Real Estate vs. Stock Market: Which is A Better Investment?
When looking at the best ways to generate potential returns for your investment portfolio, there is much debate on whether the stock market or real estate investments offer the best opportunity.
The Best Long-Term Investment: Gallup Results (U.S.)
In Gallup’s annual Economy and Personal Finance poll, respondents were asked to select the best long-term investment from among five investment groupings. Over the last two years, gold led the pack as best investment in 2012 as well as 2011 — soaring above stocks and real estate. Now, as the real estate market shows signs of improving, sentiment has changed, moving up the scale in favourability.
Although real estate has made a return in favour in terms of Americans’ perceived best investment, this month, I’d like to share my thoughts around this long standing question and suggest that it’s really not a question of Real Estate or Stocks… it’s about real estate AND stocks.
Each investment options provide a range of benefits. Regardless of your asset class, returns are determined by different factors that generate different benefits. It’s important that you investigate and consider investing in both real estate and the stock market for different reasons.
As I have mentioned in other newsletters, every investor has different needs and objectives. The first step in weathering the ups and downs of the current and future market cycles is to understand your investing goals and objectives. As H. Stanley Judd, author of “Think Rich” once said: “A good plan is like a road map: it shows the final destination and usually the best way to get there.”
Let’s look at these benefits in more detail and what to consider before you invest.
As part of diversified portfolio of all asset types, real estate provides key benefits. These include:
Leveraging Other People’s Money
Leveraging allows you to use other people’s money instead of your own money to purchase real estate. Conventional financing from banks can provide you funding up to 80% of the property’s value.
According to financial educator, Talbot Stevens, real estate can be an intelligent investment choice. In a recent interview, Stevens acknowledged: “Real estate investing is like a mini-business that doesn’t have a lot of complexity to it. For the average person, real estate can be a good strategy.”
Strategic Investment Realty encourages our clients to be wise about using leverage and understand the risks of over leveraging. Borrowing against an asset can be a great way to increase your portfolio returns, but it does carry some risks. Real estate investors must be able to:
- Manage changes in the interest rate to comfortably pay down the debt. In a worst case scenario, selling your investment may be your only option.
Timing and competition for similar investment properties are important considerations of this scenario. Bear in mind, selling your asset will crystalize your gain or loss depending on market demand and conditions.
- Earn more than you’re charged for borrowing to make an investment
- Find the right tenants to maintain your investment, as they will be the ones that pay off your mortgage through monthly rents.
Changes in the particular real estate market conditions (demand and supply) impact the value of your real estate investments. Over time, appreciation of your real estate investments can boost your net worth.
Although you as an individual can’t control the market on a large scale, you can respond to changes in the market to affect your property’s desirability. Simply put, you can affect your asset value and the income it can generate.
If, for example, you have an older investment property, you can upgrade or improve the property’s exterior and interior to appeal to a different market of renters. This allows you to attract the right kind of tenants and get additional rental income and be a step ahead of your competitors.
When comparing real estate to stocks, many people highlight the benefits of stock dividends. In a way, real estate rental income can also be viewed as a dividend. Like some stocks that provide dividends, real estate provides you monthly income (via your rent) in addition to any increase in value to realize gains over the long term investment.
Tax Reduction and Inflation Protection
In the quest for tax reduction and deferral, real estate is often left unnoticed. However, investing in real estate provides some important tax considerations. According to an article from the Financial Post, it can be considered a “secret” tax shelter.
How do real estate investments impact your taxes? Here are some tax benefits:
- Rental income is taxable and rental expenses, including mortgage or line of credit interest, are tax-deductible.
- Often, if a property has highly leveraged financing, it may operate at a loss for tax purposes creating a tax deduction against all other sources of income and therefore, a tax refund, but it must pass a test that there is a reasonable expectation of net income in a reasonable timeframe.
- If an investment runs at positive cash flow for tax purposes, depreciation can be claimed to offset some or all of the taxable income inclusion.
I always recommend discussing the impact of real estate investing with your accountant or tax professional to determine how your personal situation may be impacted from any of the items above.
Real Estate Market Conditions
As I mentioned earlier, the market conditions will play a major role in determining the price people are prepared to pay in order to purchase real estate. This means that if you are able to look at supply and demand to determine if there is an oversupply of product, you may have an opportunity to buy properties at prices below market value. This is especially apparent with motivated vendors. You can always negotiate the final price based on market and the property condition conditions.
It means that as an imperfect market – there are opportunities to invest and leverage timing to improve your returns.
As an owner of a unit in a multi-family real estate investment you can affect how your property can operate in various market conditions: getting involved in the decision making process is the best option to impact change. Each decision is voted for approval via elected directors of a governing board, which is responsible for any major decisions. This process can take time, so having a proactive governing board is a very powerful asset to your property.
The Impact of Speed and Direction
If we were to look at real estate and stocks, we could use a boat analogy to illustrate the differences.
