Should You Invest in Real Estate or Stocks?
A Comparison of Real Estate Investments vs. Stocks
By Joshua Kennon
Asking the questions, “Which is a better investment—real estate or stocks?” is like asking whether chocolate or vanilla is superior or if an Aston Martin is better than a Bentley. There really isn’t an answer because a lot of it comes down to your personality, preferences, and style. It also comes down to the specifics of the individual investment. Very few stocks would have beat buying beachfront property in California in the 1970’s using a lot of debt, and then cashing in twenty years later.
Virtually no real estate could have beat the returns you earned if you invested in shares of Microsoft, Johnson & Johnson, Wal-Mart, Berkshire Hathaway, Dell or Southwest Airlines, especially if you reinvested your dividends. So the answer isn’t as easy as it may seem.
Let’s begin by looking at each type of investment:
Real Estate: When you invest in real estate, you are buying physical land or property. Some real estate costs you money every month you hold it — think of a vacant parcel of land that you hope to sell to a developer someday but have to come up with cash out-of-pocket for taxes and maintenance. Some real estate is cash generating — think of an apartment building, rental houses, or strip mall where the tenants are sending you checks each month, you pay the expenses and keep the difference as the profit.
Stocks: When you buy shares of stock, you are buying a piece of a company. Whether that company makes ice cream cones, sells furniture, manufacturers motorcycles, creates video games, or provides tax services, you are entitled to a cut of the profit, if any, for every share you own. If a company has 1,000,000 shares outstanding and you own 10,000 shares, you own 1% of the company. Wall Street makes it seem far more complicated than it is.
The company’s Board of Directors, who are elected by stockholders just like you to watch over the management, decides how much of the profit each year gets reinvested in expansion and how much gets paid out as cash dividends. If you are interested in this concept, read Investing Lesson 1. It will explain how a company sells stock in itself and how those shares end up being traded on Wall Street. You may even want to check out Investing Lesson 2 – Why Stocks Become Over or Under Valued to understand what moves stock prices.
Pros and Cons of Real Estate vs. Stocks
Now, let’s look at the pros and cons of each type of investments to better understand them.
5 Pros of Investing in Real Estate
1. Real estate is often a more comfortable investment for the lower and middle classes because they grew up exposed to it (just as the upper classes often learned about stocks, bonds, and other securities during their childhood and teenage years). It’s likely most people heard their parents talking about the importance of “owning a home”. The result is that they are more open to buying land than many other investments.
2. When you invest in real estate, you invest in something tangible. You can look at it, feel it, drive by with your friends, point out the window, and say, “I own that”. For some people, that’s important psychologically.
3. It’s more difficult to be defrauded in real estate compared to stocks if you do your homework because you can physically show up, inspect your property, run a background check on the tenants, make sure that the building is actually there before you buy it, do repairs yourself ... with stocks, you have to trust the management and the auditors.
4. Using leverage (debt) in real estate can be structured far more safely than using debt to buy stocks by trading on margin.
5. Real estate investments have traditionally been a terrific inflation hedge to protect against a loss in purchasing power of the dollar.
3 Cons of Investing in Real Estate:
1. Compared to stocks, real estate takes a lot of hands-on work. You have to deal with the midnight phone calls about exploding sewage in a bathroom, gas leaks, the possibility of getting sued for a bad plank on the porch, and a whole host of things that you probably never even considered. Even if you hire a property manager to take care of your real estate investments, it’s still going to require occasional meetings and oversight.
2. Real estate can cost you money every month if the property is unoccupied. You still have to pay taxes, maintenance, utilities, insurance, and more, meaning that if you find yourself with a higher-than-usual vacancy rate due to factors beyond your control, you could actually have to come up with money each month!
3. As you learned in The Great Real Estate Myth, the actual value of real estate hardly ever increases in inflation-adjusted terms (there are exceptions, of course). This is made up for by the power of leverage. That is, imagine you buy a $300,000 property by putting in $60,000 of your own money, and borrowing the other $240,000. If inflation goes up 3% because the government printed more money and now each dollar is worth less, then the house would go up to $309,000 in value. Your actual “value” of the house hasn’t changed, just the number of dollars it takes to buy it. Because you only invested $60,000, however, that represents a return of $9,000 on $60,000. That’s a 15% return. Backing out the 3% inflation, that’s 12% in real gains before factoring in the costs of owning the property. That is what makes real estate so attractive.
6 Pros of Investing in Stocks
1. More than 100 years of research have proven that despite all of the crashes, buying stocks, reinvesting the dividends, and holding them for long periods of time has been the greatest wealth creator in the history of the world. Nothing, in terms of other asset classes, beats business ownership (remember — when you buy a stock, you are just buying a piece of a business).
2. Unlike a small business you start and manage on your own, your ownership of partial businesses through shares of stock doesn’t require any work on your part (other than researching each company to determine if it is right for you). There are professional managers at headquarters that run the company. You get to benefit from the company’s results but don’t have to show up to work every day.
3. High-quality stocks not only increase their profits year after year, but they increase their cash dividends, as well. This means that every year that goes by, you will receive bigger checks in the mail as the company’s earnings grow. As Fortune magazine pointed out, "If you'd bought a single share [of Johnson & Johnson] when the company went public in 1944 at its IPO price of $37.50 and had reinvested the dividends, you'd now have a bit over $900,000, a stunning annual return of 17.1%." On top of that, you'd be collecting somewhere around $34,200 per year in cash dividends! That’s money that would just keep rolling into your life without doing anything!
4. It’s much easier to diversify when you invest in stocks than when you invest in real estate. With some mutual funds, you can invest as little as $100 per month. With companies such as ShareBuilder, a division of ING, you can buy dozens of stocks for a flat monthly fee of as little as a few dollars. Real estate requires substantially more money.
5. Stocks are far more liquid than real estate investments. During regular market hours, you can sell your entire position, many times, in a matter of seconds. You may have to list real estate for days, weeks, months, or in extreme cases, years before finding a buyer.
6. Borrowing against your stocks is much easier than real estate. If your broker has approved you for margin borrowing (usually, it just requires you fill out a form), it’s as easy as writing a check against your account. If the money isn’t in there, a debt is created against your stocks and you pay interest on it, which is typically fairly low.
3 Cons of Investing in Stocks
1. Despite the fact that stocks have been proven conclusively to generate more wealth over the long run, most investors are too emotional, undisciplined, and fickle to benefit. They end up losing money because of psychological factors. Case in point: During the most recent collapse, the Credit Crisis of 2007-2009, well-known financial advisors were telling people to sell their stocks after the market had tanked 50%, at the very moment they should have been buying.
2. The price of stocks can experience extreme fluctuations in the short-term. Your $40 stock may go to $10 or to $80. If you know why you own shares of a particular company, this shouldn’t bother you in the slightest. You can use the opportunity to buy more shares if you think they are too cheap or sell shares if you think they are too expensive. As Benjamin Graham said, to get emotional about stock prices that you believe are wrong is to get upset by other peoples’ mistakes in judgment.
3. On paper, stocks may not look like they’ve gone anywhere for ten years or more during sideways markets. This, however, is often an illusion because charts don’t factor in the single most important long-term driver of value for investors: reinvested dividends. If you use the cash a company sends you for owning its stock to buy more shares, over time, you should own far more shares, which entitles you to even more cash dividends over time. For more information, read the work of Ivy League professor Jeremy Siegel.