Over the years, we've heard the arguments as to which is the better investment: real estate or stocks. Both have their advantages and disadvantages, and there are several aspects of each that make them unique investments in their own way. To make money with either investment requires that you understand the positives and negatives of both.
Real estate is something that you can physically touch and feel – it's a tangible good and, therefore, for many investors, feels more real. For many decades this investment has generated consistent wealth and long term appreciation for millions of people. Depending on the location of your real estate, you can enjoy sizable returns on your investment. Real estate investment site Biggerpockets.com produces an annual real estate investment index for major U.S. cities. According to their latest index for 2016, the area with the best returns is Dallas, TX where real estate investors saw 20.7% in unleveraged returns. While your returns may not be Texas big, investing in real estate can be very lucrative.(For more insights on the long-term average annual returns on real estate, see: What average annual return is average for a long-term investment in the real estate sector?)
There are two main types of real estate: commercial and residential. While other types exist (mobile home parks, strip malls, apartment buildings, office buildings, store fronts and single-family homes), they generally fall into those two categories. Making money in real estate isn't as cut-and-dry. Some people take the "home flipping" route – searching for distressed properties, refurbishing them and selling them for a profit at a higher market value. Others look for properties that can be rented to generate a consistent income.
Getting a mortgage to purchase a home gives you leverage, meaning that you can invest in different types of properties with less money down, helping to build your net worth or income that you could make off the properties. While this can be a positive, if this leverage is used incorrectly, you may owe more on the properties than they are actually worth. Thus, it is important to critically evaluate the terms of your loan and budget wisely.
Advantages of Investing in Real Estate
There are many positive benefits to investing in real estate, including depreciation (writing off wear and tear of a commercial property), tax deductions and finally, you can sell the property through what is know as a 1031 exchange, and will not have to pay capital gains taxes, as long as you invest the money into a similar kind of property type.
Disadvantages of Investing in Real Estate
Like all investments, real estate also has its drawbacks. Most importantly, the investment is illiquid. When you invest in a property, you usually cannot sell it right away. In many cases, you may have to hold the property for several years to realize its true profit potential. Also, the closing cost can add up to thousands of dollars, and include taxes, commissions, and fees. Further, real estate prices have a tendency to fluctuate. While long-term prices generally increase, there are times when prices could go down or stay flat. If you have borrowed too much against the property, you may have trouble making the payment with a property that is worth less money than the amount borrowed on it.
Finally, it's often hard to get diversified if investing in real estate. However, diversification is possible in real estate, provided that you do not concentrate on the same community and have a variety of different types of property. That being said, there is an additional way that you can be able to diversify in real estate through real estate investment trusts (REITs), under which you can purchase a trust that is invested in a large portfolio of real estate, and will offer you a dividend as a shareholder. However, in general, stocks offer more diversification because you can own many different industries and areas across the entire economy. (Learn more about REITs in our article Investing In Real Estate.)
Using the S&P 500 as a benchmark to illustrate the performance of stocks, the stock market has had an average annual rate of return of 10.31% from 1970-2016. It's important to use this figure as just a benchmark for the performance of U.S. stocks though as there are several other major indexes globally.
With a stock, you receive ownership in a company. When times are good, you will profit. During times of economic challenges, you may see diminishing funds as the earnings of the company drop. Taking a long-term approach and being balanced in many areas can help build your net worth at a much greater rate, compared with real estate.
As with real estate, financing in stocks allows you to use margin as leverage to increase the overall amount of shares that you own. The downside is that, if the stock position falls, you could have what is known as margin call. This is where the equity, in relation to the amount borrowed, has fallen below a certain level and money must be added to your account to bring that amount back up. If you fail to do this, the brokerage firm can sell the stock to recover the amount loaned to you. (Learn more about margin trading in our tutorial, Margin Trading.)
The Advantage of Stocks
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account – tax-free - until you start to withdraw the money. As well, many stocks can do considerably better than real estate in one year. Due to the volatility of some stocks, it is not unusual to see companies that are averaging 20% or even 50% growth in one year.
The Disadvantages of Stocks
Stocks can be very volatile, especially when the economy or the company is facing challenges. Also, stocks are often emotional investments, and your decisions within the market can often be irrational. Finally, bankruptcy is always in the back of the active stock investor's mind – as it should be, as your investment will be dissolved in this instance.
The Bottom Line
A good compromise when deciding between investing in the stock market and investing in real estate may be to own a REIT, which combines some of the benefits of stocks with some of the benefits of real estate. While each investment has its benefits and drawbacks, to decide which one would work well for you depends on your overall financial situation and level of comfort. (For further reading on real estate, take a look at Find Fortune In Commercial Real Estate.)