Investing in real estate and investing in the stock market represent two of the most reliable paths to wealth for most people.
However, it can be a challenge to determine which asset class to buy more heavily into, and how to balance both asset classes within your overall portfolio. This article looks at the pros, cons, and details of both real estate and stocks to help you make informed decisions on comparing and combining these two important asset classes into your financial plan.
Real Estate vs Stocks: Markets Compared
The U.S. stock market, closely represented by the Wilshire 5000 total market index, is worth about $30 trillion. Investors have easy access to foreign stocks through index funds and other financial products as well, which collectively are also worth tens of trillions of dollars.
Similarly, the real estate database Zillow reports that the U.S. housing market is worth over $33 trillion. The National Association of Real Estate Investment Trusts (Nareit) further estimates that the U.S. commercial real estate market is worth about half of that. The total value of residential and commercial property in the U.S. is therefore worth upwards of $50 trillion or more.
Along with bonds and cash, these two markets represent the bulk of American wealth. The same is also generally true for other countries for foreign stocks and real estate, although real estate often plays a proportionally larger share in many countries.
The stock market is historically more liquid and hands-off, meaning that it’s easier to compound wealth over decades with little or no time or input from you besides putting in money. The real estate market is historically more hands-on, but with less volatility and more opportunity to use prudent leverage in the form of mortgage loans. However, real estate investment trusts (REITs), including index funds comprised of REITs, have increased the liquidity, passiveness and accessibility of investing in commercial real estate in recent years.
Real Estate Historical Returns
Measuring historical returns in the real estate market is a far more complex task than it is for the stock market because there are so many more variables involved.
Dr. Robert Shiller, distinguished professor of economics at Yale University, maintains one of the biggest datasets for housing prices. It goes back to 1890 and shows that over the past 13 decades, inflation has averaged 2.77% per year and home prices have grown at an average rate of 3.22% per year, meaning that the real inflation-adjusted long-term price appreciation rate for housing prices has averaged under 0.5% per year.
The face value of house prices in dollar terms has increased by a tremendous amount thanks to the slow grind of inflation, but in terms of real inflation-adjusted purchasing power they often go for decades with no increase. Only in the past two decades have there been massive gains in real inflation-adjusted average housing prices.
However, the actual returns from the housing market involve many more variables than just house prices themselves. On the negative side, an investor must consider property taxes, insurance, and maintenance. On the positive side, an investment property typically produces rental cash flows which ideally offset all of the expenses to produce a rate of return that significantly exceeds inflation.
Real Estate Expenses
Property taxes range from well under 1% per year to more than 2% per year depending on what area of the country a piece of real estate is located in. This map by the Tax Foundation gives a good visual reference for property taxes around the country.
Home insurance prices vary considerably by location as well. Due to the threat of hurricanes, the cost of insurance in Florida can be more than 1.5% of a home’s value per year, while in many states it is below 1% or even 0.5%.
A common rule of thumb in the real estate industry is to save 1% of a home’s value for maintenance each year. This of course could be less for condos or new houses, and could be far more for aging houses.
Lastly, landscaping and property management are additional expenses for hands-off owners of investment properties. Property management services for investment properties are often priced at around 10% of monthly rent. Hands-on investors can do these services themselves.
Adding these expenses together comes to 2-4% of the property value per year depending on where the property is located and what kind of shape it is in. This completely offsets the average long-term average house price appreciation rate per year from Professor Shiller’s data.
In addition to these recurring expenses, closing costs are a one-time expense associated with buying a property. According to Zillow, closing costs typically fall between 2% and 5% of a home’s value.
A final shadow expense to consider is a property’s impact on your time, and time is money. It takes a large number of hours to research properties, negotiate a price, secure financing, and then oversee the property. This time commitment can be mitigated with a property manager, but still requires considerable up-front work and then some degree of time commitment and awareness.
For example, if you and your spouse each make $50 per hour in total compensation from your work, and you collectively spend 100 hours to research and buy a house, that’s the equivalent of $5,000 in time value that you invested into the property. Then, if you spend one hour per month overseeing the property, that comes out to another $600 of your time value each year. If you don’t use a property manager, your monthly commitment could be much higher.
Real Estate Cash Flows
In addition to coming with a host of expenses, real estate produces cash flows.
One of the most important metrics for a real estate investment is the capitalization rate, or cap rate for short.