I like to think of real estate a tanker – the market is slower to turn – both in direction and speed. It takes a while to get going, stop or change direction. Often, investors use a buy and hold philosophy, so they are not in any rush to turn around and resell the investment.
On the other hand, the stock market can be described as a speed boat. It can turn direction on a dime and can have significant swings in values in a short amount of time. You need to consider the timing of your trades and the impact of buying and selling in the short term, to support your portfolio goals. This is especially in times of volatility in the equities market.
Stocks and Funds
Over time, investing in stocks is a potentially profitable method of increasing your wealth. If you do your research, you may find that stocks and other equities can be an important component of a diversified investment portfolio to meet your long-term investing goals.
Like real estate, investors have the opportunity to borrow money to purchase stock. Unlike real estate, where the value and income of the property are considered by the lenders, borrowing funds for stocks will be based on and the amount determined by your existing financial position which includes your current assets, liabilities, equities or personal covenants. When borrowing against your stocks, which is also known as “buying on margin” there is a limit to the amount or percentage you can borrow and usually it is not more than 50% of the value of the existing stocks. When buying on margin you need to address how you are going to pay off the debt.
In the right market, a small percentage change in the value of a particular stock can effect in a very large change in the value of the investment.
As an investor, you have the potential to buy stock at one price, and in ten years the price may double, so you benefit from that increase. However, when you invest in real estate, you can get the additional benefit in your tenants actually paying off the debt while also gaining appreciation.
Generate an Income
Although not all stocks offer dividends, investing in certain stocks may provide an income from your stock portfolio. If you are receiving a cash dividend you can reinvest your dividends in that particular investment, another investment or take the cash.
As a stockholder, you have voting rights that allow you to elect certain directors and participate on a small scale to set direction. Although you can vote, the share price is the share price. You as an individual investor can’t negotiate for a different price per share.
With real estate, you can improve your investment by giving it an upgrade. You can’t affect the price of the stock like you can in real estate.
Liquidity and Volatility
Unlike real estate, changes in stock price and direction can happen instantly. In 2009, when the economy shifted, we saw the effects of how share price can turn. On January 14, Nortel witnessed a 79% share price drop on the Toronto Stock Exchange as it sought out bankruptcy protection.
In the end, it was not enough to save the company and thus serves as a cautionary tale of the importance of research. It’s important to be prepared for changes and swings in stock prices.
Overall equity market conditions can have a large effect on your stock value. As we saw in 2008 and 2009, many investors experienced the massive impact of several different factors converging at one time. Some people maintained their stocks, others sold, while other investors purchased stocks and depending on when and what action they took, determined their outcome.
In the real estate world, massive housing price corrections were due to lending policies with several factors converging at one time.
Nassim Nicholas Taleb, a Nobel Prize winning Economist, has a metaphor that describes these seemingly out of the blue surprise “perfect-storm” conditions. The black swan theory describes an event that:
- Has a major effect
- Is a surprise to the observer
- And after the fact is rationalized the benefit of hindsight.
Speed and Timing
Things move fast in the stock market. As we have seen in the past, your stocks can increase or decrease overnight. For investors, this allows you to modify your course and make adjustments as conditions change. When this happens you may have to respond quickly if you haven’t built an investment plan for these changes.
I always recommend that you have a plan with objectives before you start to invest. Buy rationally and see what other investors are doing. If you are unfamiliar with investing in either asset class then it is best to work with someone who is an expert in this field.
Contrarian investing can be a successful strategy. If other investors are buying, contrarian investing suggests that you sell or hold your investment. But is it is far more involved than just doing the opposite of what others are doing. I have learned a great deal about investing in the equities market from Steven Jon Kaplan at www.truecontrarian.com. And one of the lessons I have learned is: nobody gets it right every time and so managing risk and investing within your risk tolerances is a vital part of this process.
The Volatility Index can offer insight into implied investor volatility over the next 30 days. The Chicago Board Options Exchange Market Volatility Index, is often referred to as the fear index or the fear gauge, as it represents one measure of the market’s expectation of stock market volatility.
A Balanced Portfolio Approach
In the end, a balanced diversified investment portfolio can help generate income and support your long term investing returns. Your age and propensity for risk can help determine the right mix of investments for your portfolio. Most importantly, work with a team of professionals to help set up the best fit for you so that your investments perform and you can sleep at night.
Resources and Reading
- Real estate: A ‘secret’ tax shelter: http://business.financialpost.com/2011/04/06/a-secret-tax-shelter/
- Gold Loses Luster in U.S. as Investment; Real Estate Gains: http://www.gallup.com/poll/161909/gold-loses-luster-investment-real-estate-gains.aspx?goback=.gde_2894168_member_242451859
- Real estate vs. the stock market: http://www.moneysense.ca/2013/03/28/real-estate-vs-the-stock-market/
- Volatility Index: http://en.wikipedia.org/wiki/VIX