Many investors have traditionally turned to the stock market as a place to put their investing dollars. While stocks are a well-known investment option, not everyone knows that buying real estate is also considered an investment. Under the right circumstances, real estate offers an alternative that can be lower risk, yield better returns, and offer greater diversification.
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. Comparing an investment in real estate to buying stocks is a good place to start.
- The decision to invest in real estate or stocks is a personal choice that depends on your pocketbook, risk tolerance, goals, and investment style.
- Real estate and stocks have different risks and opportunities.
- Real estate is not as liquid, and it requires research, money and time. But it provides a passive income stream and the potential for substantial appreciation.
- Stocks are subject to market, economic, and inflationary risks, but don't require a big cash injection, and they generally can be easily bought and sold.
Real Estate vs. Stocks
Investing in real estate or stocks is a personal choice that depends on your pocketbook, risk tolerance, goals, and investment style. It's safe to assume that more people invest in the stock market, perhaps because it doesn't take as much time or money to buy stocks. If you're buying real estate, you're going to have to save and put down a substantial amount of money.
When you buy stocks, you buy a tiny piece of that company. In general, you make money two ways: As the value of the company's stock increases, the value of your investment goes up, too. And, depending on the company, you may receive regular dividends, which you can reinvest to grow your investment.
When you buy real estate, you acquire physical land or property. Most real estate investors make money by collecting rents (which can provide a steady income stream) and through appreciation, as the property's value goes up. Also, since real estate can be leveraged, it's possible to expand your holdings even if you can't afford to pay cash outright.
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 who buy property own something concrete for which they can be accountable. Note that this article does not focus on real estate investment trusts (REITs), which are a way to invest in real estate through financial products that are bought and sold like stocks.
There are a number of considerations for investors when choosing between investing in stocks or buying real estate as an investment.
Returns for Stock Market vs. Real Estate
Investing in the stock market makes the most 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.
Comparing the returns of real estate and the stock market is an apples-to-oranges comparison—the factors that affect prices, values, and returns are very distinct. However, we can get a general idea by comparing the S&P 500 ETF Total Return (SPY) and the Vanguard Real Estate ETF Total Return (VNQ):
Real Estate vs. Stock Risks
The housing bubble and banking crisis of 2008 brought a decline in value for investors in the real estate and the stock markets—and the COVID-19 crisis is doing it all over again, albeit for different reasons. Still, it's important to remember that stocks and real estate have very different risks overall.
Here are some things to consider when it comes to real estate and the risks associated with it. The most important risk that people miss is that real estate requires a lot of research. It's not something you can go into casually 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—as the coronavirus pandemic has demonstrated yet again—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 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.
Pros and Cons of Investing in Real Estate
Real estate investors have the ability to gain leverage on their capital and take advantage of substantial tax benefits. Although real estate is not nearly 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 real estate investments. You need to have the ability to secure a down payment and financing if you aren't making all-cash deals.
Since real estate isn't as liquid, you can't rely on selling your properties immediately when you may be in need. Other disadvantages include the costs associated with property management and the investment of time that goes into repairs and maintenance.
Hedge against inflation
Ability to leverage
More work than buying stocks
Expensive and illiquid
High transaction costs
Appreciation isn't guaranteed
Pros and Cons of the Stock Market
For most investors, it does not take a huge cash infusion to get started in the stock market, making it an appealing option. Unlike real estate, stocks are liquid and are generally easily bought and sold, so you can rely on them in case of emergencies. With so many stocks and ETFs to choose from, it can be easy to build a well-diversified portfolio.
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 able to grow much.
Easy to diversify
Low transaction fees
Easy to add to tax-advantaged retirement accounts
More volatile than real estate
Selling stocks can trigger big taxes
Some stocks move sideways for years
Potential for emotional investing
Additional Factors to Consider
Buying 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 that generates 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 investment portfolio, reduce risks, and maximize returns. Keep in mind that many investors put money into both the stock market and real estate. And if you like the idea of investing in real estate but don't want to own and manage properties, a real estate investment trust (REIT) might be worth a second look.