Real Estate vs Stocks
Which is the Better Investment?
Important Considerations
Investment in residential real estate is one of the best ways to increase the yields on invested assets. And it’s less volatile than investment in the stock market.
Despite the higher return on investment, real estate investment involves more participation than the more passive investment in stocks or bonds. The time and attention required to maintain a real estate investment may not be right for everyone.
Real estate investment is ideal for retirees … who after leaving the workforce have more time and resources to devote to managing a real estate investment.
It’s also suited to families where one of the spouses has some level of independence and sufficient free-time to devote to the handful of hours per month it takes to manage a rental property.
And in the modern day workforce, an increasing number of workers are not tied to the office or to a time-clock, and accordingly have the nominal amount of time required to manage a residential rental property.
It should be noted that the minimum amount cash to purchase the type of real estate we’re using in our comparison is probably at least $50,000, even in markets with low entry points. Whereas investment in the stock market has no real minimum limit.
Vanguard S&P 500 ETF – Our choice for the stock in this comparison
We wanted to do a comparison that would benefit the greatest number of potential investors.
To that end, for our stock participant in this comparison, we opted for the Vanguard S&P 500 ETF.
This is an exchange-traded fund that isn’t subject to some of the drawbacks of a mutual fund and can be purchased on margin. In a separate analysis we determined that leveraged-purchase of an ETF resulted in a slightly higher rate of return when compared to a non-leveraged purchase, so we’re showing a leveraged stock investment in this comparison. This Vanguard ETF also has the lowest expense ratios of all ETFs tied to the S&P 500.
The maximum amount that can be borrowed to purchase an exchange-traded fund is 50% of the price of the shares. So with a cash outlay of $125,000 our margin loan to purchase the stock would be $125,000 and the total value of the purchased stock would be $250,000.
The 10-year average annual return on the S&P 500 index was 11.68% at the time we prepared the comparison. We apportioned that between dividends at 1.2% and appreciation in value at 10.48% in the table below.
We used the lowest rate of interest on a margin loan we could find on this amount of investment. At 10.75% per annum the interest paid for the year was $13,437.
The resulting return on investment was $15,763, resulting in a rate of return of 12.61% on the stock fund investment.
The Real Estate in this comparison
For the real estate investment in our comparison we used $125,000 in cash for a down payment and used a mortgage loan for $375,000 to finance the remainder of the $500,000 purchase price of a 4-unit residential property.
We had done several loans on this type property in Texas and were familiar with the value, rent and expenses on a property in this price range. We also had access to appraisal reports on these properties to substantiate our income and expense estimates.
For appreciation of value for the real estate in our comparison we used 4.62%, representing the 10-year average of annual appreciation in new home sales in Texas. Rent was estimated at 12% of value and expenses at 35% of gross rental receipts.
Our interest computation was based on 7.625% per annum, the published rate on our DSCR program for a 30-year fixed-rate loan at a 75% loan-to-value ratio. Although principal on this program is amortized over 30 years, for clarity in our example we computed the interest as if it were an interest-only loan with no amortization of principal.
The Results – Stocks investment vs Real Estate Investment
Although we could have borrowed up to 85% of the value of the property on this loan program, doing so significantly increased the rate on the loan. We elected to show the comparison with a loan-to-value ratio of 75% with a cash-outlay of $125,000.
On the passive stock investment the appreciation in value was higher on the stock purchase. But the income, derived from dividends on the Vanguard ETF was woefully low compared to the real estate transaction.
Because we were able to leverage more in the real estate transaction and because the rate of interest on the leveraged portion of the transaction was so much lower than the rate of interest on the stock margin account our return was significantly higher on the real estate transaction.
With a rate of return of 26.8% it was more than double the rate of return on the Vanguard ETF investment.
Comparison - Real Estate vs Stocks - Professionally Managed Property
The estimates for operating expenses in the prior comparison were based on a self-managed real estate property.
For an investment requiring less participation and investor could hire a professional property manager to handle most of the management functions of the investment. When a property management fee of $6,000, representing 10% of rental receipts, was added to the amount of operating expenses, the rate of return on the real estate investment was reduced to 22%.
This rate still exceeded the rate of return on the investment in stocks by 74.46%.
Tax Consequences of these Investments
Tax treatment of each investment depends on factors which vary with each individual taxpayer and on the state in which the property is located.
A higher percentage of the total return on the leveraged real estate transaction is taxed as ordinary income versus capital gains. Thus, a taxpayer might be subjected to higher income taxes on the real estate transaction than on this particular stock transaction.
However, in the early years of ownership this income is typically negated by the depreciation deduction allowed on residential real estate, an advantage you wouldn’t have on the stock transaction.
Both investments enjoy the benefit of capital gains rates on the appreciation in value and that tax is only incurred on sale of the asset.
Conclusion
Residential real estate investment requires a higher level of participation than investment in the stock market and typically requires a minimum of $50,000 of available cash for investment. These factors limit the number of potential investors that can take advantage of these higher rates of return.
That said, an investor with the capacity to do so, that uses leverage to finance a residential real estate investment will typically experience returns on investment that are up two times higher than those achieved on investment in stocks or bonds
Retiro Financial offers investor loans like the one shown in this comparison in nineteen states.
Contact one of our investor loan consultants to explore strategies customized to your particular requirements and objectives.
