How do the two most popular types of investments stack up against each other, and what should you be adding to your portfolio?
Investing in real estate vs stocks is a common decision investors battle with. Real estate and stocks are both popular investments, but there are some key differences that may make one a better investment for you. We’ll look at the differences between real estate vs stocks to help you decide which investment is right for you.
Real estate vs stocks
It’s important to understand that real estate vs stocks is not comparing apples to apples.
Real estate is a tangible asset that you can visit and touch. No matter what happens with the market, your real estate will never go away.
A stock is a share of ownership in a publicly traded company. Most companies have millions of shares, so most investors own an insignificant share of the company. If the market tanks and the company fails, the stocks will no longer have any value.
The stock market does offer some advantages, though. Stocks are a more liquid investment because they are easily sold. Unless you’re trying to unload an enormous amount of stocks at once, you can typically liquidate your stocks within a day.
Investors can also get into the stock market with little money compared to real estate. Some apps even allow people to start investing in stocks with as little as $5. With the lower cost of entry, stock portfolios are easy to diversify across many different companies and index funds. To decide which type of investment is best for you, we’ll look at how each one provides you with a return, then look closer at the benefits of each type of investment.
Sources of a return on investment are:
- Cash flow
- Capital gains
- Equity
Cash Flow
One of the most attractive things about real estate investing is the cash flow. Whether investing in residential rental properties, multifamily properties or commercial real estate, the idea is to earn a profit each month from the rental income.
The cash flow from real estate provides consistency in income, regardless of whether the real estate market is up or down. The cash flow from real estate is used to calculate the capitalization rate, cash-on-cash return, and the internal rate of return.
Some stock investments pay dividends to investors. These dividends are usually paid quarterly and are a pro rata share of the company’s profits.
The dividends are normally a fixed percentage of the current stock price, not the amount you’ve invested into it. If the market is down, your dividends will be low. If the market is up, your dividends will be higher.
Mutual funds are often heavily invested in dividend-paying stocks. Some mutual funds allow investors to have their dividend payments reinvested into the fund to increase their returns even further.
Capital gains
Capital gain is the profit earned from selling an asset for more than you paid. Most of the profit earned from stocks is from capital gains. You purchase a stock that you believe will increase in value over time. That’s where the term “buy low, sell high” comes from.
Capital gains can also be a significant source of income for real estate investors. If you buy a property when the market is down and sell it when it’s up, you can get a significant return.
More commonly, though, people earn capital gains in real estate by increasing the value of their property. By improving the property and increasing rents, you can force the appreciation of the real estate and earn capital gains.
A clear benefit that investors see in real estate over stocks is having control over how well it performs. With stocks, you’re relying on the market to improve so your stock value goes up. With real estate, you can increase a property’s value no matter how the market is performing.
Equity
Building equity is a benefit that’s more specific to real estate. Since real estate is easy to leverage, meaning you can invest with the bank’s money, you are able to profit from the equity you build over time.
When you collect rent each month from tenants, you use a portion of that rent to pay the mortgage payments on the property. Each month, the principal balance goes down and the amount of equity you have in the property increases. Over time, you build a significant amount of equity that the tenants paid for.
Equity build is an often-overlooked benefit. Investors don’t usually consider the amount of profit they will earn when they cash out on the equity built while they owned the property.
Real estate tax advantages
Real estate provides tax benefits that other investments don’t offer. These tax benefits don’t necessarily increase cash flow or the value of the investment, but they do allow more retention of the profits at tax time.
Real estate tax advantages include:
- Depreciation
- Interest deductions
- Expense write-offs
- Tax-deferred exchanges
Depreciation allows you to deduct the cost of the improved property over a period of time. Commercial real estate is depreciated over 39 years, and rental properties are depreciated over 27.5 years. This means you get an additional annual tax deduction over this period of time.
For example, if you were to depreciate a $1,000,000 commercial real estate investment, you would have a write-off of $25,641 each year for 39 years.
Interest deductions allow you to write off the interest you pay on the mortgage on your investment property. This can be a significant deduction, especially in the first several years when interest payments are higher. The interest deduction will likely be higher than the depreciation for the first several years.
Expense write-offs include all of the costs associated with your real estate investment. Not only are maintenance, repairs and property taxes deducted as an expense, but home office expenses, telephone, and travel expenses can also be written off.
Tax deferred exchanges allow you to sell your investment property and defer your capital gains tax as long as you use the funds to purchase another property. You can continue to trade up to larger properties without paying capital gains tax after each sale.
Stock liquidity
One major advantage stocks have over real estate is liquidity. Real estate can take a long time to sell, and the transaction costs are high. On the other hand, stocks can be sold quickly with minimal cost or effort. If you need to cash out your investment quickly for any reason, you can typically have your stocks liquidated and have cash in hand within a week.
You can also sell just a portion of your stocks, while you normally can’t sell just a portion of a property.
However, If you plan to invest your money for the long run, liquidity isn’t much of an issue.
Effort in real estate vs stocks
Depending on your investment strategy, the amount of effort that goes into investing in real estate vs stocks can vary greatly. Somebody managing their own rental property will have to put a lot more time and effort into their investment than somebody who simply invests in an index fund that follows the S&P 500.
On the other hand, investing alongside another investor in a private equity fund will offer the real estate benefits while letting the fund manager put in all of the effort. Investing this way provides true passive income.