Which is a Better Investment- Stocks or Real Estate?
We all dream about striking it rich and building a fortune. Although, when it comes to achieving this goal, many investors seem to fall into one of two camps. In camp one are the investors that want to make their money by investing in real estate. We will call this camp of investors the real estate barons. In camp two are the investors that want to make their money by investing in the stock market. Let’s call this camp of investors the stock market tycoons. So which group of investors has made more money over the past few 25 years? How about the past 100 years? Was it the real estate barons or the stock market tycoons? Let’s find out.
The Advantage of Being a Real Estate Baron
Looking at the Federal Finance Housing Agency’s 2015 year end housing price index report, over the last 25 years, the housing market in the U.S. has had a compound annual growth rate (CAGR) of 3.4% (1991 – 2015). Therefore, a $100 investment made in January 1991, would be worth $230 in Jan 2016. This growth, however, is not inflation adjusted. When this growth is adjusted for inflation, it results in a fairly unimpressive inflation adjusted CAGR of 0.9%. This means that house prices, for the most part, move with inflation. In fact, even if you were to look at home prices over the last 100 years and adjust these prices for inflation, you would only see a CAGR of roughly 0.2%.
So, assuming inflation is an average 2% a year (the rate targeted by the Fed), 10 years from now, a $300,000 home might sell for $370,000, but in inflation adjusted dollars it would be worth $365,000 and only offer an inflation adjusted profit of $5,000. Does this mean you can’t make any money investing in real estate? Absolutely not. If you can get some solid rental income, buy at the right time, and use leverage (all of which are discussed below), you can certainly do very well. However, if you were just to invest a fixed sum and hold onto your investment for the long-term, chances are, this investment would rise at the same rate as inflation. Now let’s see what the historical data shows for investments made in the stock market.
The Advantage of Being a Stock Market Tycoon
According to the handy calculator provided by the website moneychimp, the CAGR of the S&P 500, from January 1991 to Dec 31 2016, was 7.6%. This being the case, a $100 investment in January 1991 would have resulted in $619 by Jan 1, 2016. This growth, however, is also not inflation adjusted. When this stock market growth is adjusted for inflation, it results in a CAGR of 5.14%. With an inflation adjusted CAGR of 5.1% for the stock market tycoons and an inflation adjusted CAGR of 0.9% for the real estate barons, the stock market tycoons certainly appear to have done better over the last 25 years. What about over the long-term?
Over the last 100 years, the stock market has averaged a CAGR of 5.54%. If this growth rate is adjusted for inflation it works out to be roughly 2.3% (not including dividends). Therefore, over both the short-term and the long-term, the stock market appears to be the clear winner. This sentiment is also supported by Warren Buffet. In talking about his own house purchase made many decade ago, Buffett had this to say – “I would have made far more money had I instead rented and used the purchase money to buy stocks.”
It’s certainly starting to look like the stock market tycoons have it, but it’s not over just yet. To get a true comparison we will need to factor in the affect of the dividends received by the stock market tycoons and the rent received by the real estate barons. As well, given that most real estate investors get a mortgage and borrow to invest, we will also have to factor in the affect that leverage (borrowing to invest) has on the real estate baron’s returns.
Rent and Dividends
The dividend yield on the S&P 500 is currently running around 2%. This means that if the real estate barons are able to find a real estate investment that pays enough rent to cover all their expenses (mortgage, taxes, insurance, maintenance..etc.) and additionally provides them with some solid leftover rental income, the barons could, conceivably, add to their total return and catch up to the return expected to be realized by the stock market tycoons. If the stock market typically outperforms the real estate market by an inflation adjusted 2.3% and realizes an annual dividend yield of 2%, the barons would need to realize leftover rental income of 4.3%, once they paid all the expenses associated with their property, to keep pace with the tycoons.
Even if the real estate barons aren’t able to realize this type of rental income, however, they still have one secret weapon in their back pockets that the stock market tycoons rarely take advantage of. That weapon is the fact that the real estate barons often take advantage of the power of leverage by getting a mortgage and borrowing money to make their investments.
The Power of Leverage
As discussed in previous posts, although it is inherently more risky, leverage can help investors to realize greater returns. To see how this might give the real estate barons the edge over the stock market tycoons, let’s consider the following example.
Let’s assume the real estate barons have $100,000 to invest. Because they love real estate, the barons use their $100,000 to make a down payment on an investment property worth $500,000 and get a $400,000 mortgage to cover the remaining cost. If the barons then get a 20 year mortgage and are able to generate just enough rental income to cover all the expenses associated with their investment property, then, 20 year later, they will own a fully paid for investment property (no mortgage) that has dramatically increased in value. Assuming this property kept pace with inflation and increased in value at 2% a year, the barons would have spent $100,000 to own a fully paid for property that would be valued at roughly $743,000. This would mean a profit of $643,000 ($743,000 – $100,000) for the barons. Not too shabby!
Now let’s see how the stock market tycoons would have faired with their $100,000 investment. Because the stock market tycoons love stocks, the tycoons put their $100,000 investment in the stock market and, over the next 20 years, they realize a CAGR of 7.6%. This means the tycoons will have total investments of roughly $433,000, twenty years later. If we also assume the tycoons stock market portfolio realized a dividend yield of 2%, generating $2,000 in dividends each year, then the tycoons would have the additional sum of $40,000 in dividends (20 x $2,000). This would amount to a grand total of $473,000 ($433,000 + $40,000) and a total profit of $373,000 (473,000 – $100,000) for the tycoons. Again not too shabby. However, with a total of $643,000, the barons outperform the tycoons by an incredible $270,000.
Even though the stock market generated returns that were much higher than the real estate market (7.6% versus 2.0%), the real estate barons wind up with $270,000 more than the stock market tycoons. This solid thumping of the tycoons is because of leverage.
In conclusion, historical data has shown that, over the long-term, the stock market typically outperforms the real estate market by a large margin. However, if you use leverage to make your real estate investments and are able to generate some solid rental income, an investment in real estate can certainly be very profitable and wind up generating higher returns than an investment in the stock market.
Of course another option would be to simply use some leverage in the stock market and get the best of both worlds. Keep in mind, however, that while leverage offers the chance to earn higher returns it also comes with the risk to suffer higher losses.
Also keep in mind that there would likely be far more work involved in finding, buying, and maintaining an investment property compared to simply purchasing an index fund that mirrors the S&P 500 and having your dividends automatically reinvested.
The best approach, however, might be to be both a stock market tycoon and a real estate mogul all at the same time. If an opportunity presents itself in real estate, then invest in real estate. If an opportunity presents itself in the stock market, then invest in the stock market. By investing in a combination of stocks and real estate, you would be better able to diversify your portfolio and, over the long-term, would likely realize a better risk-adjusted return. Instead of limiting yourself to just one type of good investment, invest in many different types of good investments. Instead of only being a stock market tycoon or only being a real estate baron, be a business magnate and own everything.