Real Estate vs the Stock Market: Which is a Better Investment?
If you are just starting out or are trying to learn more about investing then you may have some questions as to how to compare investments.
Most beginner investors start by learning about some of the common asset classes. These asset classes are typically stocks, bonds, and real estate. In this article, we are diving into two core asset classes, real estate vs stock market investing, and how these asset classes compare as investments.
Investing Your Money
Why do we invest? Simply put, individuals and companies invest their money or capital to make more money.
The most common reason why everyday people invest is for their retirement. They plan on one day not having to work anymore because they can potentially live off of their investments. We wrote a detailed article on how to live off of interest income, check it out here.
Ultimately, the key to investing is that it will help you build long term wealth. Whether this is investing in stocks in a portfolio, investing in your own business, or purchasing physical real estate, there are many ways to invest and build wealth.
Stock Market Investing vs Real Estate Investing
• Real estate and stocks can have different levels of liquidity. Liquidity is the ability to sell your investment and get cash. Depending on your real estate investment, you may not be able to easily sell. Stocks are usually more liquid as they trade on exchanges.
• The amount of control you have over your underlying investment can be different for stocks vs real estate. If you purchase a rental property and begin renting it out you have more control over your investment. However, if you purchase a passive real estate investment then you will not have much control. Similar to purchasing a stock, you do not have much of a say in how the company runs its operations.
• Cash Outlay can be a big factor in choosing between stocks vs real estate investments. The cash outlay for purchasing a rental property or physical real estate can be high. Investors will need a downpayment for the house which can be tens of thousands of dollars. However, certain passive real estate investments do not require large initial investments. Stocks, as well, do not require a high amount of capital to get started.
• Tax advantages are another factor in comparing stocks vs real estate investments. Stocks can be sold at long term capital gains rates, which are lower than ordinary income tax rates. Real estate also can take advantage of long term capital gains rates, but other deductions such as depreciation and offsetting rental income with expenses can be a big advantage. The 1031 exchange or deferring capital gains by rolling your investment into a new investment is also an advantage unique to real estate.
• Inflation is an area where both stocks and real estate are somewhat similar. When inflation is high both stocks and real estate are good ways to preserve wealth. Stocks and real estate maintain value fairly well even through high inflationary periods, especially when compared to cash.
What is an Asset?
An asset is considered a piece of property with underlying value. In finance, there are generally 5 core asset classes - stocks, bonds, real estate, commodities, and cash. These are types of property that can be bought and sold on exchanges or in transactions. Assets can be tangible or intangible property.
Let’s briefly explain the 5 major assets classes:
- Stocks - Ownership in the equity of a company
- Bonds - Ownership of a securitized debt investment
- Real Estate - Ownership in the equity of real estate
- Commodities - Ownership of a tangible good (oil, coffee, sugar, copper)
- Cash - Ownership of legal tender used to transact goods
These are the 5 traditional asset classes. Most investment professionals would include derivatives such as options and futures as assets as well as some cryptocurrencies.
Each asset class has its own advantages and disadvantages as an investment. Some of the characteristics of the 5 asset classes overlap, but many carry different traits depending on the economic environment.
What are Stocks?
A stock is a share of a company that represents the ownership of the equity in the company. The equity in a company is broken down into shares. These shares are called stock in the company.
Stocks have been around for decades and offer a way for individuals to have a financial interest in a company. This allows for an average joe investor to build wealth, without having to own and establish an entire company.
Stocks can offer capital appreciation, dividends payments, and ownership in a company. Stocks can be risky as well, we will cover the risks involved with stocks later in this article.
Public vs Private Stock
Stock can be traded on exchanges or by private transactions, depending on the size and financial structure of the company.
Some companies have their stock listed on exchanges where investors can buy and sell their positions. This makes certain stocks highly liquid, or easily bought and sold.
You can buy thousands of stocks on public exchanges such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ).
Certain stocks are transacted through private transactions. There are trillions of dollars worth of stock in the United States which is held privately. For example, Cargill Inc. is the largest privately held company in the United States. They have an annual revenue of $155 billion and employ 155,000 employees throughout the world. Source.
What are the Risks of Investing in Stocks?
Though stocks can offer many benefits such as capital appreciation and dividends, they can also be extremely risky. All of these risks can detract from the potential returns of your stock investment. Lets briefly review the risks to stock market investing
- This is the risk that the overall stock market has on your single stock investment. If the overall stock market declines, it can bring down the value of your stock even though nothing has changed at the company.
- This is the risk that you will not be able to sell or liquidate your stock investment. This may occur for multiple reasons such as panic selling or a stock that does not have a lot of trading volume.
- This is the risk that a borrower defaults on a loan and can’t make the required payments to the lender. The higher the level of credit risk, the higher the interest rate, and the higher the borrowing costs.
Interest Rate Risk
- This is the risk that interest rates rise and the company you own must take out loans at higher interest rates.
- This is the risk that the stock you own has a volatile price movement. Price volatility may be caused by the stock itself or the market as a whole. Some may debate whether volatility is a good measure of risk. Volatility risk is usually measured using standard deviation. A low standard deviation stock price has lower volatility, while a higher standard deviation means a more volatile stock.
