Stock Market vs. Real Estate: Which Is A Better Investment For You?
I was out of the army and headed into the real world. I was working at a bank while attending school full time. I wanted to focus on personal finance. At that time, I thought I could help people make money by becoming a financial planner. I was 22 when I was done with my general classes and started picking out finance and business classes. I already owned a home, and it was increasing in value. I loved real estate already and wanted that to be part of my career. As I sifted through the Metro State program in Denver, I realized that there were no real estate investing classes. The only investing classes that I could find were stocks. Why is that?
I took the course on insurance, which would have been required to be a financial planner, and I took the class on investing in the stock market. I understood the concepts in both classes well, but I did not enjoy it. The stock market class was crazy. We got bonus points for how well our phantom portfolio performed over the semester. I finished dead last because I invested in some oil future options. I thought if I could grasp a future option, I would understand both futures and options. That risky play wiped me out of contention. I realized that stocks could be a bit… unpredictable. I later took a financial planner class, which gave me a bit more flexibility, and I focused on real estate investing. I received the highest grade in the class with a shout out from the professor for my presentation on protecting your real estate portfolio. I still remember that day when he told me how much he learned from me that year.
I still wanted my finance degree, but I no longer wanted to focus on personal financial planning. I wanted to be a real estate investor. I took classes that may help me in the future, like spreadsheets and financial modeling. I received my degree 2 years later and realized that I was already working in my dream career, building my real estate portfolio.
Real Estate vs. Stocks
Stocks are not a bad investment by any means. I keep about 20% of my assets in the stock market. I do believe it is important to have diversification. Not long after I graduated, my business was going great. I had also started originating loans part-time to support my real estate addiction. Part of my lending business strategy was to connect with financial planners and attempt to get referrals. The message was, “allow me to refinance your clients’ homes to free up cash so they can invest with you.” This message was in a time of incredibly low-interest rates, solid real estate values, and a booming stock market. I remember one older gentleman allowed me into his office to discuss our relationship. He was impressed with the real state empire I was building but bluntly told me I needed to hire him. He said he was concerned about my lack of diversification and that I was too heavily focused. He told me that he was worried that I would go down if real estate took a hit. It took several years, but I realized what he meant as 2008 came barreling down on me like a freight train.
I do believe that a direct investment in real estate is not for everyone, but some combination of real estate and stocks can help create a balanced portfolio.
Investing In The Stock Market
The stock market is pretty simple to get involved in, and as long as you are not trying to time the market or outsmart the professionals, it can be easy to maneuver as well.
Most people have a vague understanding of what stocks are and what the stock market is. A stock is an ownership in a company. For example, when you purchase a stock in Apple, you are purchasing a small piece of that company. If the company does well, you will do well. If the company does poorly, you will too. The profits of a company do not drive the price of a stock, as you might think. The stock’s value is only driven by supply and demand. If investors believe in potential, for example, that would drive the price of a stock up.
Most public companies trade stock on a public market, or exchange. That is what we consider the stock market. Because the stock market is so big with millions of buyers and sellers, there is liquidity. There is always someone willing to sell you a stock or buy a stock from you at the right price.
The most significant benefit the stock market has over many other investments is that it is 100% liquid. Liquidity refers to how easy it is to turn your investment into cash. Some investments are not liquid at all with minimum investment periods, some may need some time to sell, and some you can sell with a push of a button. The liquidity is a big benefit to investing in the stock market for many reasons. You can use a stock account as reserves and get to the cash quickly if you need it. Not to mention that you can get out of an investment fast if you believe there is a risk.
I like stocks for how easy it is to diversify. You can own stocks in different companies and different industries and limit your risk. You can also buy bonds, which are a safer investment. Bonds are debt instruments issued by companies or the government. When a large company or government wants to borrow money, they can sell bonds to investors. Debt is safer than equity because it gets paid back first. It will typically come with an interest rate, so the return is predictable unless you need to sell. Many investors use a mix of stocks and bonds to balance a stock portfolio.
Last year I learned about a Pledged Asset Line (PAL) account. Much like a Home Equity Line (HELOC), a pledged asset line allows you to borrow money quickly at low interest rates. It is revolving, meaning once you pay it back, you have access to it again. Instead of being secured by a home, a PAL is secured by your stock portfolio.
Your stock market account is easy to value. Stock values move constantly, but at any given second, you can look at its value. When you have an account with a brokerage, you can log in and see your account value and all the details any time you want. Knowing asset values makes it much easier to plan.