The cap rate is the unlevered income return that a property can produce per year, and is calculated by taking the expected rent and subtracting all recurring expenses except for mortgage interest, and then dividing that figure by the market value of the property.
For example, if a single-family home can be rented for $1,500 per month ($18,000 per year), while expenses are $500 per month ($6,000 per year), then the income from the property is $12,000 per year. If the home currently has a market value of $200,000, then the cap rate is equal to $12,000 divided by $200,000, which comes to 6%. The property owner can then also benefit from potential long-term price appreciation in the market value of the property.
Cap rates are typically low for highly desirable locations with high levels of historical property price appreciation, such as major coastal cities where demand frequently exceeds supply. In these cases, most of the returns are expected to come from appreciation while cash flows barely cover expenses. In contrast, cap rates tend to be low for cooler real estate markets with more flexible supply characteristics, where the cash flows rather than price appreciation are expected to produce the bulk of the total returns.
Overall, the sum of the cap rate and the annual price appreciation of the home represent the unlevered total return that a property is expected to produce. For example, a property with a 6% cap rate and 3% annual average price appreciation can be expected to produce a 9% annual long-term total rate of return, or a bit less when closing costs are factored in.
This total rate of return can be increased with the prudent use of leverage. Since residential real estate tends to be less volatile than the stock market, banks and other lenders allow for significant levels of leverage at low-interest rates.
Real Estate Total Return Example
Suppose an investor buys a property with the following characteristics:
- Buying price: $250,000
- Closing costs: 2.5% of property value
- Annual maintenance per year: 1% of property value
- Annual property tax: 1% of property value
- Annual insurance cost: 0.5% of property value
- Long-term price appreciation: 2.5% per year
- Long-term inflation rate: 2.0% per year
- Monthly rent: $2,000/month initial, increases with inflation
- Property management fee: 10% of rent
- The property is sold after 30 years
The cap rate in this example starts at just over 6% and ends at just under 5% because the home price appreciates slightly faster than rent price inflation.
Scenario 1: No Leverage
Over the 30-year period, the property is expected to produce an 8% annual rate of return under these conditions without leverage. This expected return is slightly lower than the sum of the cap rate and the appreciation rate due to initial closing costs.
A large portion of the return in this example is in the form of income. The property generates a 5-6% cash yield per year which is better than investors will find from most safe dividend stocks.
Scenario 2: Leveraged
If the property is bought with a 25% down payment and 75% with a mortgage at a 5.5% interest rate, the expected total return is about 10.7% per year. Note that interest rates for mortgages on investment properties are generally higher than interest rates for your primary residence, all else being equal.
In exchange for likely producing a higher total rate of return, the leveraged property has more risk and produces a much lower cash yield because most of the net income goes towards the mortgage each year. However, if the property is held past its mortgage payoff date rather than sold, it could become an unlevered property that produces high income in retirement.
The expected returns of both the leveraged and unleveraged examples could fall short if the property fails to appreciate in price as expected, requires more maintenance than expected, or has a higher vacancy rate than expected.
REIT Historical Returns
Real Estate Investment Trusts (REITs) are companies that operate or finance real estate and are often publicly traded like other stocks. Therefore, they can be thought of as a blended asset class between stocks and real estate that behave mostly like stocks. In fact, we think that every portfolio benefits from REITs.
REITs are not necessarily a substitute for, or directly comparable to, owning a rental property. If you look at an index fund like the Vanguard Real Estate ETF (ticker: VNQ) for example, you’ll see that less than 15% of the value of the fund is invested in residential real estate. The rest is invested in a diverse mix of commercial properties including office space, healthcare properties, cell towers, data centers, logistics properties, hotels, and retail space.
Nonetheless, REITs have historically provided very good returns. Nareit’s set of REIT indices go back to the beginning of 1972, and their equity REIT index has grown by an average of almost 11.5% per year from 1972 to the end of 2018.
In addition, REITs typically offer higher dividend yields than most other stock sectors. While the S&P 500 currently has a dividend yield of below 2% per year, REIT indices currently yield 3-5% per year.
Stock Market Historic Returns
From the beginning of 1972 to the end of 2018, the S&P 500 grew by an average of 10.2% per year according to data from NYU. The S&P 500 represents the top 500 publicly-traded companies in the United States. Over the same 1972-2018 period, the MSCI EAFE index that represents most other developed countries has grown by about 9% per year on average.
