading, options, and leveraged ETFs), these are complex strategies which greatly amplify risk, especially given the volatility of stock markets.
Cashflow. Real estate is known for high and consistent cashflow compared to other investment types. Cashflow is attractive to many investors, especially those who want to live off their investment income. While some stocks pay dividends, most companies do not pay monthly dividends, and stock dividends are generally much lower than rental income.
Low volatility. One major drawback to the stock market is significant volatility which spooks both new and experienced investors alike. While housing markets absolutely do fluctuate (and more than most people realize), the overall volatility of real estate is much lower compared to the stock market.
Covariance. In investing, covariance is the measure of the relationship between the returns of two investments. Real estate performance is not highly correlated with the performance of the stock market. This makes real estate an attractive asset class for many investors for the purpose of diversification, as the fundamental idea behind diversification is to reduce overall portfolio risk by holding uncorrelated assets.
Finally, as previously mentioned, many people have comfort and familiarity with real estate as a tangible asset. This advantage is probably more psychological than anything, but for many people, such advantages are important.
What are the drawbacks of investing in real estate?
As with all investments, buying and renting real estate has some serious downsides.
Real estate is highly illiquid. In fact, owning actual real estate is one of the most illiquid investments you can ever make. Should you ever find yourself in an emergency where you need to convert your investments to cash, you may end up waiting weeks, if not months, to sell, and possibly at a significant loss. You may also be forced to liquidate far in excess of your needs. By comparison, an investor in the stock market has much greater control over the timing and the amount of assets to liquidate.
Real estate has high maintenance costs. This comes in many forms, including major and minor repairs, renovations, general upkeep, property taxes, and insurance. Taxes alone usually represent at least 1% of a property’s value annually, and total costs can range anywhere between 2 to 5% annually as a conservative estimate. Furthermore, many of these costs are still incurred whether the property is occupied or not. Imagine a mutual fund with expense ratio above 2% - most investors would run far away from that and never look back.
High barrier to entry. Real estate has high capital requirements. Even when leveraging with a mortgage, it takes significant capital to make an initial real estate purchase, whereas any investor can open a brokerage account and start investing in index funds or ETFs with a few clicks and less than a hundred dollars. Real estate investors can incur significant opportunity costs from sitting on the sidelines while waiting to accumulate sufficient capital. Along the same lines, it is much more difficult to immediately reinvest the returns from real estate, as you must wait until you accumulate enough capital again to purchase another property.
Low diversification. In part due to the high capital requirements for each individual real estate asset, it is much more difficult for a retail investor to properly diversify. Most investors will only have enough time and capital to manage just a few properties located in close proximity geographically. A significant amount of their portfolio can be tied up in a single asset. In contrast, for about a hundred dollars, a stock investor can buy an ETF that holds hundreds or even thousands of companies.
High transaction costs. Whereas many brokerages now offer commission-free trades for stocks, mutual funds and ETFs, real estate transaction costs are extremely high by comparison, usually in the range of 6% or more of the property’s value. Worse, some of these costs are incurred both when buying and selling. Imagine a mutual fund with both a front load and a back load - such a fund would be universally avoided.
Real estate is not passive. Real estate investing requires time and effort. You are responsible for researching the market, applying for mortgages, buying properties, advertising them, finding tenants, making repairs, etc. You will also have to deal with people, in this case, your tenants. Your overall experience as a landlord will vary greatly based on your tenants. While I don’t think Reddit is an authoritative source on anything, a quick perusal of their landlord subreddit shows that the experiences of landlords are decidedly mixed. On the other hand, investing in the stock market can be almost entirely automated and passive. I really cannot emphasize this enough - investing in any stock, ETF or index fund happens instantaneously with a few mouse clicks, and you don’t have to talk to anyone. This might sound strange for a psychiatrist to say, but I know many people in medical professions who wish to avoid as much stress as possible outside of work. Finally, your time is not free; there is a real cost to your labor. The last (and only) time we bought a house, I can’t even count how many hours we spent on the process, and this time does not reflect on any financial statements.
To this last point, it is, of course, possible to hire a real estate management company to manage your properties for you. However, this still does not make real estate completely passive, and the management fees will eat into your returns. At that point, you are really no better off than just investing in REITs, or real estate investment trusts. A REIT is a special type of company that invests most of its assets and derives most of its profits from real estate. REITs are required by law to pay at least 90% of their taxable income back to shareholders as dividends. In fact, buying a REIT stock or fund is essentially the same as investing in professionally managed real estate. REITs eliminate several of the downsides of physical real estate (such as illiquidity, capital requirements, low diversification, time and effort), and are a great way to passively invest in a diversified portfolio of income-generating real estate.
How do real estate returns compare to stock market returns?
This is the million dollar question, because on the face of it, owning real estate seems to have more downsides than benefits. However, if real estate can consistently and significantly outperform the stock market, then the hassles of real estate may be worthwhile!
