Buying Stocks vs Real Estate Investing -- Which is Better? - YouTube

Deidre Woollard: Stocks vs. real estate.

It's a long-standing question and one that isn't easily answered.

This is Deidre Woollard, editor at Millionacres, the real estate investing website from The Motley Fool.

Today, we are asking the question, should you invest in real estate or stocks?

We all know that putting some of our assets in real estate is good for diversification.

But what about returns?

Which asset class has produced better returns over long periods of time -- real estate or stocks?

This is a tough question to answer partly because there's no reliable way to gauge individual

investment property returns on a wide scale.

Every property investment in each market is different, so there's no real way to make

a comparison on a one-to-one basis.

Having said that, though, there is some broad-stroke data that can help us compare how the two

asset classes stack up as long-term investments.

First, it's important to note that stocks tend to increase in value quicker than real estate.

Over long periods of time, an S&P 500 index fund has historically produced total returns

in the 9% to 10% range. Meanwhile, real estate prices tend to outpace inflation, but not by much.

Since 1940, the median home price value in the United States has increased at an annualized

rate of 5.5%. However, this is misleading for several reasons.

Consider this: homes are significantly larger today on average than they were back then.

The average home in 1940 was 1,246 square feet -- roughly half of the 2,430 average of 2010.

So, if you just for home size, the annualized increase on a per-square-foot basis drops to 4.6%.

And, after accounting for inflation, the average home value has risen by just 1.5% per year.

Now, let's compare this to stock returns.

Stocks have generated roughly 7% per year over the long run after accounting for inflation.

In other words, the stock market has generated returns at more than 4X the rate of real estate appreciation.

If you've ever heard someone tell you that your home isn't an investment, this is probably why.

But wait. There's more to consider in this question.

This is important: real estate as an investment has much stronger return potential.

Real estate values tend to barely outpace inflation; however, there are a few reasons

why real estate investments tend to do better.

First is leverage, also known as investing with someone else's money.

Unlike stocks, where it's irresponsible to invest with borrowed money, you can use significant

amounts of financing for real estate investments without adding a ton of risk.

When you buy stocks or mutual funds, most people buy with cash they already have.

In real estate, you're generally only putting down a down payment and financing the rest.

This means that you are making your investment using your money as well as the bank's money.

Although real estate does experience price swings over time, they tend to be far less

dramatic than stock market swings.

If you look at the most dire periods of the real estate market -- AKA the Great Recession

-- the simple truth is that investors got into trouble with debt during the financial

crisis for two reasons.

One, they stopped caring about their properties' cash flow and focused on price appreciation.

People were essentially betting that home prices would go up because they go up, without

focusing on fundamentals.

Two, there were tons of creative mortgage products given to borrowers who were clearly

not creditworthy. It's unfortunate that those people got roped into complicated products.

Fortunately, many of them aren't available anymore.

If you use debt responsibly, it's a healthy part of a real estate investing strategy.

Just don't forget about the core metric of any property: its ability to generate cash

flow, when you're thinking about real estate investments.

Lenders typically finance investment properties with down payments of just 20% to 25% of the sales price.

When buying a primary home, the down payment requirements can be significantly lower.

You may have to pay mortgage insurance with less than 20% down, but you may be able to

put down as little as 3% to 5% -- or, in some cases, such as VA loans, no down payment at all.

The effect of this leverage is that small returns can be greatly amplified.

Here's an example.

Let's say that you buy an asset for $100,000 in cash, and its value increases by 3%.

You earned a $3,000, 3%, return on your investment.

On the other hand, let's say that you buy a $500,000 asset by investing $100,000 of

your own money, and borrowing the other $400,000.

If the value of this asset increases by 3%, you'll have a return of $15,000, or 15%, of

your initial $100,000 investment. This isn't a perfect example.

When it comes to real estate, you'll typically have to pay an origination fee to a lender,

as well as various closing costs when you buy property. These costs eat into your return.

Plus, if you borrow money to buy a property, you'll need to make mortgage payments each

month while you own it.

That said, leverage can still dramatically amplify your return on investment, which is

why most investors choose to use it rather than paying cash for properties.

The second reason why investment real estate can produce strong returns is that investment

properties can be rented out to generate income.

You can also rent out part of a house and live in the rest -- a move called house hacking.

Real estate investors enjoy tax advantages that stock investors don't.

For example, when you buy an investment property, you get to write off the purchase price over

a certain number of years -- a tax deduction known as depreciation.

It would be awesome if you could write off your stock investments in a similar manner.

That isn't the case.

Even if you don't own a property, real estate can offer tax advantages that the average

equity investment can't.

Real estate investment trusts, or REITs, get an extra tax benefit in that they avoid corporate

taxes by paying out most of their income as dividends.

REITs are easy for investors to buy in an IRA or other tax-advantaged retirement account,

meaning they can avoid dividend and capital gains taxes altogether in the short term.

Together, the combination of rental income, leverage, and tax benefits can combine to

produce attractive long-term gains.

How has investment real estate compared with stocks over time?

It's difficult to find reliable historical data on total returns from individual investment properties.

There are too many variables, and there's no reliable way to track total returns achieved

by individual investors.

However, one good way to visualize the power of real estate investments is to examine how

real estate investment trusts have performed over time.

Let's compare the total returns of the S&P 500 stock index and the Vanguard Real Estate

mutual fund, a good benchmark index of equity REITs.

The difference isn't too significant over the first few years, but by 20 years out,

the vanguard ETF crushed the S&P 500.

Real estate stocks tend to be correlated with interest rate fluctuations over short periods

of time, which is the main reason for the big underperformance over the three-year period.

Rising interest rates are bad for REITs, and the Federal Reserve raised interest rates

eight times over the past three years.

However, over longer periods of time, the effect of interest rate fluctuations tend

to balance out, and we can get a better look at how the performance of these two asset

classes stack up side by side.

If you look at the longest time period, you'll notice that the performance is comparable,

but with a significant edge to real estate.

This is an imperfect conclusion, as there are other ways to invest in real estate besides REITs,

and they have different investment dynamics, but it does illustrate the long-term

return potential of real estate investments. Now, there are some downsides to real estate investing.

Actually buying real estate is a time-consuming investment.

Hiring a property manager helps, but searching for, evaluating, and buying properties consumes

far more time than simply buying stocks. Also, real estate is an illiquid investment.

You can sell stocks with a couple of clicks in no time at all.

Conversely, it can take months to sell an investment property unless you want to accept

a highly discounted price.

Of course, if you invest in real estate investment trusts, you have the same flexibility that

you would with stocks; however, to really see the benefits of REIT investing, it generally

makes sense to hold these investments for the long term.

It's tough to make an apples to apples comparison of the two, but it's fair to say that real

estate investments have just as much, if not more, return potential as stock investments.

When you combine the safe use of leverage, price appreciation, income potential,

and the inherent tax benefits of real estate investing, there's potential for impressive long-term returns.

In the end, you don't really have to choose.

Since stocks and real estate investments are vastly different and each offers their own

advantages, why choose?

A diversified portfolio with stocks, bonds, and real estate will put you in a position

to better weather market hiccups, while also seizing the relative advantages each asset has to offer.

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