Low fees are a huge advantage! Stocks trade for fees charged by brokerage houses. If you go with a bigger one like Charles Schwab, you may pay a little more but can get some benefits of stock advice, banking, and access to PALs. You can also do a cheaper account with a company like TD Ameritrade and save on fees. Many of the larger companies have their own funds as well. A fund is used to own multiple stocks and/or bonds in one investment. You will be buying into a fund instead of a specific stock. Buying into a fund is the appropriate way to invest in the stock market for beginners because you have someone else managing it for you. There is a fee for that, but even fund fees are relatively small. If you are trying to save on fees, you should consider Exchange Traded Funds (ETFs) over mutual funds.
Although the stock market’s use can reduce risk with diversification, there is no denying the stock market has risk. It can be something crazy like an Enron when the company goes out of business or erodes confidence in the market because of events such as COVID-19, 9/11, or a simple Tweet from someone in power. As I did in school, you can also do something crazy, such as investing in something you don’t understand. Futures, options, derivatives, and other creative financial instruments can be extremely risky. It is also risky when investors panic. If a stock’s value starts to tank, investors begin to sell out of fear, and the stock goes down even further.
Stocks can be challenging to understand, as well. I see stocks fall all the time for reasons no one can explain, and stocks go up for the same reason. The car rental company Hertz’s stock price went up in value when they declared bankruptcy. How can you analyze a stock when this is possible? Because of its unpredictable nature, investing in individual stocks feels a lot like gambling, which is why I suggest sticking to funds for most investors.
Although you can get a PAL or a margin account, using these vehicles amounts to using debt to buy stock. In real estate, you can control a lot more assets for a fraction of the down payment. Leverage is a double-edged sword, so stocks can also be considered safer because you have little to no leverage.
Cash flow is hard to come by. A dividend is when the company pays out a portion of profits to its owners. You can search for higher dividend-paying stocks and generate some cash flow and bonds, of course, pay interest, but in general, your stock accounts will not produce a lot of income. Most stocks and most funds earn money on capital gains, which refers to selling a stock at a higher price than you paid for it. There are other better income options, but most of those investments don’t have the potential upside that stocks have.
Investing In Real Estate
There is a reason more millionaires either made their fortune or hold their wealth in real estate than any other investment. Real estate can provide the cash flow an income-seeking investor is after and the upside of appreciation like stocks. It is indeed an investment worth looking into.
I remember I was in the army making next to nothing but having almost no expenses. I was eating in the mess hall, working out at the gym on base, living in the barracks rent-free, and I paid off my truck. Even though I did not make a lot, I was saving money. I wanted to invest but was not sure where. As I read the most popular books on investing and making money, real estate popped up again and again. As I narrowed in on real estate, I learned how powerful the benefits are.
The biggest benefit is that you don’t need money to get involved. I was broke with no credit buying houses while working and attending school. I learned to buy houses without down payments because I had no down payment. Using tools like owner carry and hard money loans makes this possible.
No money down is possible with some effort and the right team, but you can leverage real estate more than any other investments — even without creative strategies. You can easily buy a rental with a 20% down payment. The big benefit of that is it can magnify returns. For example, if you purchase a $100,000 house with a 20% down payment, you will have a cash investment of $20,000. If that house only increases in value by 5% in a year (well below a 30-year average), you will earn $5,000. That $5,000 in growth is 5% of the value of $100,000 but is a return of 25% on your $20,000 investment.
Another big benefit is that you can rent the house and generate income. The idea is to buy properties that can rent for enough to pay all your expenses and create some positive cash flow. Over time, you can potentially generate enough positive cash flow from rentals to cover all your expenses. It takes several properties and time but is achievable.
Real estate is also a great hedge to inflation. As the value of the dollar decreases, the cost of living increases. In times with high inflation, real assets tend to farewell. Real estate does especially well because both the resell value and the rental amount should increase.
Real estate investors have learned that another benefit of owning real estate is the tax breaks. They are numerous and beyond the scope of this article, but the largest one is depreciation. Depreciation is when you can deduct a certain percent of the cost of the property each year. It is not an actual loss to the investor, but they get the benefit of a loss, which significantly reduces the amount in taxes they need to pay each year.
Most real estate loans amortize, which means you have a set monthly payment, and each month, a portion is applied to the principal of the loan. Over time you will pay the house off. When you rent the property, you will use the rent money to make the mortgage payment, so each month, your tenant pays a portion of your house off. When you consider this, you will see the return on your investment go through the roof!