This question is surprisingly difficult to answer, because real estate investing runs the gamut from a landlord with a single rental property all the way to commercial real estate companies investing in apartments, stores, hospitals, office space, warehouses, and even timberland. Whereas the S&P 500 is often used as a proxy for US stock market returns, each type of real estate investment and each geographic location is a distinct investment with different returns. There is one total US stock market, but there are probably thousands or more real estate markets in the United States.
With regard to public and commercial real estate performance, we can look at the FTSE NAREIT index, which is a cap-weighted index tracking the performance of REITs, or real estate investment trusts. This is as close as we can get to a total public US real estate market. Keep in mind that REIT performance, in theory, should be similar to the returns of private real estate if you hired a company to manage your properties for you.
We can see that out to 30 years, the NAREIT index had almost identical performance to the S&P 500. Over shorter time periods, however, REIT and stock market performance can differ a lot. As previously mentioned, this is not a bad thing - low correlation with the stock market can provide diversification. However, evidence that REITs can outright outperform stocks in the long run is lacking.
When it comes to smaller, private real estate investments, such as rental properties, performance data is much harder to obtain. Whereas any investor can replicate another investor’s performance in the S&P 500 or a REIT index, it’s impossible for any landlord to replicate another landlord’s returns. Each landlord will experience very individualized results based on their property size, tenants, occupancy rate, local housing market, and a myriad of other factors, and much of this data is not publicly available.
I did find a 2015 paper for the National Bureau of Economic Research where the authors examined the total returns of Single Family Rentals (SFRs), including total house appreciation as well as total rental yield net of fees, from 1986 to 2014. They found that the national average annualized total returns for SFRs during this time period was 8.9%, although returns varied greatly (from 7.1% to 11.9%) depending on the city. They also found that in most cities (18 out of 30), rent income accounted for the majority of the total returns. However, in New York, Boston, Seattle, and every city in California, house price appreciation rather than rent accounted for the majority of the total returns. By comparison, the annualized total returns of the S&P 500 from the same time period (1986 to 2014) was 10.70%.
So when it comes to performance of private rental properties, the data is quite limited, as there is no national database or index. It is obvious, however, that returns can vary tremendously based on location and many other factors. At least during the time period of this particular study, single family rentals did not outperform the S&P 500 in returns.
Let me also dispel the notion that real estate is a good investment from capital appreciation alone. I have more than one colleague who believes that they can buy a piece of land or property, “sit” on it without needing to rent it out at all, and sell it in the future for high returns from skyrocketing home prices. Home prices do not increase nearly as rapidly as some people imagine. The S&P Corelogic Case-Shiller US National Home Price NSA index (which is based on the original Case-Shiller index) tracks single-family home prices over time. Let’s compare that with the S&P 500 index:
In this graph, I have normalized the S&P 500 to start at the same value as the S&P Case-Shiller home price index in 1975. The data shows that in the past 46 years, home prices increased by 4.9% annualized. During this same time period, the S&P 500 index price increased by 8.9% annualized, and the S&P 500 total returns (dividends reinvested) were 11.7%.
In fact, home prices barely increase by more than inflation over time, even going back to 1890. While there are outliers in certain markets, the overall data on this is indisputable. Robert Shiller, in his book Irrational Exuberance, explains that the common perception of constantly increasing home prices comes mostly from psychological factors. Because homes are infrequent purchases, people are often surprised by the increase in home price of a new home compared to their previous home from years or decades ago. In reality, the interval increase in home prices are mostly explained by inflation. If you buy real estate as an investment, you must generate income from it. Waiting for capital appreciation alone is not a viable investment strategy!
My conclusion, from looking at all this data, is that public REITs have long-term performance that is broadly similar to the stock market, but private rental property returns seem disappointing, especially considering the effort involved. In fact, when taxes are considered, all types of real estate may underperform the market, as real estate derives more of its total returns from dividends or rent, whereas stocks derive more of its total returns from asset appreciation. With stocks, an investor can better control the timing of taxable events in the form of capital gains, and during the accumulation phase, a stock investor can experience significant portfolio growth without needing to pay much in taxes at all.
Do I invest in real estate?
Currently, I do not own any physical real estate investments. Despite the potential drawbacks, I am personally less concerned about the illiquidity, poor diversification, or capital requirements of real estate investing. For me, the reasons for not having any rental properties are two-fold. First, I have a full time job and I do not have the time or inclination to learn the real estate market or manage a rental property. My index funds will never call me at 2 am to complain that the air conditioner just broke. Secondly, and most importantly, I can overlook the first reason if returns on investment are high enough, but I am not convinced that rental properties bring sufficient total returns, compared to stocks, to justify any additional work and effort. With that said, I do have some REITs in my portfolio (and I should point out that if you own a total stock market index fund, you too already own some REITs in proportion to their market cap compared to the overall market; usually about 3 to 5%). My stance on real estate may change in the future, but for now, I am satisfied with the ease and passivity of index fund and REIT investments.
Happy investing!
