Are stocks or real estate a better investment?
This question is comparing apples and oranges. But it's worth considering if you want to maximize the value of your investments.
There are significant differences to consider when you’re allocating funds in your portfolio. We'll look at each of those differences in detail.
I've also summarized them here in this table:
|What am I buying?||Shares of a company||Physical land or property|
|How do I make money on my investment?||Dividend payouts||Rental income|
|Where does my long-term return on investment (ROI) come from?||Share price increase||Market appreciation of the property|
|How much money do I need to invest?||Depends on share price; varies widely||20% down payment of purchase price (typically)|
|What do I own?||Intangible assets (paper ownership)||Tangible assets (you can touch and live in it)|
|What type of investing is involved?||Passive -- you own part of a business without doing any work||Active -- generally requires active management and local market knowledge|
|Can I get my money out quickly?||Yes -- you can trade in and out of stocks easily||No -- real estate is a long-term investment|
|Can I leverage my investment?||Yes -- you can use margin to leverage stock investments but it’s very risky and not recommended||Yes -- you use leverage to own 100% of a property with a 20% down payment|
|How much will the value of my investment fluctuate?||The price of stocks can experience extreme fluctuations||Real estate values are typically less volatile|
|What about tax advantages?||No special treatment (unless held in tax-advantaged accounts)||Property depreciation is an annual tax deferment real estate investors love (there are others, too)|
|What about capital gains taxes?||You pay capital gains tax on your gains, depending on the account you hold them in||Capital gains can be deferred through a 1031 exchange|
|What about diversification?||You can own shares of many companies with low minimum investments||Even using leverage, it takes more money to diversify real estate holdings|
Now let's take a look at the five key elements of each investment in detail.
Both real estate and stock values fluctuate.
The stock market can drop suddenly when the economy faces challenges. Individual stocks can experience dramatic drops based on sector and company performance. Investors sometimes “panic sell,” losing years of stock appreciation with one emotional move. It could take many years to recoup losses and get back to where they started.
Real estate investments are generally less susceptible to short-term market volatility. In most markets, the value of property gradually increases year after year, keeping pace with inflation. And some markets see tremendous appreciation that far outpaces inflation. Of course, there are times when real estate prices drop or stay flat. If an investor took on significant debt to purchase or rehab a property and the market drops significantly, they may end up with a property that’s worth less than what they owe on it. This is what happened to many homeowners and investors during the housing bubble that burst in 2007, and they were stuck selling at a loss.
While a long-term view is recommended when investing in stocks or real estate, it’s easy to make a rash decision and panic sell stocks. That’s not easy to do with real estate. Investors must ride out short-term volatility -- which helps avoid disastrous decisions.
Stocks are very liquid. You can trade in and out of them easily, quickly, and inexpensively.
Thanks to discount brokers and index funds, the cost to buy, sell, and own shares have gone down drastically over the past couple of decades.
Real estate is a long-term investment and very illiquid. When you invest in a property, you typically cannot sell it right away if you have an emergency need for funds. In most cases, you have to hold the property for several years to realize its true profit potential.
The transaction costs of real estate are also far higher than trading stocks. Closing costs include transfer taxes, commissions, and fees that add up to thousands of dollars. It doesn’t make financial sense to buy and sell real estate holdings in the short term.
3. Tax advantages
There are many tax deductions for owning property. Depreciation is a big one -- it provides an annual tax write-off to offset the wear-and-tear of a property. You get a tax deduction on an asset that's likely appreciating in value year after year. And real estate investors can postpone, or even avoid, paying capital gains tax on their gains by selling property through a 1031 exchange.
If you’re investing in stocks through a tax-advantaged account such as a retirement account, you can defer taxes. However, you can't capitalize on tax deductions like you can with real estate investments. Generally, stock dividends are taxed as ordinary income. And when you sell stock, the proceeds are taxed as capital gains.
It’s harder to diversify when investing in real estate than in stocks. Properties are more expensive than shares of stock, so you need more capital to diversify. You can, of course, buy different types of property in different communities to diversify. But you need much more capital.
You can also diversify in real estate through real estate investment trusts (REITs). These let you purchase shares of a trust that's invested in a large portfolio of real estate. As a shareholder, you get dividends.
In general, stocks offer more diversification. You can own shares of many companies in different industries with a smaller investment.
Real estate lets you build wealth faster than stocks thanks to leverage (debt). Putting 20% down means you can buy, control, and profit from $500,000 worth of real estate with just $100,000 out of pocket.
Real estate has historically been a safe way to build wealth using leverage because the property has real market value. Rental property investors often use leverage to exponentially grow their portfolio. The mortgage payment, which stays the same over the course of the loan, is paid by the rental tenant. That builds equity for the investor with no additional out-of-pocket investment month after month.
Of course, you can use margin as leverage to increase the number of shares you own, but it’s rarely a good idea and carries a tremendous amount of risk. If your stock position falls, you could have what's known as a margin call. You may be forced to sell the stock to recover the amount loaned to you.
Which is better? Both
Since stocks and real estate investments are vastly different, it’s a moot point to argue which is better. An investment portfolio diversified with asset classes including stocks, bonds, and real estate will fare better over the long term.
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