- This is the risk involved with economic fluctuation. The economy tends to be cyclical, with booms and busts. Every so often there are economic recessions where GDP growth is negative for multiple quarters in a row. This can have a high impact on stocks as the majority of companies are impacted by the health of the economy.
- This is the most common risk associated with an individual stock. Unsystematic risk is all the risk associated with the operation of the individual company. Management decisions, financial health, and other company-specific risks are all considered unsystematic risk. Unsystematic risk can be significantly reduced through the use of diversification. We will discuss this further in this article.
Stock Market Returns
The stock market has the potential to earn compound returns over time. It is common to use a market index to get an average return.
From 1926 to 2018 the S&P 500 has earned an annual return of approximately 8% after inflation.
One of the most important things to understand when investing your money is that return and risk have a direct correlation. For this reason, the higher the potential return, the higher the risk in the investment.
Think of the cryptocurrency craziness in 2018. The high returns early investors were earning was in a way too good to be true. After the crash of 90% of the cryptocurrencies or crypto assets, some investors lost 95% of what they invested.
When it comes to the stock market there are ways to reduce some of your risks. Using a smart investment strategy can be vital to building long term wealth.
One of the ways to reduce unsystematic risk is to diversify your stock portfolio with multiple uncorrelated holdings. This way you can eventually rid your investment of company-specific risk. By investing in multiple stocks, compared to a single company, you can significantly reduce your overall portfolio risk.
Say you hold 1 single company in your stock portfolio, you will have your entire portfolio dependent on the performance of that single stock. However, if you invest an equal amount into a group of 5 stocks you can diversify away risk from a single company.
One of the most important aspects of diversification is correlation.
Correlation between the stocks in your portfolio can have a big impact on your overall portfolio diversification.
For example, if you invest in a group of technology companies, your entire portfolio will be subject to fluctuation in the tech industry. Since many sectors and regions have markets that move in tandem, you should avoid investing your entire portfolio in 1 industry or region.
The goal of stock diversification is to rid your portfolio of company-specific, region-specific, and industry-specific risks. By investing in a group of uncorrelated stocks, it is easier to achieve diversification.
How are Stocks Valued?
There are multiple ways to value companies/ stocks. One of the most common traditional ways used by Warren Buffett and Benjamin Graham is the discounted cash flows method.
By discounting the cash flows of a company to the present value, you can estimate the value of the company today. Using this method you can come up with your own price for the intrinsic value of a stock.
There are many variables that come into play when attempting to come up with an intrinsic value of a stock. Some of the variables to consider when trying to discount the cash flows of a company are:
- Current Earnings
- Projected Earnings
- Earnings growth rate
- Interest rates
- Expected Returns
- Risk/ Volatility
Of course, many of these variables must be assumed or projected, and a change in these variables can have a drastic impact on your results. When trying to find the discounted value of cash flows for a company you can virtually come up with your own price of the stock on paper. If you’d like to learn how to do this I suggest the book Security Analysis by Benjamin Graham.
Fees For Investing in Stocks
Today, stock market investing does not have many fees. Recently, many brokerages got rid of their commission fees for purchasing stock. Now, most brokerages have completely free trading for U.S. stocks.
However, if you invest in stock mutual funds or ETFs there are typically management fees involved. These fees vary between 0% and 2% annually of your total investment. Typically these are fees for managing the fund and called expense ratios. Each fund is legally required to disclose its expense ratio to investors.
Active Management Fees
Active management funds can typically have higher fees but are attempting to earn returns above the market. Index funds are passive funds that invest in market indexes, there is typically less portfolio turnover with index funds. Check out our detailed review where we outline the pros and cons of investing in index funds.
Some active managers earn fees for managing your money as well as providing financial planning advice. This wealth management method is popular for wealthier individuals who have more complex financial situations.
Other companies offer building portfolios completely free. Platforms such as M1 Finance will let you pick from a variety of portfolios for free.
How to Start Investing in Stocks
With so many online investing apps and platforms available today, it has never been easier to invest in stocks. Some of our favorite platforms are M1 Finance and Webull.
M1 Finance allows you to invest in stocks and ETFs for free as long as you have a minimum balance of $100 ($500 for retirement accounts). You can build your own portfolios or choose from a variety of pre-built portfolios available for free on its platform. Check out our full M1 Finance review here.
Webull is a stock, bond, ETF, option, trading platform that allows you to invest for free. There are zero fees or commissions for trading. This platform is typically better for a more active investing style. Check out our full Webull review here.
Real Estate Investing
Buying real estate is one of the oldest and most common investments people make. The purchase of your home will be most people’s largest financial purchase of their life. Investing in real estate can be rewarding, but can also bring with it many risks and tough decisions as well.
When first starting out investing in real estate there are a few primary ways most people begin.
The most common ways to start investing in real estate:
- Your first house/ apartment
- Buying securitized real estate (REITs, partnerships, etc.)
- Buying your first rental property (single-family, multi-family, owner-occupied)
Each of these investment strategies can have different risks, rewards, and outcomes. For this reason, it is important for investors to understand the ins and outs of their real estate investment. Check out our guide to real estate investing here.
