People work hard. Over time, they grind out hours, days, months and ultimately decades in jobs and careers that they may or may not enjoy. Many get to a point where their income surpasses their daily living needs, leaving them with excess cash flow. At some point, they realize that if they can invest some of this excess cash, it could take some pressure off their need to work indefinitely.
When investors begin putting their hard-earned money to work, they turn to what they know. Many people grow up hearing about the stock market, big Fortune 500 companies (GE, McDonald’s, Google,etc.), initial public offerings, etc. (SpaceX IPO anyone?) They hear about investing in stocks and how doing so can provide upside for an investor who is willing to live with the inherent volatility that comes with publicly traded stocks.
Other investors learn about real estate from an early age. They may hear their family talk about the house they live in, the mortgage they carry, or the growth in their home equity. They may have read that rental properties, and the subsequent rental income that comes from them, can be a good way to generate passive income. They understand that real estate can be an attractive investment if you have enough capital to get into it and are willing to lock up that capital for a period of time.
Some investors believe this is an either/or decision between the two asset classes, and it isn’t. Both investment opportunities are proven ways to make an investor’s money work for them. Yet many are unsure of which one is better for them. To be sure, there are many factors to consider, including the characteristics of each investment as well as the unique financial situation of the investor themselves.
RETURN EXPECTATIONS AND TAX DIFFERENCE
Both asset classes provide great opportunities to earn a return greater than inflation. Stocks generally offer more in terms of capital appreciation, whereas buy-and-hold real estate investing earns the majority of its return through income earned on rents. This can lead to different tax outcomes as well, given that capital appreciation is taxed at a lower rate than ordinary income. However, real estate can offer other tax advantages in terms of depreciation expenses and capital gain deferral in the form of 1031 exchanges.
Stock Market Returns of Large Cap US Equities (S&P 500)
The S&P 500 has generated roughly 10% annualized total returns over the last 40 years. Total return includes price appreciation and dividends received. That’s an attractive return, but it comes with a caveat. The average standard deviation (annual expected volatility) is about 15-20% over that time period. That means, on average, in any given year the market could be down 10% or up 30%. However, in some years, such as 2008, the index was down as much as 37%. And from 2000 to 2002, it had a peak-to-trough decline of 45% over that time period.
Single Family Rental and Institutional Multifamily Real Estate Returns
Single-family real estate returns over the last 40 years have been closer to 8-9%, with about 3.5% coming from price appreciation and another 5% coming from rental income. However, what’s unique about investing in real estate is that it is much more common to use leverage (i.e., a mortgage from the bank) to facilitate a higher purchase price, resulting in a higher leveraged return on the equity invested. If you apply a standard 75% loan-to-value mortgage at historical 30-year fixed rates, your leveraged equity returns climbs to about 11%.
Larger multifamily real estate investments can be intriguing, given that an investor can diversify across tenants, providing more reliable income. The unleveraged returns, however, are similar to single-family rental investments, coming in at around 9% annually, with income accounting for about 60% (5.4%) of that return. Similarly to single-family, if you apply 60% leverage at historical commercial lending rates, your returns climb to over 11%, annually.
CHOOSING BETWEEN LIQUIDITY AND COMPLEXITY
While the return profiles of each asset class are similar, their risk characteristics are very different. These characteristics may include income potential, price volatility, investment costs, transaction complexity and liquidity constraints.
Liquidity and Volatility of Stocks
Publicly traded equity is very liquid and relatively low cost compared to real estate, allowing any investor an opportunity to buy and sell at will. However, its accessibility means it is also very volatile, as millions of people can trade in the same stock simultaneously. This can lead to significant swings in market prices and may result in significant drawdowns and portfolio losses over time. While equities can generate income, their return potential is heavily dependent on price appreciation, with dividend income being a much smaller component.
Illiquidity and Stability of Real Estate
Real estate can be much more stable over the short term and can be a consistent income producer, but the asset class is much less liquid and transaction costs can be significantly higher. In addition, due to the high price of the assets acquired, diversification across properties can be difficult for all but the wealthiest of investors. Despite being less liquid, real estate can still suffer losses over extended periods, as macroeconomic forces erode demand. And while total return can be attractive, the complexity of buying and selling real estate, and of using leverage to enhance yields, may be too time-consuming for many investors.
The Tangible Vs. Intangible
Some investors carry a subconscious desire to own something more physical, a tangible asset. Real estate is a specific property or building that you can inspect, renovate, and make decisions about. This is very different from what can feel like an obscure share of stock held in a brokerage account that you access digitally. This difference in tangibility can change how investors perceive the risk of each investment.
The allure of the physical can give way to the reality that investing in real estate, whether single-family or larger multifamily complexes (or even other commercial assets), is a much more complex process that requires a lot more time and energy to do well. Saving money in a brokerage account can be done in small increments, with little time or energy. Accessing these funds can be just as easy. The ease with which an investor can transact or access value via stocks makes the intangibility of the asset less relevant.
ITS NOT AN EITHER/OR DECISION
As advisors, we know both asset classes provide great long-term return potential. Both belong in an investor’s long-term financial plan. What balance of these assets is right for an investor depends on their unique needs, and it is helpful to have an outside perspective to better understand whether familiarity or tangibility biases are driving investors’ decisions.
It is important to be objective in determining what combination of liquidity, income, and risk fits the investor’s lifestyle. Uncovering hidden biases can help with the process. Spending time evaluating what combination of liquidity, complexity, stability, and tangibility matters most to them and their daily life will go a long way. With the right guidance, investors can build an economically resilient portfolio using a combination of both asset classes that meets their core needs and underlying desires.