Whether it's planning for retirement, saving for a college fund, or earning residual income, you need an investment strategy that fits your budget and your needs. Many individuals first consider turning to the stock market when they think of investing. While the market is a common investment option, there is another investment vehicle that could be more effective. Real estate investments offer an alternative to the stock market. Under the right circumstances, they may be low risk, may yield better returns, and generally offer greater diversification.
A decade ago, approximately two-thirds of American adults had money in the stock market. But after the Great Recession, job security, financial confidence, and the means by which investors invested their money were threatened, which all took a major toll on investment sentiment.
By 2016, market participation dropped to just over 50%. Americans are still recovering from the fallout and financial advisers often encourage them to invest in order to maximize their long-term returns. However, a majority of young adults aged 18 to 34 are ignoring this advice; instead, they're saving their money or investing in real estate.
- Investing in real estate or stocks is a personal choice and depends on an investor's pocketbook, risk tolerance, goals, and investment style.
- Real estate and stocks bring with them different risks and opportunities.
- Real estate is not as liquid, requires research, a large amount of money and time, but also provides passive rental income.
- Stocks are subject to market, economic, and inflationary risks, but do not require a big cash injection, and can be easily bought and sold.
Real Estate vs. Stock Investments
Investing in real estate or stocks is a personal choice, which means there's no better option. It all depends on the investor, their pocketbook, risk tolerance, goals, and investment style. It's safe to assume, though, that more people invest in the stock market—perhaps because it doesn't take much to buy stocks. With real estate, you're going to have to save and put a substantial amount of money down.
Approximately 15% of Americans invest in real estate outside of their primary residence. While more people own stocks or mutual funds, only 80% of stocks are held by 10% of the country's population. Many advisors may find it useful to discuss the options of both the stock market and the real estate market with their clients who are ready to invest.
For many prospective investors, real estate is appealing because it is a tangible asset that can be controlled, with the added benefit of diversification. Real estate investors own something concrete for which they can be accountable. But there are several considerations for advisors and investors when choosing between investing in stocks or real estate.
Compare Returns With Clients
For decades, stocks have averaged a compounded return of about 8% per year. Needless to say, there were periods with negative returns, too. But many investment firms are forecasting dramatically lower returns in the years ahead. Investing in the stock market makes sense when paired with benefits that boost your returns, such as company matching or catch-up contributions. But those perks are not always available and there is a limit to how much you can benefit from them. Investing in the stock market independently can be unpredictable and the return on investment is often lower than expected.
While comparing the returns of real estate and the stock market is an apples-to-oranges comparison—the factors affecting prices, values, and returns are very distinct—we can look at them just on the basis of value. Real estate has outperformed the stock market approximately two to one since 2000, earning 10.71% annually versus 5.43% for stocks. With this sharp contrast in return on investment, many money seekers want to cash in and leverage real estate by acquiring rental properties.
Generally, people buy real estate expecting it to significantly appreciate over time. In fact, it appreciates 3% to 4% per year on average nationally. However, investors benefit from the appreciation rental property, but also receive 8% to 12% per year in return on their investment from the income generated from renting out the property.
Real Estate vs. Stock Risks
The housing bubble and banking crisis brought a decline in value for investors in the real estate and the stock markets. But it's important to remember, that even though they were both affected during the Great Recession, they do come with very different risks.
There are a few things to consider when it comes to real estate and the risks associated with it. The most important risk that people fail to understand is that real estate requires a lot of research. It's not something you can go into headfirst and expect immediate results and returns. Real estate is not an asset that's easily liquidated, and it can't be cashed in quickly. This means you can't cash it in when you're in a bind.
For house flippers or those who have rental properties, there are risks that come with handling repairs or managing rentals on your own. Some of the main issues you'll come across are the great costs, not to mention the time and headache of having to deal with tenants. It isn't something you can do during your off-time—especially if it's a rental. Tenants will always need something, and you may not be able to put them off if there's an emergency. As an investor, you may want and need to consider hiring a contractor to handle repairs and renovations of your flip, or a property manager to oversee the upkeep of your rental. This may cut into your bottom line, but it does reduce your valuable time overseeing your investment.
The stock market is subject to several different kinds of risk: Market risk, economic risks, and inflationary risk.
First, stock values can be extremely volatile, which means their prices are subject to fluctuations in the market. Volatility can be caused by geopolitical as well as company-specific events. Say, for instance, a company has operations in another country. This foreign division is subject to the laws and rules of that nation. But if that country's economy has problems, or any political troubles arise, that company's stock may suffer. Stocks are also subject to the economic cycle as well as monetary policy, regulations, tax revisions, or even changes in the interest rates set by a country's central bank.
Other risks may stem from the investor himself. Investors who choose not to diversify their holdings, or rely on specific types of stocks are also setting themselves up for a higher risk. Consider this: Dividend-paying stocks can generate some reliable income, but it would take a considerable investment in a high dividend stock to generate enough income to sustain retirement without selling additional securities. Relying solely on high dividend stocks means an investor may miss out on opportunities for higher growth investments.
Benefits and Disadvantages
Pros and Cons of Real Estate
Real Estate investors have the ability to gain more leverage on their capital and see some tax benefits. Although real estate is not as liquid as the stock market, the long-term cash flow provides passive income and the promise of appreciation.
Despite this, it's important to consider the amount of money that goes into investing in real estate. Investors need to have the ability to secure a down payment and financing if they aren't making all-cash deals. Since real estate isn't as liquid, investors can't rely on selling their properties immediately when they may be in need. Other disadvantages include other costs associated with property management and the investment of time that goes into the building's upkeep.
Real estate can't be easily liquidated or sold quickly, while stocks can be traded with relative ease.
Pros and Cons of the Stock Market
For most investors, it does not take a huge cash infusion to get started in this market, making it an appealing option. Unlike real estate, stocks are liquid and are easily bought and sold, so you can rely on them in case of emergencies.
But, as noted above, stocks tend to be more volatile, leading to a more risky investment. Selling your stocks may result in a capital gains tax, making your tax burden much heavier. And unless you have a lot of money in the market, your holdings may not be very sizable.
Additional Factors to Consider
Purchasing property requires more initial capital than investing in stocks, mutual funds or even real estate investment trusts. However, when purchasing property, investors have more leverage over their money enabling them to buy a more valuable investment vehicle. Putting $25,000 into securities buys $25,000 in value. Conversely, the same investment in real estate could buy $125,000 in property with a mortgage and tax-deductible interest.
Cash garnered from rent is expected to cover the mortgage, insurance, property taxes, and repairs. But a well-managed property also generates income for the owners. Additional real estate investment benefits include depreciation and other tax write-offs.
Real estate generating monthly rental income can increase with inflation even in a rent-controlled area, which offers an additional advantage.
Another consideration is taxes after selling the investment. Selling stocks typically results in capital gains taxes. Real estate capital gains can be deferred if another property is purchased after the sale, called a 1031 exchange in the tax code.
The Bottom Line
Real estate and stocks both present risks and rewards. Investing in the stock market receives a lot of attention as a retirement investment vehicle, particularly for people who contribute regularly to a 401(k) or Roth IRA. However, diversification is important, especially when saving for the long term. Investors should opt for a variety of asset classes or sectors to reduce their risk. Investing in real estate is an ideal way to diversify your own investment portfolio, or your client's, while at the same time reducing risk and maximizing returns.
Ryan Boykin is the co-founder of Atlas Real Estate Group, a Denver-based full-service realty firm.