Whether it's planning for retirement, saving for a college fund or earning residual income, many individuals consider turning to the stock market first when it comes to investing. It's a common situation - people want to invest but often don't know where, how or what might yield the best result. While the stock market is a common approach to investing, there is another investment vehicle that could be more effective.
Real estate investments offer an alternative to the stock market and under the right circumstances, they are lower risk, yield better returns and offer greater diversification. A decade ago, approximately two-thirds of American adults had money in the stock market but, due to the Great Recession, American's sense of job security, financial confidence and their means to invest were threatened, taking a major toll on the willingness to invest. (For more from this author, see: Real Estate Rentals for Retirement Income and Building Wealth.)
By 2016, market participation dropped to just over 50%. Americans are still recovering from the fall out and financial advisors 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 saving their money or investing in real estate.
Today, approximately 15% of Americans have invested in real estate outside of their primary residence. While more people own stocks or mutual funds, the reality is that 80% of stocks in the country are held by 10% of the 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 something tangible 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. There were, however, periods with negative returns and 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.
In fact, 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, with rental properties not only do investors benefit from appreciation, but they can also receive 8% to 12% per year in return on their investment from the income generated from renting out the property. (For more from this author, see: 8 Questions to Ask Before Managing Rental Properties.)
The Risks of Real Estate Versus Stocks
The burst of the housing bubble and the banking crisis saw a decline in value for both types of investments. However, they have very different risks.
Stocks are liquid and easily bought and sold. For most investors, it does not take a huge cash infusion to get started in this market, making it an appealing option. However, stocks can be extremely volatile in value. High dividend 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. Further, relying solely on high dividend stocks could mean missing out on opportunities for higher growth investments.
While real estate may not be liquid, 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. However, one cannot venture into the real estate world without doing research. There are risks in real estate, such as inability to sell and vacancies. But understanding the market and staying abreast of marketplace news and trends will help mitigate risks.
For people house flipping or planning to manage their own property, potential risks include inability to handle repairs or properly oversee the property. For larger properties, a property management firm is advisable since they can handle repairs and rent collections. Hiring one cuts into income but reduces the need to spend time on upkeep and it makes real estate a passive investment. Real estate is a long-term commitment. In essence, it becomes a forced retirement plan for investors, though investors will be grateful in the long-term when cash flow and wealth begins to build.
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 taxdeductible 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. (For more from this author, see: Explaining Rising Interest Rates and Real Estate to Clients.)
Ryan Boykin is co-founder of Atlas Real Estate Group, a Denver-based full-service realty firm.