As a real estate investor, one of the most frequently asked questions of me is: what’s a better investment, real estate vs stocks? Especially with the craziness of life in 2020, this question has a way of popping up over and over for investors looking to maximize their returns.
In the following article, I’ll explain the inherent advantages and benefits of real estate investment and why those advantages make this a better long-term investment. Specifically, I’ll dive into the following topics:
⦁ Stocks as an investment
⦁ Benefits of investing in stocks
⦁ Drawbacks to investing in stocks
⦁ Real estate as an investment
⦁ Real estate investment advantage
Stocks as an investment
Investing in real estate is easy to wrap your head around, that is, you own a property and people pay you to use that property.
Stocks can seem more confusing, as it’s not quite as clear what the connection is between A) owning a stock, and B) making money.
First, I need to define what stock actually is. A stock – or share – in a company is a proportional ownership stake in that company. Corporations are not owned by their managers, employees, or directors; they’re owned by their shareholders. As such, when you own a share in a company like Apple, you technically own Apple (albeit an extremely small portion of the company).
Next, as shareholders, there are two primary ways you can make money through your investments:
⦁ Dividends: When a corporation makes money, it keeps some for future operations and returns some to its shareholders. The money that is returned to shareholders is known as a dividend, and it’s typically declared as a per share amount (e.g. if you own 2 shares of a company and that company’s board of directors declares a dividend of $2.00, you would receive $4.00, or 2 shares times $2.00 dividend/share).
⦁ Stock appreciation: Stock investors also make money through the appreciation, or increasing value, of their shares. However, this money isn’t actually realized until a shareholder sells his or her stocks.
Benefits of Investing in Stocks
Having outlined the general overview of stocks, investors must next weigh the associated benefits. Broadly speaking, two primary benefits to investing in stocks exist:
⦁ Passive nature: As shareholders, you entrust the daily management of a company to its management. As such, once you purchase a stock, you have no management responsibility – you just sit back and hope for solid returns.
⦁ Potential tax benefits: If a dividend meets the requirements to be classified as a qualified dividend, shareholders who receive that dividend only need to pay the capital gains tax rate (as opposed to the far higher ordinary income rate).
Drawbacks to Investing in Stocks
While the above benefits to stocks exist (benefits that I’ll show also exist for real estate investors), investing in stocks also has several significant drawbacks that people need to consider:
⦁ No depreciation tax shield: With real estate, your taxable rental income is offset each year by depreciation, a non-cash deductible expense. This means that whatever taxable income you have, you’ll actually be taxed on less due to the depreciation tax shield. With stock dividends, you’re taxed on whatever you receive, as no depreciation benefit exists.
⦁ Bankruptcy proceedings for shareholders: A corporation goes into bankruptcy when it can no longer pay the debt it owes. If ultimately liquidated (that is, all its assets are sold to pay creditors) shareholders typically receive nothing, as liquidation proceeds first go to all creditors. This means that if you own stock in a company that goes bankrupt, you’ll receive nothing for your shares.
⦁ Limited control as a minority shareholder: If you own a property, you can generally determine how that property will be used. As a minority shareholder of a company, you have essentially no control over the strategic direction of a company, even though you technically have the right to vote in the board of directors, who in turn make the strategic decisions for the company.
Benefits of real estate investment
While many niches exist in the real estate field (e.g. residential, commercial, medical, industrial, etc), the fundamentals of real estate investing remain largely the same. Put simply, an investor purchases a property, receives rents from a tenant to use the property in a particular way, and eventually sells the property.
This simple structure lends itself to a variety of benefits, with ten of the most relevant to investors outlined in the following sections.
Of all the benefits inherent to real estate investing, leverage offers the most value in terms of return on investment.
In basic terms, leverage means using borrowed funds to make an investment. In real estate, this translates to purchasing properties with a mix of both your cash and a lender’s money, a practice that can significantly amplify returns.
For example, assume an investor purchased a single-family home for $100,000 cash. If that property’s net operating income (NOI) ended up being $10,000, that would translate to a 10% annual return on investment ($10,000 NOI / $100,000 cash investment).
Now, assume that same investor purchased the same property with a conventional, 20% down payment loan, meaning $20,000 investor cash in the deal and $80,000 financed. With an $80,000 loan and a high-ball first-year interest assumption of $4,000, that brings after-interest NOI down to $6,000.
However, despite a lower NOI due to the interest portion of the debt service, the first-year return on investment with a leveraged approach has increased to 30% ($6,000 NOI / $20,000 cash investment)!
The next – and quite obvious – benefit of income-producing real estate is its inherent cash flow. As stated, every month, your tenant pays an agreed upon amount in rent.
Now, cash flow doesn’t necessarily mean excess cash flow, that is, not all properties perform to the level of covering expenses and providing cash on top. But, by signing a lease agreement with a tenant, the investor understands exactly how much cash will be coming every month, potentially over multiple years with a long-term lease.
And, if the investor conducted the appropriate analysis prior to entering a real estate deal, the rental income will, in fact, cover monthly expenses while providing excess cash flow – funds that can be rolled into further deals.
While an argument can be made for dividend-heavy stocks also providing cash flow, dividend declarations are controlled by the board of directors, not the shareholders.
The regular cash flow provided by rents is not the only way investors profit from real estate deals. They also gain the tax-deferred benefits of property appreciation. In other words, the longer you hold a property, the more valuable it generally becomes.
And, while real estate markets certainly face fluctuations, they are not nearly to the level of the daily volatility of the stock market. As such, over the long-term, investors can be confident that, on average, property values will increase.
