Best investment on Earth = earth?

With traditional investments struggling this year, we have been fielding many questions about buying real estate.  The question is often “Is real estate a good investment?”—and for us, the answer is “maybe”.

On the surface, it seems that investing in the stock market returns more over time—below is the S&P 500 return over the past 50 years compared to the Case-Shiller Home Price Index (which is a widely used measure of home price returns):

While the Case-Shiller Home Price Index is a national average measure, comparison of local markets vs. the S&P 500 over the past 30 years tells a similar story:

However, when looking at the time period of ultra low interest rates, which fueled a housing price boom, real estate investment returns, as measured by publicly traded real estate investment trusts (REITS) have nudged past the S&P 500, earning 11.2% on average annually.

The problem with a general answer to whether real estate is a good investment is that each piece of real estate is very unique—so many variables go into price and cash flow returns for a property.  Location, local economy/jobs, local taxes, condition of property, lease arrangements, local supply of alternatives…just to name a few!

And comparing real estate to stock investing is difficult too, as they are very different levels of cash commitment and effort.  In general, stocks have lower annual costs, less time commitments, more diversification, and more liquidity.   While real estate has more steady cash flow, less daily (visible) price fluctuation, and more visible tangible value.

While real estate involves far more time and ongoing costs, it is unique in that investors can use other people’s cash to build equity.  By using leverage and only putting a small amount of actual cash down, a real estate investor can magnify their potential return.  And, if the property is rented, then the investor is able to use the cash flow from the tenant to pay the loan payment, taxes, and maintenance costs, for (hopefully) very little additional out of pocket ongoing investment cost.

Some reasons that real estate investment is attractive are:

  • You have more direct input/control with real estate.
  • Use of leverage magnifies returns.
  • Many real estate expenses are deductible, which helps to shelter real estate income from tax.
  • Real estate is a tangible asset that can be seen and touched.
  • Real estate is easier to analyze and quantify in terms of cash flow and estimated expenses.
  • Real estate has less visible price volatility than stocks.

Reasons that investing in stocks is attractive are:

  • Stocks historically have had a higher rate of return.
  • Stocks are more liquid.
  • Stocks have much lower transaction costs and are easier to trade.
  • Owning stocks requires way less work.
  • Stocks offer more variety and it is easier to diversify.
  • Stocks make it easier for you to invest in what you use or in companies you believe in.
  • Stocks have favorable tax treatment.
  • Less ongoing maintenance costs (like taxes and fees) with stocks.

A good case can be made for investing in both.  With real estate, a potential investor must be ready to commit the time:

  • At the beginning–with real estate, it is critical to analyze the cash flow of the property.  From the initial financing plans, to the rental rate that the market will support (and planning for vacancy), to the repairs and ongoing maintenance costs (property manager, real estate taxes, insurance, etc.)—all of the money flow must be estimated and analyzed carefully before buying.  While capitalization rates will fluctuate with local markets, it is a general rule of thumb to look for rental properties with an 8% cap rate or higher (a capitalization rate is the total net income expected from the property, divided by the current market value of the property)
  • While owning property—with real estate investments, unless an investor has a management company to assist, they must be ready to work to find tenants, handle repair requests, schedule maintenance, and inspect the property periodically.  Depending on the property (and the tenant!), a real estate investment can consume a fair bit of time.
  • When selling—unwinding a real estate investment can also take time.  Finding a buyer and negotiating a sale can take months of communication.

Most importantly, when deciding to invest in real estate, knowing what the exit plan will be in advance is critical.  Annie Duke, a professional poker player, has written two books on decision making and knowing when to quit.  If a decision will be difficult to quit, then she advises moving slowly and carefully on making the decision.  As real estate can be hard to sell, careful deliberation before investing is advised.

Is real estate a good investment?  It depends…

Is the tangible enjoyment of real estate valuable?  Milo thinks so…

Mr. Handsome Dog of the Month
Categories : Financial Planning

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