Most people use one of three options for excess cash:
- Option 1: Keep your cash in a savings account.
- Option 2: Invest in the stock market.
- Option 3: Invest in real estate.
It’s important to have a safety net of six months of expenses saved in case something unexpected happens. However, after this point, consider making your money work for you. Your money isn’t compounding and growing much in a savings account when interest rates are near zero.
So let’s look at your other options: real estate vs. the stock market.
Stock Market vs. Housing Growth
Stock investors use this kind of chart as a way to state that investing in stocks is better than real estate. Most of the arguments about real estate vs. the stock market involve some type of chart that looks like this:
But there’s a gigantic problem with this argument. That chart gave no credit for the income received over that period if you held real estate as rental property!
When you use cash flow data plus appreciation of real estate vs. the stock market, stocks don’t stand a chance. This point is even more true when you use leverage.
A friend of mine who encouraged me to buy a lot of rentals told me this:
There isn’t another investment out there where you can borrow most of the money to buy an asset and then have that asset produce cash flow that you get to spend and use to pay the debt off.
The funny thing is that even with the flawed data of real estate appreciation vs. stock appreciation, over some time periods real estate still does better. Think about that.
Excluding the actual cash flow of real estate, real estate still does better over certain time periods than stocks:
The Housing Growth Potential is Greater
If you consider the actual cash flow of the properties, stock investments don’t stand a chance. Also consider Warren Buffett’s thoughts on real estate investing. Warren Buffett is arguably the world’s greatest investor and stock picker who has ever lived.
But in 2014, he wrote an exclusive article for Fortune on his real estate investing. Why would the most famous stock investor of all time write a major real estate article for a major finance publication like Fortune magazine?
Here is one of my favorite quotes from the article:
Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
I think I have a pretty unique perspective on what is the better investment. Why? I know something about the stock market.
I won a stock market competition when I was 12 and read the Wall Street Journal daily through high school. After college, I got my dream job as an analyst at small hedge fund. A couple of years later, I became a partner at the hedge fund, and a couple of years after that, we sold it to a private equity firm.
Then I got into real estate, sort of by accident. My wife and I put 20% down, and we were really shocked at how early we were able to pay off the mortgage using our tenants’ rent. The area had appreciated modestly, so that was a nice bonus on top of the paid-off mortgage.
I don’t know of any other type of investment where you can put a very modest amount of money down and then have somebody else pay off your debt for you. You also make money while they are paying your debt off!
You have inevitably heard of a real estate horror story.
What can go wrong?
- Tenants destroy the house
- Property depreciates
- Neighborhoods go bad
- Cities go bad
- The house is a money pit
- The bank calls your loan
- Business partner is bad
- Tenants don’t pay
- Wrong location
I have owned rental property for over 10 years and have learned many lessons the hard way.
If you’re serious about growing your income and wealth, most people make a choice between real estate vs. the stock market:
7 Ways to Compare the Stock Market vs. Real Estate
1. Compounding Growth
If you made a 20% down payment, and the property value rises 5%, you made a gain of 25%. Although the bank owns 80% of your property, you get all the gains, so the 5% rise in overall value is a 25% rise relative to your 20% down.
The best part is this is just after year one. The growth compounds significantly after you have held a property for a certain amount of time.
There isn’t anything like this in the stock-market.
2. Long-Term Returns
Stock index funds can underperform inflation over certain time spans. These time spans can include several decades. Real estate has never underperformed inflation over a decade.
3. Taxes for Income
You get to deduct your mortgage interest and depreciate your property on your taxes. This can mean that you effectively break even on your property, even if the rent doesn’t cover the mortgage.
The stock market does not have these advantages.
4. Taxes for Selling
When you sell a stock, you pay capital gains taxes. However, when you sell real estate, you can put the proceeds in a 1031 exchange, whereby you can defer paying the capital gains tax.
Therefore, buying another property within a certain time period helps you compound your growth faster since you have more funds.
If you get a fixed-rate mortgage, you have locked in your biggest expense for 30 years (or less depending on what type of mortgage you get). Thanks to rent increases, your cash flow profit margin should improve year after year.
You can buy stocks on margin. However, margin interest rates are substantially higher than interest rates for loans related to real estate investing. Additionally, margin loans can get called if your stocks fall below a certain level.
Real estate loans are only called if you stopped making payments (generally speaking).
7. Digital vs. Real
I will never forget the night that I had to cancel a date with my wife and stay on a conference call until 10 p.m. because a CFO mis-accrued revenue numbers, and the company was going to have to restate their financials. The stock went down 25% the next day, and there was absolutely no way we could have known about this.
Logging into the company’s account wasn’t fun that day. I also don’t know how fun it would be for my 4-year-old boy to log in and look at stocks and bonds.
But it can be fun to drive by real estate. I like taking my kids to rental properties and having them help me fix places up. I think it’s good family bonding and teaches a good work ethic.
The best part of the “real estate vs. the stock market” argument is that you don’t have to choose. You can invest in both!
You can invest in both
I mainly focus on real estate, but I also have an IRA that I rolled over from a 401(k) and plan to keep that in mutual funds and individual stocks. I also keep a small stock portfolio.
What are your thoughts on this topic? Let me know in the comments!
If you have a brokerage account of stocks and bonds that is not a retirement account, consider pledging that as collateral for a line of credit with a local bank. The rates on lines of credit are generally very cheap. Note that this is a different product than a margin account.
Use the line of credit to buy your next investment property if you plan on flipping the house. If you plan on renting the house out, you could use the line of credit to buy the house fast, and then refinance the line of credit with a term note!