The returns come from a combination of dividends and stock price appreciation. Companies reinvest their profits into growth and acquisitions, and give excess capital back to shareholders in the form of dividends and share buybacks. Research by J.P. Morgan shows that dividends have historically contributed about a third of total returns going back to 1950 while capital appreciation has contributed the other two-thirds:
Using leverage in the form of margin loans is considered very risky for stocks and is usually not a good idea. Since stock indices are volatile, and individual stocks can be far more volatile than the indices, margin lenders typically charge fairly high interest rates on margin loans, and leverage must be kept at conservative levels. Using margin debt at high levels can result in investors being forced to sell their holdings during a market crash in order to meet a margin call, and thus miss out on the subsequent recovery.
Personal Considerations for Investors
The best way to build wealth for one person can be very different from the best way for another person.
When it comes to real estate investing vs stock investing, both asset classes have the potential to provide good long-term returns. Which asset class you as an investor are best-suited to focus on can come down to qualitative differences and how those differences resonate with you as a person.
For example, real estate is a more tangible asset class, and that characteristic appeals to a lot of people. Owning a rental property is something you can see, touch, and personally modify. It’s a simple concept at its core. If you’re handy, you can choose to manage it yourself to save on expenses. Real estate is also a form of forced savings- owning a property with a mortgage forces you to pay money every single month and build equity in the property.
However, real estate investing can be time-consuming and illiquid. A considerable portion of your wealth can be tied up in a single property, and can potentially reduce or at least complicate your geographic mobility.
Stocks on the other hand are more liquid and diversified. It takes virtually no time to set up a diversified portfolio of index funds consisting of thousands of companies around the world. Many platforms even automatically re-balance and perform tax-loss harvesting for you.
Ironically, the advantages of stocks can be a curse for some people. Because stocks can be bought or sold within seconds, they allow negative behavioral biases to influence their returns. In other words, stock investors can easily and quickly sell their shares in a panic when the prices are low and then miss out on the subsequent recovery, whereas real estate requires a far more deliberate and long-lasting decision to sell in most cases.
Overall, it’s fair to say that if you want to have a lighter, more liquid, and more mobile portfolio, then emphasizing stocks and REITs over individual investment properties may suit you best. On the other hand, if you want a more tangible, more local, more hands-on portfolio, then direct ownership of one or more investment properties might be up your alley.
The Best of All Worlds: Diversification
Appropriately diversifying your portfolio is the easiest way to increase risk-adjusted returns.
Owning several asset classes that are partially uncorrelated with each other allows you to rebalance into asset classes during periods of weakness, reduces maximum drawdowns, and smooths out overall portfolio volatility. It lets you buy low and sell high without trying to time the market simply by maintaining a static portfolio allocation to your various asset classes over time.
For example, if you have a set allocation to REITs and normal stocks, and rebalance the portfolio whenever your actual allocations deviate significantly from your targets, you’ll naturally buy low and sell high. If REITs go up a lot faster than normal stocks for a while, then your REIT exposure will be over your target allocation, and simply rebalancing to your target allocation means selling REITs and buying stocks. On the other hand, if normal stocks go up a lot faster than REITs for a while, then your stock exposure will be over your target allocation, meaning it’s time to sell some expensive stocks and buy some cheaper REITs.
Consider the following chart that shows the Wilshire REIT index (blue line) compared to the Wilshire total stock market index (red line), with recessions shaded in grey:
During the 1987 “Black Monday” crash, normal stocks fell significantly more than REITs.
By the year 2000, stocks had significantly outpaced REITs and were in a bubble according to most valuation measures. As the bubble popped and stocks crashed, especially technology stocks, REITs were almost completely unfazed.
On the other hand, the subprime mortgage crisis in 2007 was primarily a real estate and banking bubble. The prices of real estate including REITs had dramatically outpaced stocks and were overleveraged on a large scale. When that bubble popped and caused the deepest recession in decades, both REITs and normal stocks were negatively affected but REITs and banks were hit harder than stocks in other sectors.
The takeaway here is that the stock market and the real estate market don’t always go up or down together by the same degree or at the same time. By including both in your portfolio and rebalancing as needed, you can spread out your bets, minimize your exposure to any one specific problem, and improve risk-adjusted returns if history is of any guide.
Similarly, being invested in both an investment property and the stock market means that not all of your net worth is affected by any potential crisis or bubble, and distributes risk and reward accordingly.