Stocks vs Real Estate which is a better Investment

Stocks vs Real Estate which is a better Investment The recent volatility in the stock market may have you wondering if you should have so much of your money tied up in the stock market. In this short article we will answer that question and show how alternatives such as real estate can reduce the volatility effects on your portfolio. We will also briefly touch on some regulatory changes that have changed how people invest in real estate, thus effectively lowering the barrier to entry.

Lets begin with stocks. Stocks are very easy to get into. The burden of entry can be quite low. Sometimes a few hundred dollars or less. Buying stock today takes nothing more than the press of a button on your computer. The difficulty in purchasing a stock comes down to which one to buy. You can do the research yourself or trust a professional financial adviser. Both of these get you into the market and all of them suffer from the same problem.

They can not protect from the ups and downs of the market. One could argue that over time the SP 500 stock index has returned about a five percent annual return after adjusting for inflation so short term market fluctuations are not really a factor. Consider this however, those numbers are true for time scales of 20 years or more. Deep fluctuations occur about every 5 to seven years with the index losing as much as half of its value. The long term returns of the market are of little comfort to someone facing retirement in one of these down cycles. After all, who wants to go into your golden years with half the money you thought that you would have for retirement?

Do you have the capital to invest in real estate? Can real estate protect you from this scenario? Can it beat the return of the stock indexes? Lets breakdown each one these questions and see how real estate compares to stocks. Can I afford it?

Previously investing in real estate required large upfront costs. Simply purchasing a residential property that you intend to rent out requires that you put up a down payment sufficient to ensure that the rent paid covers the mortgage, taxes, insurance and maintenance. Generally, we are talking about a down payment of about 30 percent of the price of the property. For even a modest piece of property this is a substantial amount of capital.

Fortunately, a change to the US securities regulations now makes it possible for investors to pool there funds for the purpose of investing in real estate. Were previously an investor would have to come up with thirty thousand plus to buy into a rental property you can now own a percentage of one for as little as a few hundred dollars. This effectively sets the barrier to entry equal to buying a few shares of stock. Will real estate protect me from market volatility?

Real estate is generally a long term investment and while its price fluctuations are far less than the stock market's there are fluctuations. Here is an important difference between real estate and stocks, the fluctuations in price do not matter to a real estate investor. The reason is that real estate investing done properly is income producing. The profit from rent payments far exceed dollar for dollar any dividend paid from a stock. So even if the property's appreciation in value goes flat its revenue steam continues. Even though property values may flatten for a period of time the revenue stream from real estate income will pay down the mortgage over time. This means that each month you own more and more of the equity in the property courtesy of your tenants. This leads to our next question. Can real estate beat the returns from the stock indexes?

Lets look at some numbers to answer that question. According to the National Association of Realtors (NAR) home prices from 1968 to 2004 appreciated at a rate of 6.4 percent per year. Even after factoring the reduction in home values in 2008 Zillow.com calculated a 5 percent average appreciation in home prices per year over the past 15 years. Lets assume a worst case scenario and adjust these numbers downward for inflation. That gives us a national average adjusted return of 2 percent. Lets add to that real estates secret weapon, Leverage.

Real estate can be safely leveraged through a mortgage. Its how it is commonly done even for the home that you are living in now. This means that the structure of any real estate deal must be analyzed on a cash on cash basis. Lets look at an example to see what I mean by that. Lets assume that the property in question has the following numbers,

Since the tenants pay off the balance of the loan through their rental payments the following numbers are based on the investor original investment of $95,000 and factors in the inflation adjusted appreciation value of 2 percent for the purchase price of the property. This is how the numbers look for years 1 through 30.

So we see that on a cash on cash basis the investor's original $95,000 investment would return $235, 000 on the original cash investment in rental income. We then must add to that the remaining equity in the property of $255,000 paid for by the tenants plus $140,000 of appreciation based on the nationwide NAR estimate of 2%. As we can see from the table below this gives us a total return on the original investment of $630,000 Original price minus down payment $255,000.00 Appreciation of 2% adjusted for inflation $140,000.00 Revenue generated by rent $235,000.00 Total return on the $95,000 investment $630,000.00

This model would also have numerous tax advantages for the investors also but they have been left out since they would be specific to the individual investor tax profile.

Now lets take a look at stocks. Lets assume that the same $95,000 was invested in stocks. To make the comparison easier we will use the SP500 stock index. According to investpedia the SP500 has returned approximately 4.9 percent return per year for the past 30 years after adjusting for taxes and inflation. Lets look at that $95,000 investment after 30 years and compare. In this comparison we will use the following numbers.

As we can see our real estate investment returned a total of $630,000 and our stock investment in the SP 500 returned $379,000. It would be tempting to say that real estate is the clear winner here and put thee discussion to rest but in fairness there are some things to consider. Taxes for example. In this example the SP 500 profits were assumed to be taxable income. This may or may not be true depending on the individual. The real estate tax advantages have also been disregarded for the same reason. Depending on the investors tax profile it could sway the discussion either way. So to the original question, which should you own stocks or real estate? In my opinion the answer is both. By combining both stocks and real estate in your portfolio you can not only diversify your wealth building strategies but also protect yourself from market volatility.

John Larsen is the managing partner of Eco7group and has a passion for the environment and real estate investing. He takes great satisfaction in teaching other investors how to be successful. Learn more at eco7group.com