For example, say an investor purchases a rental property for $100,000. Assuming 3% appreciation (conservative relative to long-term national averages), after holding that property for 10 years, it’ll be worth approximately $134,000.
And, this unrealized (and therefore tax-deferred) $34,000 gain is also combined with tenant rent payments over that 10 years. When combined with the return-amplifying effects of leverage, this speaks to the significant profit potential of real estate investing.
Income Tax Benefits
As outlined above, the cash investors receive via stock dividends are taxed at either the long-term capital gains or ordinary income rates, depending on the type of dividend.
Rental income has two clear tax advantages over this dividend income. First, as passive income, it’s always taxed at the more advantageous long-term capital gains rate, which can save investors in the top federal tax bracket 17%.
Next, and of greater income tax benefit, taxable rental income has the tremendous advantage of being offset by depreciation, a benefit not afforded stocks. Rather than allowing investors to deduct the entire portion of a property in the year of purchase, the IRS mandates that investors recover these costs over 27.5 years for residential and 39 years for commercial properties.
This means that, if an investor purchased a $250,000 residential property (assuming $200,000 allocation to the building, as land is not depreciable) – even if leveraged – the IRS allows a depreciation expense of ~$7,300 per year ($200,000 divided by 27.5 years)!
NOTE: When considering depreciation, investors also need to understand how the IRS claws this benefit back upon the sale of a property via depreciation recapture. But, this can also be deferred (more on that in the next section).
Capital Gains Tax Benefits
Upon selling stocks, investors must pay capital gains tax on any unrealized gains that occurred via stock appreciation.
Similarly, when an investor sells real estate that has appreciated, he or she must pay both A) capital gains tax for the property appreciation (at the relevant long-term capital gains rate), and B) depreciation recapture for the allowed depreciation (at a flat 25% rate).
But, the IRS gives real estate investors a path to defer both of these taxes! Currently, Section 1031 of the Internal Revenue Code allows for a like-kind exchange (a.k.a. 1031 exchange), which lets investors sell one property, purchase another within a set period of time, and not recognize any depreciation recapture or gains upon sale.
Instead, those gains are rolled into the new property and deferred, but there’s no limit to how many times this can be done!
If you own a few shares in a publicly-traded company, you have essentially zero ability to tell that company’s management how and where to focus its efforts.
On the other hand, if you own a rental property, you 100% control what added value you provide. For example, an investor may look at a property and say, as is, I can lease this for $1,000/month, but if I provide $50,000 in improvements, I can rent it for $1,750/mo.
It doesn’t matter which of these options the investors chooses. Rather, what’s important is the ability to choose and determine where and when you want to add value.
Income Forecasting Accuracy
This advantage goes hand-in-hand with the monthly cash flow afforded by regular rent payments.
Savvy investors place a premium on long-term capital budgeting and tax planning. In other words, how should investors invest their money to maximize returns, and what are the tax consequences of these investments?
The stability and predictability of rental income – especially long-term leases – provides investors a way to accurately forecast income.
While no investment is guaranteed, these real estate forecasts allow for far more detailed – and accurate – planning than more volatile stock dividends and returns.
Control Your Level of Involvement
This benefit somewhat relates to the value-add control discussed above, but with a slightly different emphasis.
As a minority shareholder, your involvement is largely limited to passive observation. This limits your ability to involve yourself with a company’s day-to-day operations if you wanted to do so.
On the other hand, real estate investors can choose exactly how involved – or uninvolved – they want to be with a property. On one end of the spectrum, they can outsource everything to accountants and property managers. On the other end, they could handle all financial and operational responsibilities associated with the property.
Especially for new investors, there’s tremendous value to becoming involved in a rental property – even if it’s not your long-term plan – as this involvement will teach you lessons about real estate investing you wouldn’t learn with a fully passive approach (often by making mistakes!).
Limited Outsourcing/Irrelevance Risk
When you invest in a company’s stock, you make a bet that the underlying technology, labor, management, and strategic fundamentals of that company continue to drive returns. What happens if the technology becomes irrelevant and the company fails to innovate? What happens if local labor becomes cost-prohibitive so the industry goes overseas?
In either of these situations, the value of the company’s stock will inevitably plummet and crush an investor’s portfolio.
You can’t send residential real estate overseas. You can’t send grocery stores overseas. Furthermore, while real estate can certainly become outdated, it won’t become irrelevant. People will always need a place to live. They’ll always need a place to shop (even if it’s a local warehouse delivering goods via app).
This fact of life provides a long-term hedge for real estate investors. Regardless of what else changes in the world, people will always need places to eat and to get their groceries, and smart real estate investors understand how to benefit from this reality.
This benefit is certainly not discussed frequently in real estate investor circles, but it warrants mentioning.
Anyone who’s ever compulsively checked a stock ticker to track a company’s price understands how detrimental this can be to your mental health. Honestly, it can become all-consuming.
While real estate deals – especially in the development and construction phases – can absolutely be stressful, there’s a peace of mind afforded by a stabilized property. Sure, maintenance and tenant issues will always exist, but there’s no app that shows you the up-to-the-minute fluctuations in your property’s value.
Not having the ability to compulsively check your rental property’s value every time you use your phone provides a tremendous – though typically unspoken – mental health benefit.
Arguments can certainly be made for investing in stocks. But, as the ten advantages I discuss above make abundantly clear, investing in real estate vs stocks, I think investing in real estate is a far better option for a variety of reasons!