Why
Real Estate Could Be a Better Investment Than Stocks
Investors must decide if the returns are worth the
risk and effort involved in owning rental property.
With the right property, neighborhood location and
cash reserves, investing in real estate can be a great option.
Once you're on track with your financial goals –
such as retirement contributions or repaying student loan debt – you may find
yourself exploring real estate investments in lieu of the stock market. Buying
real estate as an investment can be lucrative, but it's also cash-intensive and
carries risks.
As you weigh your options, consider the following
points in your analysis.
Risk
versus expected returns: Whether putting cash into the
market or purchasing real estate, you need to assess the risk versus the expected
returns. Traditional equity investments are much easier to analyze in this way.
You have historical data, and although past performance is not indicative of
future results, you have a bit more control over how much risk you're exposed
to when deciding what amount to invest, the asset allocation and so on.
Investing in single stocks versus an index fund is a calculated risk some are
willing to take in search of higher expected returns.
The risks when buying real estate can be much harder
to quantify. While there is data available, such as comparable home prices in
the area and average rents, unpredictable changes in the market can be costly.
When investing in the equity market, your risk of loss is limited to your
initial investment. This isn't the case with real estate – you could wind up
owing the bank more than the value of your property if the market experiences a
downturn, or even due to changes that negatively impact a neighborhood.
For landlords, vacancy and repairs can eat into
profits. Once you calculate your expected mortgage, operating costs, taxes and
maintenance, how much can you expect to earn in net rental income? The answer
for every investor will be different, but for some, the anticipated return will
not be worth the risk and effort involved in owning real estate.
Required
capital: Virtually anyone can invest in traditional equity
assets. Some shares can be very inexpensive and you can often determine the
volume as well. The same cannot be said for real estate. To purchase a
property, you need to either come up with a down payment yourself, or enlist
partners to invest with you. Typically, you need to put down 20 percent for a
traditional mortgage, and although various programs can help you to put down a
smaller percentage, there are fewer options for investment properties.
The initial cash outlay is what deters many would-be
real estate investors, as you could easily spend upwards of $100,000 on a down
payment and initial repairs. Furthermore, real estate requires additional
capital to maintain the property, often not at the owner's behest. With stocks,
you can make a one-time investment or purchase additional shares later, at your
discretion.
Taxes:
Another aspect to consider when deciding to invest in real estate or the stock
market is taxes. If you own property, you will be required to pay property
taxes every quarter, based on the assessed value as determined by the city or
country. This is included in your mortgage payment. Whether you want to flip
the property or hold onto it as a landlord, you will also have to pay tax on
the sale or rental proceeds.
There are certain tax benefits unique to owning real
estate as a landlord, however. The interest expense on your mortgage is tax
deductible, along with operating expenses, property taxes, insurance and
depreciation. Exactly how much you can deduct will likely depend on the rental
income. In most situations, under the passive activity loss rules, you cannot
write off deductions that are more than the rental income, which would generate
a loss. Working with a CPA can be very helpful, particularly when investment
properties or multiple residences are involved.
Stocks have tax consequences as well; first, you are
required to pay a capital gains tax on any profits you made from selling stock.
Furthermore, even without a sale, you are also required to pay a tax on any
dividends you receive.
Inflation:
Real estate can be a potential hedge against inflation as historically, rental
rates and home prices rise with inflation. This provides a potential inflation
hedge for both your rental income and sale of the property. Since your mortgage
payments will not increase with inflation, it offers a benefit over time.
Traditional equity investments are not as directly
linked to inflationary measures. Although prices do tend to rise over time, the
market cannot offer the same potential inflation protection as real estate.
Time:
Another factor to consider when choosing to invest in real estate or the stock
market is to factor in your time as a cost during the analysis. While you do
need to do some research when deciding which funds to buy, you can purchase
traditional equity investments in a matter of moments.
There is a lot more time
required in buying and maintaining a property, as well as managing any improvements.
As a landlord, you will be on call for the tenants as problems arise. Hiring a
property manager is an option, but depending on the size of your property,
could eliminate your profit margin.
With the right property, neighborhood location and
cash reserves, investing in real estate can be a great option. Many investors
are drawn to the ongoing "coupon" payment of rental income, and as a
long-term strategy, the ultimate sale of the property can fund a large portion
of their retirement. If you're considering whether you should invest in the
equity market or buy an investment property, carefully weigh these factors and
determine whether your expected income is worth the risk it carries, especially
in light of other investment options.
