Stocks Versus Real Estate Investing

 The proponents of leverage argue that real estate has numerous advantages over stock investing. A Warren Buffett business perspective investor would argue though that a consumer monopoly stock investment is far superior to a rental investment due to its strong economics and the potential reinvestment value.  

Here are the advantages to rental according to the property investment proponents.

Ten Advantages of Real Estate

Cash Flow

The chief thing regarding cash flow is that the property is self-maintaining as far as expenses go. It is a business model in itself – the income minus the outflow equals the cash flow. All expenses should first be covered in order for the investment to make sense and secondly the property should generate cash flow which adds icing to the cake of property appreciation. When comparing real estate investing to stock investing, it is important to not only compare the national average real estate appreciation rate of 6% to the historic average stock market return of 10%, you must also factor in the cash flow received.

In addition, the cash flow is passive. Although you might have to handle tenant issues, arrange for repairs or do them yourself, your physical presence is not required 100% of the time in order to generate the income. In the stock universe, relatively, cash flow must be generated via dividends unless you plan on dipping into capital gains or principle. Although it is not impossible to generate a healthy amount of cash flow through dividends, it is difficult to find yields that match ten to fifteen percent rates of return on money invested in rental property. Additionally, dividend stocks must be monitored for dividend cuts and omissions, just as rental property must be managed for vacancy and repairs and maintenance.

An individual is financially independent once their monthly passive cash flow is equal to or greater than their monthly expenses.

Control

In the stock universe the individual stock investor does not have much control over a business’s operations or management – unless of course you are Warren Buffet and own a controlling interest. Thus, it is really difficult to have an impact on the company’s financial results.  If you own shares of Coca Cola, you can buy up all of the Coke at your local super market in order to ratchet up sales but we both have to agree, this would be a fruitless effort.

In the real estate universe, if you own a rental property, you can increase rents, screen tenants, throw in some new landscaping, paint the walls, drive by the property in the evenings and check its appearance. If rents drop in the area by $25 you can drop your rent rates and keep vacancy rates low. If prices go up, you can raise rents. In real estate you have much more control over the investment, unless of course you use property management. In stocks, the control comes through the initial and follow-up analysis in order to make buy, sell and hold decisions.

There exists a hypocrisy in the land of rental property though. If you manage the property yourself in order to gain control then the property is no longer a passive investment. If on the other hand you hire property management, the property is now move of a passive investment but you have minimal control … just like a mutual fund.

Appreciation

Real estate on average appreciates 6% nationally. Although this has not been the case recently, when comparing apples to apples, let’s use the long-term returns for both stocks and property. Stocks appreciate on average at 10% over the long-term, real estate at 6%. The problem with the simple 10% versus 6% rate comparison, from a property investor’s point of view, is that it does not take leverage into account.

Leverage

If you put $20,000 down on a $100,000 property and it generates $3,000 a year in cash flow, what is your rate of return? It is $3,000/$20,000 or 15%.

If the property increases in value by 6%, how much have you gained?

Answer: $100,000 x 6% = $6,000

How much of a rate of return is this over your initial investment?

Answer: $6,000/$20,000 = 30%

When you add this to your $3,000 of cash flow, your true rate of return is $9,000/$20,000 or 45%.

If you took that money instead and invested it in a stock mutual fund, how much rate of return would you expect? 

Answer: 10% over the long haul.

Stocks 10%

Real Estate 45% … when you account for leverage which can swing both ways.

‘Nuff said.

Additionally, one of the pros of a rental real estate investment is that the tenant is essentially paying down the mortgage and buying the asset for you over time.

Depreciation

This is one of those lovely phantom tax deductions a property investor gets to claim at the end of the year that will turn rental money into 0% tax money. According to Rich Dad, your earned income is taxed at 50%, your portfolio income or dividend income is taxed at 15% and your passive or rental income can be taxed at 0%.

Here’s how:

You get to depreciate residential real estate property over 27.5 years and commercial over 39 years. If you cash flow at $20,000 a year out of your property but have depreciation of $25,000, you have a tax loss of $5,000 and no tax is paid on income. Sure, it is easy to argue that the property is actually depreciating and generating a real repair cost, but this expense is already factored in in the income statement.

The Depreciation Equation:

(Total Asset Value – Land Value) / Depreciable Years = Annual Depreciation

Refinance

If you increase the property value you can refinance it and withdraw the money tax free. Say you finance a $200,000 property and through a property improvement plan (reduction in vacancy rates due to more thorough tenant screening, an increase in rents based on a rent premium for ground floor apartments, etcetera) the property is now worth $250,000. You can now refinance the property at $250,000 pay off the initial $200,000 and withdraw the $50,000 tax free.

Asset Protection

Two things here: insurance and incorporation. If a stock drops 50% in value, what protection do you have? Perhaps a stop loss order or a put option? If a rental property investment burns down, what protection do you have?

Answer: insurance

The second form of protection is incorporation. By placing your property in the bucket of a legal entity, you shield your personal assets should from most legal attacks stemming from the property.

1031 Exchanges

A property investor can roll over property gains tax free by buying bigger properties using a 1031 Exchange. The capital gains do not go away – they carry forward but by using a 1031 exchange, you can continue to roll those gains into bigger and hopefully better properties tax free. If you finish and choose not to hold the last property or roll it, you will have tax consequences.

Hedge Against Inflation

Because real estate is a tangible asset, it will generally rise at the rate of inflation or higher. Historically inflation has averaged 4.1% a year. That means real estate, with its average, historical appreciation of 6% has beaten inflation by nearly 2% and this does not take into account cash flow.

A Physical Asset

You can walk up to a piece of property and touch it. You can inspect it, you can visit the tenants, you can see cracks forming in the walls. With a stock, in a lot of respects, it exists out in the ether. Sure if you own Coke you can drink a Coke and you can go visit Coke headquarters in Atlanta. But the investment truly lives throughout the intricate business model which you do not directly manage. A property on the other hand, can be managed directly by you.

In Conclusion

To sum up there are many advantages in real estate investing over stock investing and many analysts neglect to make a fair comparison between the two. Many merely compare the 6% appreciation in real estate to the 10% return in stocks. What they are leaving out chiefly are the benefits of passive cash flow, leverage and depreciation. Once these three factors alone are included in the mix, it is clear that real estate has some unique advantages over stocks. I do not wholeheartedly endorse real estate investing by itself. I believe one must have a diversified investment strategy across the three investment asset classes of stocks, real estate and business, not just merely a handful of mutual funds.