The final benefit is that real estate is essential and finite. It is limited, and people need a place to live. Although rental and resale values can go up and down, they cannot go to zero, as we saw with Enron. You can always rent a house out for something, and it will always be worth something.
As good as real estate is, there are some drawbacks. Real estate does take more effort. Even if you hire a management company, there are still decisions to make and an asset to look after, and that takes time. Unlike a stock, it takes effort to locate the right property to buy, make the offer, and have it accepted.
Although the idea of owning rentals is to generate income, it can also cost you money. A bad tenant can be very expensive. Any turnover is costly, but if they stop making payments or trash your property, it can be especially expensive.
The final drawback is a lack of liquidity. Unlike stocks, it is tough to turn a piece of property into cash. You typically need to clean it up, stage it, list it with a Realtor, deal with showings, wait for an offer, negotiate, wait for a closing, and hope it closes.
Additional Factors To Consider
Here are some other items to consider when comparing real estate investments to the stock market.
Return On Investment
If you compared a stock investment to a real estate investment at the end of a year, you might compare them by looking at your ROI. To calculate your ROI, you take the amount of money you made in the year and divide that by your investment. The result is your annualized ROI. For a stock, it is easy. Simply look at what the stock is trading for and subtract what you paid for it to get your gain, then add in any dividends and divide that number by your investment. Real estate is much more complicated, which typically makes the ROI much higher.
First, you will want to look at your cash on cash return. A cash-on-cash return is the amount of money you put in your pocket over the year divided by your investment. For rentals, you need to take all your rental income minus your mortgage payment and all your other expenses. If you are buying good rentals, this will typically be competitive to what you might see with a stock investment. To get your ROI, however, you need to calculate your total return. To calculate this, you will need to add your total positive cash flow, which was calculated in the COC formula, and add to that the reduction in your loan balance and any appreciation in the house. Once those three are combined, divide that by your investment.
Degree Of Risk Involved
All investments have some degree of risk. Even a CD insured by the government carries risk in that there is a chance that inflation is higher than your return. The tricky part is identifying your risk and mitigating it. With stocks, this is typically done with diversification or buying into a fund. With real estate, this takes time. You can reduce your risk by hiring good property management, screening tenants, buying in good locations, and decreasing your leverage.
Control Of Your Investment
How much control you have over your investment is another factor to consider. With stocks, you have complete control over what and when you buy but have very little control if you invest in a fund other than you can sell at any time. As a stockholder, you will have no control over how the company operates.
With real estate, you will be giving up a lot of control as well. As soon as you sign a lease, you are giving the tenant control of your property. Unless they break the lease, they can use the home as they wish. It is important to have a great lease. You will also give up some control when you hire a property manager, but in most cases, that is a good thing.
Time And Effort Needed
I remember when I was learning about the stock market. I spent a ton of time on it. I watched the news and Mad Money on CNBC, trying to find the next Apple. It was too time-consuming and frankly a little stressful. Investing in a fund eliminates the time needed to be successful.
Real estate is similar. It takes a lot of time to locate and purchase a property. Finding properties to offer on, making offers, and negotiating deals can get intense. Once you have the property, it is getting it ready to rent, finding tenants, and so on. It also takes time to manage your portfolio.
Both investments will take research. It just depends on how much effort you want to put into this. To pick stocks individually is a ton of reading and understanding how the company operates, who operates it, and the strength of its financials. Real estate requires an understanding of managing the property, the locations you are investing in, and maybe picking a manager. In both cases, but especially real estate, it is easy to find support to get you the information you need through Realtors, lenders, and associations.
As mentioned, fees with stock investing are relatively low, particularly if you invest in a fund. That is not the case with real estate, especially when you sell. There are title fees, closing fees, lender fees, appraisal fees, and Realtor commissions. It can add up to a lot, but you will be fine if you account for fees when running your numbers.
An Alternative To Consider: REITs
If you think real estate is a good investment but do not want the hassle of owning actual property, you could invest in a REIT. A REIT is a real estate investment trust, which is a fancy way to say real estate fund. Much like an ETF or mutual fund, a REIT combines investor money to buy real estate. You will get much of the benefit of owning real estate with none of the hassle. They won’t perform as well as if you owned the property yourself but are a great alternative and an excellent way to diversify a stock portfolio.
Opt For A Variety Of Sectors
The most successful investors focus on a balanced portfolio. They will likely buy stocks and real estate, and maybe other investments like precious metal or private lending. It is smart to compare real estate to other investments like the stock market, but you may want to own both.