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Which is the better investment: real estate or the stock market? It's a question that never seems to stop circulating, mostly because there's never a crystal-clear answer. There are pros and cons to both, and they can vary from one investor to the next.
Fortunately, it's possible to figure out the best answer for you. The key is getting a handle on which upsides and which downsides are most applicable in your particular situation.
Someone recently asked an entire Reddit community if he should stop buying and renting out residential real estate and instead start pouring this money into the stock market to achieve faster returns.
What would you do if you were me?
by u/Straight_Ad8203 in Fire
It's a great question to be sure. To fully appreciate the answer though, there's a bit more context needed. The individual in question is a 35-year-old medical doctor earning on the order of $400,000 per year at a job that's very demanding. There's a fair amount of money already tucked away in a retirement account and plenty in an emergency fund as well.
This person also owns -- and owes on -- four different rental houses. His plan is to accelerate the payoff on these properties with whatever net cash flow is left behind from their rent revenue. This plan at least implies there will be little to no net profit from these properties for the foreseeable future.
But paying off these rental houses as soon as possible will allow this doctor to semi-retire at 45 and enjoy some income as an MD, as well as some respectable rental income. His only concern? "Real estate is great but just feels like a slow return."
The numbers technically add up
This feeling isn't an uncommon one. But it's also possibly misleading, mostly because the money involved with being a one-person rental real estate company isn't the neat and tidy matter it is when you're running an apartment complex or own enormous office buildings.
Yes, the net gains in the value of real estate itself generally lag the stock market's average annual return of around 10%. Although the wild real estate market of late has been an exception to this number, mortgage lender Griffin Funding reports that since 1967, the average U.S. home gains just a little more than 4% per year. Not great.
That's also not the whole story, however. In this instance, the property owner is also monetizing this real estate by (presumably) charging rent that's at least a little more than his mortgage payments. The taxes, mortgage interest, and depreciation on this real estate are also tax-deductible expenses, adding to the owner's net/reported profits even if not adding to his tangible cash flow.
On balance, renting out real estate you're conventionally financing produces an annual return on your investment of anywhere from 5% to 12%, with an average of 10%, matching the stock market's average full-year return.
But that might not be the actual concern to address here, particularly for this busy investor. Far more important are the stress and missed opportunity that come with this plan over the course of the coming decade before he reaches age 45.
The downside of this particular plan for this particular person
Being a small-time residential landlord isn't a great venture for busy people. Even just four different tenants are a lot to handle when they're living in four different properties. And, while these rental houses are almost certainly insured, as a landlord, one accident can wreck what's already relatively thin cash flow.
Then there's the time factor. This individual is already busy. Finding a new tenant or coordinating with repair people will require more personal time that simply doesn't exist. Also consider the opportunity cost involved with this plan. That's the cost of tying up money to finance the purchase of real estate, or for that matter, just taking care of it.
While interest payments are tax-deductible expenses, they're still a real out-of-pocket personal expense using money that could otherwise be invested for growth in other ways -- for free. Ditto for sales commissions and buying and selling. Tax-deductible? Yes. But they're a net cost all the same. (Remember, tax deductions aren't the same as tax credits. You may not get all of this spent money back on the back-end, even if you've got a great accountant.) These nickels and dimes add up when you're not looking.
Image source: Getty Images.
Perhaps the chief reason owning rental real estate isn't quite ideal in this scenario -- when there's a viable alternative use of after-tax income -- is the lack of liquidity should the owner choose to sell a property. You can always sell stocks, even if at a price you don't love. There's never a guarantee you'll be able to get rid of a rental home you no longer want, however, even if you're offering it at a great price.
If all goes as planned and this doctor can cut back to working three days per week 10 years from now, the time to effectively manage four rental houses likely will exist then. The business will be net-profitable, with at least a big chunk of properties being paid off.
That's a pretty big "if," though. There aren't a lot of part-time doctors who actually only work part-time hours these days. The job often just doesn't allow it.
And the winner is...
There are no absolutely correct answers, and there's always more to the story. Indeed, there may be a terrific unmentioned reason here to continue focusing on real estate rather than committing this money to stocks.
On balance, though, what's known about this particular situation favors owning buy-and-hold stocks over rental homes. If this individual invests wisely over the course of the coming decade -- keeping things simple and efficient, like just owning an index fund -- and actually ends up cutting back to part-time hours at age 45, he can still buy rental property then.
He may even be able to outright purchase rental real estate rather than financing it if that's still his goal at that time, saving at least some money as a result. He'll save some money in the meantime too, since the cost of being in the stock market is a pittance compared to owning rental real estate.
But you're still committed to owning rental properties right now? Consider this: While it feels great to pay down these loans early, that's not necessarily the best financial move. If the interest rates on these mortgages are low enough, there's a case to be made for drawing out these tax-deductible loans on this cheap money for as long as you can, and investing the extra cash flow in something with a higher rate of return.
Your cash flow is certainly going to grow. Remember, rental rates rise regularly, but the size of your mortgage payments usually doesn't. This real estate venture should at least be a measurably higher-margin one 10 years from now. That's one of the chief reasons to stick with it. If you've got time, inclination, money, and ability to own rental real estate, your answer may be different.
