As you work toward financial independence the question pops into your head: Which investment is best to get me there? Index funds usually, or at least should, top the list. Real estate is not far behind. People wrongly believe real estate is a better investment vehicle than a broad basket of stocks.
The first fallacy I hear when I inform clients of this misnomer is a list of all the people who made it big in real estate. The current U.S. President, they argue, made his money in real estate. Except he didn’t. He made most of his money licensing his name to real estate others own. When the President was in the real estate business big he also went through a wrenching bankruptcy.
Then, of course, I hear about the Carlton Sheets, the late night infomercial guy selling courses on how to make it big in real estate without any money down or work! If you bought one of those courses I have a beautiful tower in Paris I’d like to offer you for an unbelievable price if you act now. (By the way, Carlton makes his real money selling courses, not in real estate.)
Real estate isn’t as bad as I’m making it, but the numbers tell a story you should understand when adding real estate to your portfolio. There are decided differences between an investment property and an index fund. We will explore those differences and the historical returns on each.
Jeremy J. Siegel’s work on the historical performance of the stock market over the last 200 years is available in numerous editions of his bestselling book, Stocks for the Long Run. As much work as Siegel put into his research, the evidence is clear and simple to understand. Over long periods of time the stock market has a real return of around 7%, plus the inflation rate. The only time the market went for any meaningful period outside this norm is from 1966 to 1981 when interest rates and inflations were high. When inflation waned the market reverted back to the mean.
The story is an easy one to tell. Invest when money is available, don’t try to outguess the market by trading and wait a while.
Dividends tend to climb at a steadier rate than the overall market. Whereas the broad market can race ahead at times, it can also experience a temporary hissy fit. Dividends for the whole market rarely decline, but periodically do before resuming their upward march.
Index fund investing is also highly diversified. A total market or S&P 500 index fund spreads your investment over a vast range of industries. Index investing gives you exposure to large and small companies, including growth and value stocks.
The value of the broad market follows the growth of the economy, plus increases in productivity. Interest rates play a large role in determining the discounted value of future earnings.
The automatic advantages of index investing are absent in real estate unless you invest via a real estate investment trust (REIT).
Real Estate Investing
Dividends tend to be smaller than the cash flow from a real estate investment if it is an income property.
Your personal residence will not produce a rental income stream, but you avoid paying rent so there is an implied value.
Real estate values tend to track personal income. If prices get ahead of themselves buyers don’t have the income to support the payments, thus containing real estate gains.
Unlike index funds, real estate is local. Prices accelerating on the coast have nothing to do with prices of homes in the Midwest. Even the section of town a property is located in has an effect on the value and potential for future gains.
Buying a stock or mutual fund is the end of the work. Periodic review of the investment is the maximum extent of effort required to maintain the investment. Real estate holdings require continuous management.
Real estate has serious holding costs! Property taxes, insurance and maintenance are the obvious costs. If the property is used as a rental you have the cost of finding a tenant. If the tenant damages the property legal costs will be added to the mix.
Investment properties are considered passive income for tax purposes, but as any seasoned landlord can attest, it takes work to turn a profit on a real estate investment. Even with a property manager you need to remain active with your investment or serious losses can occur.
Real estate has one major advantage: rents. Rent income can spike the investment’s return.
Real estate also has a double edged sword: leverage. For a real estate investment to achieve close to stock market returns leverage must be used. And with leverage comes risk. The longer you maintain a high level of leverage (borrowed money compared to the value of the asset) the greater your investment return as long as prices are increasing. If prices stagnate or decline the real risk of bankruptcy rears its ugly head.
I’ve included two charts in this post. The first chart comes from Siegel’s work and shows the relatively stable rate of return of the stock market over long periods of time. Inflation affects results, but the market returns about 7% per year after inflation (real return). The inflation of the 70s smacked the stock market around while rallying smartly in the 80s when inflation and interest rates declined.
The second chart compares real estate to the S&P 500 from 1977 to 2014. This chart unfairly gives real estate an advantage. Real estate prices were moving higher fast in the late 1970s and early 1980s while the stock market was getting crushed until August of 1982.
Real estate was given a head start and still lost the race by a massive margin! In the 34 years covered the broad stock market returned nearly 2 ½ times what real estate did without the risk of leverage or the work real estate investments require. Even if you used no leverage, you needed to fund the property from other investments (lost opportunity cost) and if a roof or furnace died you would also need to use leverage or cash from other investments to cover the cost.
What the second chart doesn’t show is individual markets. Averages work wonderful for index funds, but are terrible for real estate. Real estate has more opportunities to find a hidden gem than individual stocks.
Tax laws have changed radically over the years as it applies to real estate.
Until a few years ago, dividends were taxed as ordinary income, but now are treated as long-term capital gains in most cases.
Tax laws favored real estate holdings in the 1970s and early 1980s. The 1981 and 1987 tax overhaul changed all that.
Real estate sometimes has other serious tax issues such as depreciation recapture.
Both real estate and index funds tax income currently (unless held inside a retirement account (easier for an index fund than real estate)). Both investments enjoy long-term capital gains treatment if held for a year or longer.
Rent profits are treated as ordinary income and taxed higher than most index fund profits/dividends. Losses are limited to each: real estate is limited to $25,000 under passive activity rules if you are not a real estate professional and capital losses on index funds are limited to $3,000 per year against other income.
REITs are taxed as ordinary income and are required to distribute 90% of gains each year. The REIT itself does not pay taxes; they pass the bill on to investors.
The Best Investment
It might sound strange coming from a man who owned millions in real estate over the years, but real estate is frequently a poor performing asset compared to equities (stocks; business ownership). That said I still own my home and farm, office building and paper on some real estate.
Real estate has a home in many portfolios. I always cringe when I see people overloaded with real estate compared to other more liquid investments. I understand the risks of leverage and the capital requirements real estate frequently demands.
Investing in the stock market can be made automatic. Real estate is less forgiving.
Buying in a down market or distressed properties has its adherents. If the right property shows up I’m always happy to buy it and sometimes do.
My experience also gives me an advantage when it comes to determining which investments are best. As the owner of a tax practice for over 30 years I know who is winning who is and losing. Landlords have the distinction of having more bankruptcies of any client class in my office. They also are among the richest.
Leverage determines the winners. Property investors who pay down and eliminate leverage fast have less risk. Those who manage their properties as a business also do well. Those who buy a program thinking real estate is easy money go broke.
Real estate has one final advantage and it’s a big one: forced saving. The increase in property value is hard to access and it doesn’t always feel like value unless the property is sold. Mortgage payments applied to principle is another form of forced savings. “Good” investment property owners keep a cushion of cash for emergency property expenses which is another form of forced savings.
My successful investors don’t spend every penny of profit from their properties. There is a compounding effect with income properties harder to calculate than with equities (stocks).
A smart person will consider all traditional investments. Index funds should be a part of most portfolios. Real estate, for those who are interested in such investments, is a great way to round out a portfolio with a larger cash flow.
You can retire on real estate faster than index funds due to the extra cash flow investment properties provide. But you don’t want your eggs all in one real estate basket in case we end up back in 2008 again.