Real Estate Stocks: Getting the Best of Both Asset Classes

Real estate and stock investing are almost always viewed as a choice between the two. Here's how you can invest in both at the same time.

Often, investing in real estate or stocks are pitted against each other to compare which is the better investment. While either option certainly has its advantages and drawbacks, there is a select class of stocks that can give you exposure to both real estate and the businesses built around the real estate market.

So let's take a look at this unique class of stocks and why you may want to consider incorporating real estate stocks into your overall portfolio

What are real estate stocks?

Real estate stocks is a pretty broad term because it can involve any publicly traded stock for a business that touches the real estate market in some shape or form. They can be technology companies, manufacturers, developers, real estate brokers, retailers, and financiers.

Just to give you an idea of the breadth of investments in real estate stocks, here is a quick glance at a few publicly traded businesses you may have heard of:

Company Market cap Industry
Toll Brothers (NYSE: TOL) $5.6 billion Homebuilder
Zillow (NYSE: Z) $8.2 billion Real estate broker
Home Depot (NYSE: HD) $259.8 billion Home improvement retailer
CBRE Group (NYSE: CBRE) $18.8 billion  Property management
RE/MAX Holdings (NYSE: RMAX) $1.14 billion Real estate broker
U.S. Concrete (NASDAQ: USCR) $720 million Building materials

Market data: Yahoo! Finance. Market capitalizations as of 12/16/2019

This is by no means a recommendation of these particular companies, but it shows the breadth of directions one can go when investing in real estate through stocks.

What about REITs?

On top of the various industries that have significant exposure to real estate, there is even a unique class of stocks that own and operate property themselves. They are called real estate investment trusts -- also known as REITs. These are such a unique type of investment on the stock market that they receive special tax treatment because of the way they are structured.

There are several things about REITs and equities that are the same. They are both publicly traded and allow you to easily buy and sell them with little fees. They have to disclose their financials to the Securities and Exchange Commission and make them public for all potential investors to read. And the things that you want from a REIT investment are very similar to what you want from a regular stock investment -- a great business that can generate returns and grow your wealth over time.

The added bonus with REITs is that they all tend to be dividend stocks that pay income rather generously. The FTSE Nareit All REIT Index -- an index that tracks all publicly-traded REITs -- has a dividend yield of 3.93% compared to the broader stock market S&P 500 dividend yield of 1.98%. For those looking for stocks to pay income, REITs are a popular income investment

There are, though, some subtle differences between REITs and other stocks that make them a unique asset class. The way dividends are taxed is slightly different, and the way to analyze REITs can be slightly different than a prototypical business. Please check out this comprehensive guide on REITs that will help give you a better picture of this special asset class.

Buying bundles of stocks at once, ETFs

Like investing in a single rental property, investing in any single company carries unique risks. A company in a fast-growing industry may not be able to capture market share, or another company may have made some poor decisions and made a bad investment that is hurting their bottom line.

One way you can avoid the perils of an individual company is to buy an exchange-traded fund, or ETF. ETFs are a basket of several stocks that you can invest in and give you exposure to dozens, even hundreds of companies at once. By instantly diversifying your portfolio with ETFs, you can capture the gains of the great stocks in that basket while also mitigating against poor performance from others.

There are hundreds of ETFs out there these days allowing you to invest in a broad set of companies, or even a unique industry like real estate. Here is a list of the five largest real estate exchange-traded funds on the market today:

ETF Total assets
Vanguard Real Estate Index Fund (NYSEMKT: VNQ) $37.2 billion
Schwab U.S. REIT ETF (NYSEMKT: SCHH) $6.1 billion
iShares U.S. Real Estate ETF (NYSEMKT: IYR) $4.9 billion
Real Estate Select Sector SPDR Fund (NYSEMKT: XLRE) $3.9 billion
SPDR Dow Jones REIT ETF (NYSEMKT:RWR)  $2.7 billion

Source: Yahoo!Finance

How to buy stocks

Buying stocks is a relatively simple process. When you have enough money saved that you can allocate some towards a longer term investment, you can purchase those stocks through a stock brokerage account.

One of the advantages of investing in stocks is that the amount of money required to buy stocks is considerably less than what it would take to invest in real estate directly. So for those looking to get started in investing that don't have much savings built up yet, real estate stocks can be a good option.

In fact, the ability to invest in stocks, in general, has become significantly easier and less expensive than ever before. More and more online brokerage companies are allowing you to buy and sell stocks without having to pay commissions. It's a welcome change for those just getting started on their path to building wealth.

Why invest in stocks?

There are dozens of ways to look at stocks as investments. While some will likely say that stocks are "just a piece of paper" and don't represent a real asset, the best way to think about an investment in a stock is if it were a real asset that you intend to hold over a long period of time.

Stocks are a much more volatile asset class than real estate and therefore the price of a stock can go up and down by double digits or more in a single day. Sometimes, those price movements are caused by no more than what people think of a stock at any given moment. For some, this volatility makes stocks a risky investment and to be avoided.

