Are stocks or real estate a better investment? There’s no short answer to this question, and the better choice depends on several factors.
With that in mind, here are some of the most frequently asked questions by investors who aren’t sure which is best for them.
Which is the better investment -- real estate or stocks?
Both have advantages and disadvantages. The best answer for you depends on your investment style, risk tolerance, and goals.
Not only that, but there's also a ton of variation within both investment classes. For example, an S&P 500 index fund is a very different investment from a risky up-and-coming biotech stock.
Similarly, investing in a rental property and buying shares of a real estate investment trust (REIT) are two completely different types of investments.
Does real estate generate superior returns to stocks?
The short answer is not really, but there’s a big caveat here. Over long periods of time, property values tend to appreciate at 2.5–3% per year, barely outpacing inflation. After accounting for expenses, real estate investments usually earn about 5–6% of their value in rent annually. Combined, this adds up to total returns of 7.5–9% per year. The S&P 500 has historically generated total returns of about 10% annually over long periods.
However, real estate investments often involve significantly more debt (or "leverage"). While it’s generally not a good idea to buy stocks on margin due to their volatile nature, it’s rather safe to use borrowed money to acquire real estate. When accounting for the benefits of leverage, real estate investments can produce higher long-term returns than stocks.
What advantages does real estate have over stocks?
The ability to safely use debt to acquire real estate has the ability to translate into some pretty impressive returns over time. In fact, it’s not uncommon for an investment property purchased with 20–25% down to deliver annualized returns around 15%.
In addition, real estate investments have some unique tax advantages over stocks. For example, real estate investors can take a depreciation "expense" each year that reduces their taxable rental income. And, through a process called a 1031 exchange, real estate investors can defer taxes when they sell a property by reinvesting the proceeds. Furthermore, REITs have the unique advantage of not paying taxes on their profits.
Isn’t too much leverage dangerous?
"But wait," you might say, "didn’t leverage play a key role in some of the worst market crashes of all time?"
Leverage is typically used when investing in real estate. This begs the question of whether this inherently makes real estate investment dangerous. After all, too much leverage when buying stocks was a major contributing factor to the crash of 1929. And real estate leverage was a main contributor to the financial crisis a decade ago.
However, there are some key points to keep in mind:
First, when you buy a stock on margin, your broker has the right to ask you for more money or automatically sell your stock if its value goes down. This is known as a margin call and can be a nightmare scenario to a long-term investor.
On the other hand, a lender won’t demand immediate payment of your mortgage or sell your home because its value declined. This is a big difference and the main reason why real estate debt makes sense for long-term investors but taking on debt to buy stocks does not.
Second, although real estate does experience price swings over time, they tend to be far less dramatic than stock market swings.
Third, investors got into trouble with debt during the financial crisis for two reasons. They stopped caring about their properties' cash flow and focused on price appreciation. In fact, many investors bought homes and didn’t even rent them out, planning to pay the mortgage for a little while and sell the property for a big profit.
And there were tons of "creative" mortgage products given to borrowers who were clearly not creditworthy. Fortunately, many of these don’t exist anymore.
If you use debt responsibly, it's a healthy part of a real estate investing strategy. Just don't forget about the cash flow of your real estate investments.
What are some of the downsides of real estate investing?
While investment properties can produce big returns, there’s no such thing as a free lunch. So it’s important to keep these drawbacks in mind.
Buying real estate is a time-consuming investment. Hiring a property manager helps. But searching for, evaluating, and buying properties consumes far more time than a stock investment.
Real estate is an illiquid investment. You can sell stocks with a couple clicks in no time at all. Conversely, it can take months to sell an investment property unless you want to accept a highly discounted price.
Finally, there are some unique risk factors that could hurt your investment returns. Vacancy risk is a real-estate-specific issue. If your property sits vacant, you have no money coming in but you still have to pay the mortgage and other expenses.
What are some of the advantages of stock investing?
Stocks have a history of the strongest long-term unlevered returns of any major asset class. Besides that, the biggest advantage of stock investing over real estate is liquidity. If you want to sell your stocks, you can do so for full market price with the click of a button.
And, while there is homework involved in buying stocks, they're almost maintenance-free. Aside from the decisions to buy and sell, there isn’t any upkeep you have to do with your stocks -- at least not in the sense of real estate maintenance.
It’s also easier to diversify your holdings with stocks. You can buy the stocks of companies in a variety of industries to hedge against economic and industry-specific risks. Meanwhile, if you’re buying a portfolio of investment properties, you’re essentially putting all of your money in the same investment sector.
What are some of the drawbacks of stock investing?
Although stock market returns have been quite consistent over decades, they tend to be volatile over short time periods. Statistically speaking, returns of 45% or a plunge of 22% in a single year wouldn’t be considered unusual.
Because of readily available market prices and the liquidity of the market, it’s easy to let emotions take over and make bad trading decisions. In fact, emotional investing is why most stock investors end up underperforming the market. Investors want to throw money into the market when they see everyone else making money and stocks can’t seem to go anywhere but up. But when the market plunges, it’s human nature to sell before things get even worse. It’s common knowledge that the main goal of investing is to buy low and sell high, but human emotions tend to make people do the opposite.
The bottom line
There’s a lot more to the story than saying one type of investment is better. For most investors (myself included), the best option is a combination of stocks and real estate. This lets you take advantage of the best parts of each.