In Part 1 of this series, a brief list of the advantages and disadvantages of investing in publicly traded equities vs. direct real estate was provided. In this article, I will try to more directly answer the question, “which is better, stocks or real estate”?
First of all, that is probably the wrong question to ask. Real estate, along with stocks and bonds, is just another asset class. And because real estate behaves differently than stocks and bonds, it provides a diversification benefit. Therefore, most investors should have a portion of their investments in real estate, just as they should have a portion in stocks and bonds.
But getting this diversification benefit doesn’t mean you have to go out and buy an investment property. Exposure to real estate as an asset class can be accomplished using publicly traded Real Estate Investment Trusts (REITs). Generally, our firm recommends REITs because they allow investors to invest in real estate with full liquidity and the ability to easily diversify both geographically and across types of real estate.
What About Returns?
Frankly, the data on returns isn’t all that clear. Residential real estate appreciates at a clip not much above the rate of inflation, but that does not include the net rental income component of investment return. While REITs have slightly outperformed large company stocks over the last few decades, historical returns on directly held real estate are hard to come by.
Regardless, investors can earn higher returns investing indirectly held real estate. The power of leverage (using borrowed money) can boost investment returns significantly, especially in an environment of rising prices.
That being said, when calculating returns, real estate investors must also take into account the costs of ownership. Out of pocket costs for things like maintenance, repairs, insurance, and property taxes and high transaction costs for buying and selling real estate can reduce returns significantly. And then there is the value of the owner’s time and labor that may be required to manage an investment property. When that cost is factored in, the returns can start to look fairly low given the risks involved.
What Are Those Risks?
Two of the most significant are leverage and concentration risk. When you combine leverage with concentrating a large portion of your net worth in one or two properties located in the same geographic region (or same neighborhood!) as your primary residence, you begin to introduce the possibility of being completely wiped out if real estate prices begin to dive.
My conclusion is that to be a successful real estate investor and make the risks worthwhile, you need some kind of advantage. Maybe that advantage is the ability to efficiently manage a property because you are in the property management business, or the ability to inexpensively improve the property because you are a contractor. Or maybe you possess some kind of advantage in obtaining mortgage financing. But the most important advantage is most likely the ability to skillfully identify undervalued properties. Without this skill, consistently good returns that compensate the investor for the risks involved will be hard to come by.