When you buy real estate, though, you are intending to invest for a long time horizon, as it is prohibitively expensive to trade in and out of real estate properties regularly. If you are willing to take a similar approach to stocks, you are much more likely going to have success.

Despite the large daily, weekly, or monthly swings in price, the long term rates of return for stocks are some of the highest out there. According to the Federal Reserve Bank of San Francisco, stocks, as a whole, have achieved a real return of 8.28% annually since 1950. Real returns mean that those returns are adjusted for inflation over that whole time period. It makes stocks the highest returning asset class over that time frame.

Of course, these rates of returns aren't linear. So far in 2019, for example, the total return for the S&P 500 Index -- total return is in the increase in price as well as annual dividend payments from all stocks in the index -- is up 26.5% as of the time of this writing, an absolutely fantastic year historically speaking. While you can likely expect down years and great years with stocks, over the very long haul they tend to average out to that 8.2% rate above inflation.

The case against stocks

No investment is perfect, and going into any investment with eyes open to the benefits and shortcomings of that asset class will help you make better decisions. Real estate stocks are no different.

It is worth repeating this. Stocks. Are. Volatile. Any investment in stocks comes with the caveat that you need to be able to stomach wild swings in valuation, especially when times get rough. This is where we pull out an investment writing cliche and drop a Warren Buffett quote here to emphasize this point:

You shouldn't own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.

These things will happen, and those that are prepared to handle these market fluctuations will be better off in the long run.

Another drawback of investing in real estate stock is that you are betting that the company's management will act in your best interests. As fundamental as that may sound, not all management teams act in this way. Part of your job when choosing stocks to invest in is finding management teams that will be good stewards of your invested capital.

Finally, another thing to consider about real estate stocks is that they tend to be cyclical like the real estate market. Stocks in cyclical industries like real estate tend to have periods of rapid revenue and profit growth followed by periods of flat to declining results. A cyclical industry can be challenging to invest in because even great investments can lead to low returns depending on what time during that cycle you invest. Understanding how stock prices work and basic valuation concepts like the P/E ratio are some concepts you will want to brush up on when investing in cyclical stocks.

What makes a good stock investment?

If you go into investing in stocks knowing full well that there will be up and down years and have the temperament to see beyond these short-term fluctuations, then you are likely ready to invest in individual real estate stocks.

Just like investing in property, investing in stocks requires that you do some homework upfront to identify your best opportunities. After all, by definition, a stock is a small portion of a business. That means you need to spend a considerable amount of time understanding the business you are buying.

There have been enough books written on investing in and analyzing stocks to fill a few large libraries. Trying to cover all that here would do it a disservice. With that in mind, here are some questions for which you should seek answers to determine whether a stock is worth buying:

  • How does the company make money?
  • Does it do something different or better than anyone else?
  • What do some of its competitors do, and is it a better product or service?
  • What are some of the risks to its business that could prevent it from being profitable in the future?
  • What are the opportunities in front of it to make more money?
  • Does the current stock price seem like a reasonable amount to pay for this company?

It sounds incredibly simple, but sometimes the answers to those questions are complex and can take a long time to figure out.

One of the things that makes real estate stocks unique to so many other stocks, though, is that they tend to follow the market cycles of the real estate market. Remember, cyclical industries can be good investments, but buying a company at the top of a market cycle will likely take much longer to generate a decent return than someone with the poise to identify market dips as investment opportunities instead of times to avoid stocks. If you do intend to invest in stocks, you should keep tabs on the current state of the real estate market and where it could go in the coming years.

Are real estate stocks right for you?

Any kind of investing that helps make your financial future more certain is a good thing, whether it be stocks or real estate or some blend of those with other asset classes.

Another thing to consider, too, is portfolio diversity. The amount of money required to invest in stocks is orders of magnitude lower than typical real estate deals, and the ability to allocate that money to several stocks all at once allows one to diversify their holdings. To achieve the same amount of diversity in real estate, it can take hundreds of thousands, even millions, of dollars.

Real estate stocks are also a great entry point into the real estate market as a whole. Reports from a home improvement retailer like Home Depot can provide a lot of insight into new construction and renovation activity across the U.S. Or the speed at which homebuilders are selling homes in certain areas can tell the strength of a particular real estate market. Information like this can be valuable for both investing in real estate stocks as well as other real-estate-related asset classes.

Whether stocks are right for you comes down to whether you have the right kind of temperament to handle the volatility of stocks and are able to identify good businesses in which to invest over the long haul.

Tyler Crowe owns shares of Vanguard REIT ETF. The Motley Fool owns shares of and recommends Vanguard REIT ETF and Zillow Group (C shares). The Motley Fool recommends Home Depot and recommends the following options: long January 2021 $120 calls on Home Depot and short February 2020 $205 calls on Home Depot. The Motley Fool has a disclosure policy.