Do Stocks Beat Rental Real Estate?

Stocks or rentals. Which investment is better?

The answer may surprise you.

Stock investors tell you they win by referencing Jeremy’s Siegel’s seminal book “Stocks for the  Long Run.” With over 125 years of data, this is the de facto guide on why stocks beat cash, bonds, gold and your home.

Next, they will point out the Nobel Prize winning work of Robert Schiller on housing versus stocks and how real estate has basically grown at the rate of inflation. As Ben Carlson points out in his blog “A Wealth of Common Sense,” the real return (after you adjust for the rising cost of living) is almost zero.

Source: A Wealth of Common Sense

By the way, Ben writes a great blog. I highly recommend subscribing to it if you want to learn about stocks and behavioral finance.

Real estate investors will tell you comparing your home to stocks is not fair.

For one, a home is not an investment.

Two, cash flowing real estate is a business.

Three, most people don’t make money on their home after subtracting maintenance, improvements, real estate taxes and insurance. A home should be considered a forced savings account assuming you purchase it with a mortgage.

Worse, who likes to lose 50% on their investments whenever Mr. Market goes off his meds?

Landlords are happy to collect rents, field tenant calls and tinker with their portfolio. Sure, it’s more work than investing passively in market indexes, but they feel it is less risky since they have more control over the outcome.

Real estate investors like to brag about the 5 ways they make money.

1. Rent checks automatically show up in their bank account.
2. Equity increases since they outsource their debt payments to tenants.
3. Appreciation increases slightly above inflation.
4. Leverage allows them to control 100% of the asset with only 20% of their money.
5. Depreciation (a phantom expense) allows them to pay little or no income tax. Better yet, it offsets W-2 income if you or your spouse can be classified as a real estate professional in the event you exceed the passive income loss limitation.

Well, it looks like a recently published working paper at the Federal Reserve Bank of San Francisco has finally proven what income property investors have known all along.

Residential income producing real estate is the clear winner over the last 145 years across 16 developed economies.

In “The Rate of Return on Everything, 1870-2015,” Scar Jorda, Katharina Knoll, Dimitry Kuvshinov, Moritz Schularick and Alan M. Taylor put together one of the first datasets of rental property yields and appreciation among 16 developed countries.

They also expanded upon the global return indices of stocks, bonds, t-bills and inflation beyond Jeremy Siegel’s book.

Some of the key findings…

• Rental housing outperformed stocks up to WWII; thereafter, equites outperformed real estate at higher risk and more correlation to the business cycle.
• The covariance of stocks to rental housing offers substantial diversification benefits without sacrificing returns. For example, most financial advisors recommend holding short term to medium term government bonds, gold, commodities long/short funds or annuities to diversify from stock market risk. This lowers your potential return but allows you to sleep at night.
• Investors should consider the diversification benefits of international rentals in addition to international stocks and bonds. While this could be implemented in a REIT structure, REIT’s tend to be highly correlated with the stock market. A better approach would be investing in actual properties, private equity or syndication.

If income producing real estate offers higher returns than stocks, isn’t it riskier?

Great question.

Everyone knows if you have a higher return you must be taking on higher risk.

Over the entire 145 period, stocks earned a nominal (not adjusted for inflation) annual return of 10.81% while sporting a 22.67% standard deviation.

Ok, sounds like what all the financial folks tell ya. Stocks earn 10% over the long run and are risky. This is why you should never invest in stocks with money you plan to spend in five years or less.

Hell, a 22% standard deviation means you can lose 12% in one year or gain 32% in another. That’s some serious risk.

Income properties, on the other hand, posted a 11.22% annualized return at a 10.76% standard deviation.

What’s not to like?

Higher return; half the risk.

Better yet, this is after factoring in all expenses on the rental properties (except property taxes) and assuming the properties were paid for free and clear.

Got leverage?

I would not advise leveraging your stock portfolio. You don’t want to end up like these investors.

Long term capital

Bear Stearns

Lehman Brothers (I had a commercial loan with them)

2018 Volpocalypse

Or, this mutual fund. It plunged 82% over two days after the market hit a speed bump this year.

Source: Morningstar

Yikes…there goes 772 million of shareholders dollars while making mutual fund history.

Being that real estate has less risk (standard deviation) than stocks, it becomes the perfect vehicle to boost returns via some conservative debt. I’m talking about fixed rate long-term debt. Forget interest only loans or products with short-term balloons. This is one of the reasons why people got into trouble during the housing bust.

As mentioned before, the authors did not include property taxes and depreciation benefits in their calculations since different countries have byzantine tax laws. They estimated the return would drop by 1% if you included property taxes. I estimate, it is a wash since you can eliminate almost all your taxes in the good ‘ole USA via 1031 exchanges and depreciation.

If you were to simply put 20% down on a single family rental plus closing costs, you could increase your return from 11.22% to 17% assuming a conventional 30-year fixed  mortgage at 4.5% on a $150,000 purchase based upon my prior blog post.

Plus, most people don’t have the resources to pay cash for a decent single-family or multi-family rental. Once you add in the leverage, you can easily outperform the stock market with less risk.

As the authors pointed out in this table, stocks posted higher average annual returns (arithmetic) since the 1950’s. Note the standard deviation in parentheses. As post 1950 returns on stocks increased, so did their risk. The opposite was true for housing.

On a compounded basis (geometric return), housing wins in both periods. The reason for this is real estate is less volatile. This is one concept that many investors fail to grasp when it comes to picking mutual funds based upon average annual returns.

For instance, if you had a $100,000 investment that went up by 5% the first year and fell by 5% the next year, the average annual return is 0%.

The compounded return(CAGR) would look like this.

Year 1-$105,000

Year 2-$99,750

CAGR-negative 0.125%

Let’s invest in Bitcoin and see what happens.

The first year you make 50% and the second year you lose 50%. Again, the average return is 0%.

Compounded…

Year 1-$150,000

Year 2-$75,000

CAGR-negative 13.40%

This is one of the main reasons you have to weigh the risks before rewards whenever you deploy your hard-earned savings. Be especially careful when you invest in volatile assets like futures, derivatives, FOREX, or Bitcoin.

For the record, Bitcoin is not an investment. An investment is something that puts cash in your pocket no matter where the market is going and doesn’t get hacked by organized crime syndicates.

Clearly, the debate is not over on stocks versus real estate. I’ve always suspected the latter was superior simply due to my personal experience of investing in both stocks and small multi-family housing. What surprised me was how unlevered real estate outperformed stocks both in and out of the USA.

Should you invest in stock or real estate? Now that you are armed with this knowledge, consider both as a way to increase your return while lowering your risk.