Putting some of your assets in real estate is good for diversification, but what about returns? Which asset class has produced better returns over long periods of time -- real estate or stocks?
This is a tough question to answer. There’s no way to reliably gauge individual investment property returns on a wide scale. Having said that, here’s a rundown of how the two asset classes compare as long-term investments.
The simple answer
First, it’s important to note that stocks tend to increase in value quicker than real estate. Over long periods of time, an S&P 500 index fund has historically produced total returns in the 9–10% range. Meanwhile, real estate prices tend to outpace inflation, but not by much.
Since 1940, the median home value in the United States has increased at an annualized rate of 5.5%. But this is misleading. Homes are significantly larger today, on average, than they were back then. The average home in 1940 was 1,246 square feet, roughly half of the 2,430 average of 2010. Adjusting for home size, the annualized increase on a per-square-foot basis drops to 4.6%. After accounting for inflation, the average home value has risen by just 1.5% per year.
Compare this to stock returns. Stocks have generated roughly 7% per year over the long run after accounting for inflation. In other words, the stock market has generated returns at more than four times the rate of real estate appreciation. If you’ve ever heard someone tell you that “your home isn’t an investment,” this is probably why.
Real estate as an investment has much stronger return potential
Real estate values tend to barely outpace inflation. However, there are a few reasons why real estate investments tend to do better.
The first reason is leverage. Unlike stocks, where it’s irresponsible to invest with borrowed money, you can use significant amounts of financing for real estate investments without adding a ton of risk.
Unlike stocks, where it’s irresponsible to invest with borrowed money, you can use significant amounts of financing for real estate investments without adding a ton of risk.
Lenders typically finance investment properties with down payments of just 20–25% of the sale price. When buying a primary home, the down payment requirements can be significantly lower (although you may have to pay mortgage insurance with less than 20% down).
The effect of this leverage is that small returns can be greatly amplified. Consider this simplified mathematical example. Let’s say that you buy an asset for $100,000 in cash and its value increases by 3%. You earned a $3,000 (3%) return on your investment.
On the other hand, let’s say that you buy a $500,000 asset by investing $100,000 of your own money and borrowing the other $400,000. If the value of this asset increases by 3%, you’ll have a return of $15,000, or 15% of your initial $100,000 investment.
This isn’t a perfect example. When it comes to real estate, you’ll typically have to pay an origination fee to a lender as well as various closing costs when you buy a property. These costs eat into your returns. Plus, if you borrow money to buy a property, you’ll need to make mortgage payments each month while you own it. That said, leverage can still dramatically amplify real estate returns, which is why most investors choose to use it.
The second reason why investment real estate can produce strong returns is that investment properties can be rented out to generate income. To give a personal example, I recently bought a triplex as an investment property. It would be nice if the property value went up over time. But the primary driver of my returns is likely to be the rental income collected from the three apartments.
Finally, real estate investors enjoy tax advantages that stock investors don’t. For example, when you buy an investment property, you get to write off the purchase price over a certain number of years -- a tax deduction known as depreciation. It would be awesome if you could write off your stock investments in a similar manner, but that isn’t the case.
Real estate investment trusts, or REITs, get an extra tax benefit in that they avoid corporate taxes by paying out most of their income as dividends. These are easy for investors to buy in an IRA or other tax-advantaged retirement account, meaning they can avoid dividend and capital gains taxes altogether.
As we’re about to see, the combination of rental income, leverage, and tax benefits can combine to produce attractive long-term gains.
How has investment real estate compared with stocks over time?
It’s difficult to find reliable historical data on total returns from individual investment properties. There are too many variables, and there’s no reliable way to track total returns achieved by individual investors.
However, one good way to visualize the power of real estate investments is to examine how real estate investment trusts have performed over time.
With that in mind, here’s a comparison of the total returns of the S&P 500 stock index and the Vanguard Real Estate mutual fund, a good benchmark index of equity REITs:
|Time Period||S&P 500 Total Return||Vanguard Real Estate ETF Total Return|
|Since May 13, 1996||621.8%||865.3%|
Real estate stocks tend to be correlated with interest rate fluctuations over short periods of time, which is the main reason for the big underperformance in the three-year row. Rising interest rates are bad for REITs, and the Federal Reserve raised interest rates eight times over the past three years.
However, over longer periods of time, the effects of interest rate fluctuations tend to balance out, and we can get a better look at how the performance of these two asset classes stack up side by side.
If you look at the longest time period, you’ll notice that the performance is comparable but with a significant edge to real estate. This is an imperfect conclusion, as there are other ways to invest in real estate besides REITs and they have different investment dynamics. But it does illustrate the long-term return potential of real estate investments.
The bottom line
I’s tough to make an apples-to-apples comparison of the two. But it’s fair to say that real estate investments have just as much, if not more, return potential as stock investments. When you combine price appreciation, income potential, and the inherent tax benefits of real estate investing, there’s potential for impressive long-term returns.