Monday, September 15, 2014

Which is the better investment, real estate or stocks?

Is it better to invest in the stock market or buy real estate?

That's the century-old debate, rekindled every time we have a Bull or a Bear market, a boom or a bust. There are plenty of fancy charts and statistics to support both arguments but in essence, there is no once correct answer. I know, someone who's made their career as a real estate broker should probably sing the praises of owning a home as the one and only investment you should ever make. And for many people, it is. Even 94% of millionaires cite real estate as a significant part of how they obtained and held their wealth.

However, so much of the data used to make these arguments and foster comparison is situational, and therefore a case can be made for either/or. For instance, are we talking about residential real estate or rental properties? Are we mistakenly only counting home price appreciation? And is there a mortgage involved, or are we assuming the house is owned outright? With our stock investments, will we be reinvesting the dividends? Are we trading stocks ourselves or enlisting a financial planner? What’s our risk tolerance and tax position? All of these things factor in to the argument, but at the risk of letting the air out of the balloon well before the party has started, I’ll give you the answer we’ll arrive at by the end of this blog. The average earnings over time for real estate and stocks pretty much mirror each other, an ideally you should invest in both

First, for the sake of defining and clarifying these two different classes of investments, let me present each of their inherent advantages and disadvantages. Then, I will propose some widely accepted statistics for purposes of comparison.

Investing in stocks.

Advantages:

Liquidity.
It’s very easy to sell off your whole position in stocks, almost instantaneously.

Low acquisition costs.
Anyone can invest in stocks because they have such a small acquisition price – you can buy just one share if you wish. There are fees involved but they are not prohibitive.

Easy to diversify.
By investing in mutual funds or other vehicles, you can diversity your stock holdings over different classes of stocks. You can also mirror the S &P 500 or buy only blue chips to minimize risk and foster stability.

Low management.
Once you buy your stocks, you can choose to hold them without additional cost or maintenance. There is no additional time or money investment if you don’t want.

Reinvesting dividends.
This is the big advantage to investing in stocks, as you can choose to cash out your dividends or reinvest them. By reinvesting, or buying more of the same stock, you speed up the curve of your investment and take advantage of the principle of compounding.

Some tax advantages.
Depending on your financial situation, stock capital gains offer may offer some tax advantages. Additionally, IRAs, 401ks, etc. can also help reduce the tax load on stock holdings.

Disadvantages:

Human error.
Investing in stocks is more are subject to fear, groupthink, fickle emotions, and human error – not to mention greed and fraud.

No Control.
As a stockholder, there is nothing immediate and direct you can do to improve the company or even help them make good decisions, other than possibly voting for the Board.

Short-term fluctuations.
Stocks are subject to extreme short-term volatility.

Investing in Real Estate.

Advantages:

Leverage.
The huge advantage to owning real estate is that you can leverage other people’s money – i.e., the bank’s – to acquire an asset. For instance, you may only have to put 20% or even 10% or less of your own money down to acquire a whole asset. Yes, you have to pay interest for the privilege of using the bank’s money (a mortgage) but you still benefit when it appreciates or cash flows.

Control.
You can decide where you want to buy real estate and actively improve your own property to increase its value. You can do maintenance, redecorate, improve your landscaping, or even add an addition on your own time and dime, all of which adds value.

Paying it off.
Even if you use a mortgage (most people do) to acquire your real estate, you can pay it off to reach the point where you own the asset outright. In fact, you can accelerate payments much faster if you wish, by adding extra towards principal or just paying the whole thing off earlier if desired. 

Tax benefits.
The government doesn’t want to be in the business of housing 300 million Americans so it long ago made the decision to offer huge tax advantages to promote home ownership and investment. Owning a home will allow you to get mortgage interest write offs: you can deduct the interest on up to $1.1 million in mortgage indebtedness on your primary home, you can also sell your primary home for tax free profits up to $250,000 for singles and $500,000 for married couples if you live in the home for the last two of a five year period. And if you own rentals, all expenses associated with managing your rental properties are also deductible towards your income.

Real estate is local.
If you own a home in California, so what if the real estate market crashes overseas, or even if homes are loosing value in Detroit? It doesn’t affect your investment at all. In fact, real estate has regional, local, and even micro markets that are largely independent. So by purchasing a good house in a good neighborhood, you’re ensuring your investment.

You have to live somewhere!
I come across many articles and blogs about investing in real estate v. stocks, written by brilliant economists and analysts. But the one thing they’re often missing in the debate is a tangible reality for everyone: you have to live somewhere. That means that if you don’t purchase your own real estate to live in, you’ll have to rent. So unless we’re talking about buying rental properties or commercial real estate, there’s an opportunity cost if you don’t buy real estate and have to rent to live.

Disadvantages:

Not liquid.
Selling real estate is not fast nor easy compared to selling stocks, which you can unload at any time.

Maintenance.
Owning real estate requires maintenance and physical upkeep, which takes time and money.

Acquisition and surrender costs.
There are costs incurred when you sell a property and closing costs and often fees related to your mortgage.  

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So now that we’ve outlined the pros and cons of real estate and stocks, what’s our final answer to the question, which is better? 

Like I mentioned, there are many studies that analyze gains in the stock market versus real estate. Most all of them are situational, so don’t apply to everyone. Some forget to factor in dividends, others don’t account for the tax implications, and even more don’t account for rental income – or the opportunity cost of having to rent - just appreciation.



But by far the best study I’ve found is an analysis of economist Robert Shiller’s theories and research that led to his widely accepted historical housing index. If we use Shiller’s indices for real estate and Dow Jones stock market gains and put them head to head, we’re offered a snapshot that speaks to the general trend; real estate and stocks generally mirror each other over the long term and both yield approximately similar gains as investments. So the real question becomes not, “Should you buy a home or buy stocks?” but “Which is right for you based on your life circumstances and financial situation?” One thing we can be certain of is that for the average person, a balanced and prudent financial future includes both.

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