Source: Investopedia. Over the years, we have heard the comparisons as to which is the better investment: real estate or stocks. Both have their advantages and disadvantages, and there are several aspects of each that make them unique investments in their own way. To make money with either investment requires that you understand the positives and negatives of both.
Real estate is something that you can physically touch and feel – it’s a tangible good and, therefore, for many investors, feels more real. Maybe this partially accounts for the high return on the investment, as from 1978-2004, real estate has had an average return of 8.6%. For many decades this investment has generated consistent wealth and long term appreciation for millions of people.
How it Works
Generally, there are two main types of real estate: commercial and residential. While other types exist (mobile home parks, strip malls, apartment buildings, office buildings, store fronts and single family homes), they generally fall into those two categories. Making money in real estate isn’t as cut-and-dry. Some people take the “home flipping” route – searching for distressed properties, refurbishing them and selling them for a profit at a higher market value. Others look for properties that can be rented in order to generate a consistent income.
Generally, a down payment of up to 20% of the purchase price can be made, and the rest can be financed. This gives you leverage, meaning that you can invest in different types of properties with less money down, helping to build your net worth or income that you could make off the properties. While this can be a positive, if this leverage is used incorrectly, you may owe more on the properties than they are actually worth.
There are many positive benefits to investing in real estate, including depreciation (writing off wear and tear of a commercial property), tax deductions and finally, you can sell the property through what is know as a 1031 exchange, and will not have to pay capital gains taxes, as long as you invest the money into a similar kind of property type.
Like all investments, real estate also has its drawbacks. Most importantly, the investment is illiquid. When you invest in a property, you usually cannot sell it right away. In many cases, you may have to hold the property for several years to realize its true profit potential. Also, the closing cost can add up to thousands of dollars, and include taxes, commissions, and fees. Also, real estate prices have a tendency to fluctuate. While long-term prices generally increase, there are times when prices could go down or stay flat. If you have borrowed too much against the property, you may have trouble making the payment with a property that is worth less money than the amount borrowed on it.
Finally, it’s often hard to get diversified if investing in real estate. However, diversification is possible in real estate, provided that you do not concentrate on the same community and have a variety of different types of property. That being said, there is an additional way that you can be able to diversify in real estate through real estate investment trusts (REITs), under which you can purchase a trust that is invested in a large portfolio of real estate, and will offer you a dividend as a shareholder. However, in general, stocks offer more diversification because you can own many different industries and areas across the entire economy.
From 1978-2006, stocks have delivered an average return of 13.4%. They can be more volatile than real estate but over the long run they have provided a much better return than real estate’s 8.6% average.
How They Work
With a stock, you receive ownership in a company. When times are good, you will profit. During times of economic challenges, you may see diminishing funds as the earnings of the company drop. Taking a long-term approach and being balanced in many areas can help build your net worth at a much greater rate, compared with real estate.
As with real estate, financing in stocks allows you to use margin as leverage to increase the overall amount of shares that you own. The downside is that, if the stock position falls, you could have what is known as margin call. This is where the equity, in relation to amount borrowed, has fallen below a certain level and money must be added to your account to bring that amount back up. If you fail to do this, the brokerage firm can sell the stock to recover the amount loaned to you.
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account – tax-free – until you start to withdraw the money. As well, many stocks can do considerably better than real estate in one year. Due to the volatility of some stocks, it is not unusual to see companies that are averaging 20% or even 50% growth in one year.
Stocks can be very volatile, especially when the economy or the company is facing challenges. Also, stocks are often emotional investments, and your decisions within the market can often be irrational. Finally, bankruptcy is always in the back of the active stock investor’s mind – as it should be, as your investment will be dissolved in this instance.
In general, stocks may have the advantage in more categories than real estate. However, real estate seems to be better when it comes to stability and tax advantages. A good compromise may be to own a REIT, which combines some of the benefits of stocks with some of the benefits of real estate. While each area has its own benefits and drawbacks, to decide which one would work well for you depends on your overall financial situation and level of comfort. (For further reading on real estate, take a look at Find Fortune In Commercial Real Estate.)
I’m so glad I never took my financial advisor’s advice. He told me to max out my 401k (18k) year after year, and that would insure my financial freedom in the future. He said stocks have done so good for so many people. after I did some research I wanted to be sure that all the mutual funds invested were paying dividends because I was aware that dividend’s contribute to the compounded return over the long haul. He gave me recommendations of diversity and gave me a list of what stocks to buy week after week. I wrote each ticker down and researched each mutual fund, it seems only 2 of the 6 paid dividends which were minimal, but I figured he’s a professional and I should probably listen. After a year and a half of continued ignorance, I check the performance of my portfolio…. 4% annual return on investment. Sounds great to a 56 year old but from a concerned 25 year old, after plugging the numbers into a compound interest calculator, I felt betrayed!! How could this older professional advisor, be so nice on the phone and give me bad advice?? I thought it could either be intentional misguidence or complete ignorance, either way they are both unacceptable to me. He is a professional, I thought. A financial advisor, someone to set me up for my future, not someone who’s going to leave me poor at 62. I called them back demanding answers, they come back with technical terms like dollar cost averaging, the time value of money and how the Market is doing great but it always has its ups and downs, etc etc. They told me to not look at it and in the long term it will grow, exponentially! Ignorant me saying okay okay, then hangin up the phone. I decided to do my own research and become much less ingnorant on this investing thing, I read books and books and books, online articles, forums, and so on, I even came across a great website that you can sign up with to set up a dividend re-investing plan to buy any dividend paying stock at a small fee. The only thing I didn’t like was that I wouldn’t be able to make these deposits automatic. I felt that it’s a great way to bypass your 401k fees and make a lot more money in the stock market, semi passively.
But then I came across a little book at Barnes and nobles that had nothing to do with stocks and dividends. The book was- “start small and profit big in real estate”.. I didn’t even have to finish the book before I realized what I had to do. When the stock market was up kinda, I took a %50 loan out of my 401k and purchased an investment property (which took 10 months to find). It was a single family home with a duplex in the back, 1 bed 1 bath on each side. The single family home in the front is a 3 bed 1 bath. This property made sense to me, not because I had any emotions involved but because of the numbers and the numbers only. It makes so much sense that you don’t even need a spread sheet to understand it. The FHA mortgage including taxes, insurance, principal and interest is $1800/M the water bill for the entire property is $250/M the lawn care is $80/ month.. all expenses combined is $2130/ month.
Now I can look at this two ways. I can be an owner/investor and live in one of the units or I can live elsewhere. Since I decided to live on the property, we’ll look at the returns based on that scenario. The front house rents for $1350/M, the other 1bed 1 bath unit rents for $850/M totaling $2200 of monthly income and $70 of cash flow while I’m living on the property, that $70 pays for my electric bill. The only other expense I have, is my internet bill.
To compare this to my 401k, I would be left so far behind if I stuck with my financial advisor’s advice. I never trusted him or the market enough to put 18k into that investment but I now trust real estate enough to save 18k a year for it.
52% is the annual return I make from this property while living there, and it only gets better. Without even looking at the tax benefits, housing market appreciation, etc. that 52% alone is the reason why “for now” I will always choose real estate over stocks, even if they’re dividend paying stocks.