Risks of Investing in Real Estate
As with all investments, there are risks involved with investing in real estate. Some of these risks vary depending on the type of real estate investment, but for the most part, there are common risks involved.
- Market Risk - This is the risk that the overall real estate market declines, causing the market value of your investment to decline.
- Liquidity Risk - This is the risk that you will not be able to sell or liquidate your real estate investment. Traditionally real estate has generally been a less liquid investment compared to stocks.
- Leverage Risk - This is the risk that arises under certain leveraged real estate deals. Leverage is used when trying to get more return with the same dollars. Using leverage can be risky because it involves borrowing.
- Interest Rate Risk - This is the risk that interest rates rise and the debt payments on your real estate become more expensive.
- Credit Risk - This is the risk of default on the real estate loan.
Real Estate Returns
Real estate is one of the most common ways for average joe investors to begin investing. The annual returns can vary significantly depending on the investment. Returns are never guaranteed.
According to Investopedia.com long term diversified residential real estate investments on average earn a 10.6% annual return.
As all investments are very different, this figure can have a significant amount of variance, so investors should be cautious about earning this type of return.
How is Real Estate Valued?
Real estate has an intrinsic value that can be computed in multiple different ways. The two primary drivers of real estate valuation are appreciation and rental income.
Similar to stocks, real estate can be valued by discounting its cash flows (rental income) to the present value. There are also capital appreciation models that can help value real estate.
Depending on the type of real estate investment, you can choose many types of valuation techniques. One of the most important measures is the capitalization rate.
What is the Capitalization Rate?
The capitalization rate is the rate used to determine the required or expected rate of return on a real estate investment.
For example, if you have a piece of real estate that will generate $5,000,000 in operating income over 10 years, to generate a valuation you divide the total net operating income by the capitalization rate say 12%. $5,000,000/.12 = $41,666,666. Roughly $41.6 million would be the intrinsic value or the value today of the real estate. You may be able to negotiate a market value below the intrinsic value to get a better deal on the real estate transaction.
To determine the capitalization rate you are trying to determine the profitability of the piece of real estate based on its market value.
Capitalization Rate = Net Operating Income / Market Value of Real Estate
The capitalization rate, or cap rate, is a useful measure when comparing two similar pieces of real estate. However, it does not take into other considerations such as time value of money or leverage.
Fees For Investing in Real Estate
Depending on the type of real estate investment, fees can be discrete, blatant, or non-existent. Let’s explain the difference in fees between buying physical real estate vs passive real estate investments.
Physical real estate has many fees involved when making a purchase. When purchasing a house or apartment there are multiple different types of fees and it can be absolutely overwhelming. Application fees, attorney fees, home inspection fees, escrow fees, appraisal fees, recording fees, and closing fees are just a few off the list.
When purchasing passive real estate investments, the fees can be more reasonable. This depends on the type of real estate investment, but investors can purchase publicly traded no-load REITs for free. An annual expense ratio between 0% - 2% for managing the REIT is common.
Load on a mutual fund or REIT is a common term and just means upfront commission. You may be able to purchase a fund and pay higher fees upfront, but a lower expense ratio as you hold the investment.
How to Invest in Real Estate
Investing in real estate has traditionally been a difficult thing to do. But, over the last hundred years with the securitization of real estate, individual investors can now gain easy access to real estate investments.
Ther are multiple ways to invest in real estate. Here are just a few
- House/ apartment - Whether you are buying your first house or your first rental property, purchasing physical real estate can be a great investment. Investors must be aware of the leg work involved with managing a property as well as its tenants.
- REIT - Real Estate Investment Trusts are great ways for individual investors to gain exposure to real estate investing. Investors must learn about the differences between REITs and all the fees involved.
- Crowdfunded Real Estate - This is a relatively new term, but similar to REITs crowdfunding allows investors to pool their money to purchase real estate properties. One of the more popular crowdfunded real estate platforms being Fundrise, where you can begin investing with a minimum of $500. Check out our full Fundrise review here where we talk about the pros and cons of the platform.
Investing in Stocks vs Real Estate: In Summary
Comparing stocks vs real estate investing is not as cut and dry as people may think. Real estate and stocks have their differences, but the similarities are clear. Some of the differences between real estate investing and stocks:
- Certain real estate investments can give you more control over your investment in general and the results of its success. While most stock market investing you do not have any say in the day to day operations of the company. Most of the time you are limited to your say on a proxy vote just like the other thousands or millions of shareholders.
- If the economy crashes, real estate has a tangible value. For this reason, real estate will always be a great store of wealth, people will always need a place to live.
- Stocks are often more liquid than real estate investments and can be sold at a moment’s notice. Real estate can take months or even years to sell your investment.
- Stocks offer a more passive way to invest in companies, certain real estate investments are more involved.
- Both stocks and real estate offer diversified investments and should be considered as a part of any diversified portfolio.
Once you begin investing in either stocks or real estate, you may gain some more clarity in how real estate and stock market investing compare.
Which of the two investments do you prefer? Let us know in the comments below!