CNN published an article awhile back (http://money.cnn.com/galleries/2007/real_estate/0704/gallery.stocks_v_realestate.moneymag/index.html) in which they drew a direct comparison between the stock market and real estate. The article pointed to an annual average return of 13.4% for the S&P 500 from 1978 to 2004.
During that same period, they pointed to a “solid but unimpressive annualized return of 8.6%” for residential real estate. The return calculated for real estate was based upon sort of a national average for appreciation in home values during that period.
There conclusion was therefore that in the long run, the stock market easily “crushes” real estate. The article also points to a study by Robert Shiller that suggests the “real” return of real estate is really somewhere close to 3%, barely better than the rate of inflation.
The problems with this article? The article is fatally flawed for the following reasons:
1) These two types of investments are so different that drawing a direct comparison is absurd. Think about a typical stock market investment. You buy x number of shares at $y. You hold them for some period of time in which the price per share goes up (hopefully for you). At some point, you decide to sell the shares.
Most buy and hold real estate investors leverage their money when they buy the real estate instead of paying cash and never putting financing on the property. At this point, the two start to diverge. However, these properties also produce income. The two investments diverge even further.
An investor who buys multiple income properties is building a business. It is much easier to draw a comparison between a buy and hold real estate business and, for example, a service business like a plumbing company or a franchise like a Subway. Perhaps the biggest difference is that real estate has an intrinsic value apart from the business. On the other hand, service businesses have much of their value in the intangible asset of its book of business / client list.
A stock market investment is much more comparable to, for example, art, precious metals, gems, or collectibles purchased with the anticipation that they will increase in value with time.
2) The S&P/Case-Shiller U.S. Home Price index on which the “unimpressive” rate of return for real estate was calculated (8.6%) is based upon home prices. The cash flow and tax benefits from real estate are completely overlooked by this oversimplification. Shame on the author for making this misrepresentation of the numbers. Because residential real estate creates passive income where stock do not, the analysis presented in this article is not valid.
3) For the average investor who does not have the time or inclination to invest in real estate, an investment in an indexed mutual fund based on the S&P 500 may be as good a move as any. That is, if they are able to really discipline themselves to hold onto these mutual funds for the long term.
The biggest advantage a guy who decides to start investing in rental residential real estate has over the guy who buys and holds mutual funds is control. The decisions that the real estate investor makes on a day to day basis determine his financial success. He will be able to do very well regardless if real estate prices are going up, down, or sideways.
March 25th, 2010 at 12:15 am
Well said
March 25th, 2010 at 12:15 am
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
March 25th, 2010 at 11:32 am
Excellent post, Scott! You pointed out some differences between real estate investments and the stock market even I wouldn’t have thought of. Good job!
March 25th, 2010 at 11:51 am
I agree with Scott. I would also add that the article chose the greatest bull market in stocks in American history to draw this conclusion:
“The article pointed to an annual average return of 13.4% for the S&P 500 from 1978 to 2004.”
That bull market is over unless someone can tell me why we should expect low inflation a…nd high growth in the American economy from here on out.
The return of the S&P 500 in the decade from 2000 to 2009 is a big, fat zero. Adjusted for inflation, the gains are negative.
Why should real estate be any better? Well, Scott points out that real estate is more like a business than a completely passive investment. Since it can be managed, the gains can be controlled.
People are more likely to treat real estate like a business than they do stocks. This is a good thing, since real estate is typically bought with a loan, and the leverage magnifies gains and losses.
The smart real estate investors sold out in 2006 and 2007 when subprime lending problems began to affect property values.
The smart stock investors sold out in 2007, too. But the real estate investors had higher gains because they were able to buy with loans and collect rent.
March 25th, 2010 at 12:17 pm
Oh, and to address the point people keep making, that inflation is good for stocks:
Well, it depends on which stocks. If we have higher inflation, long-term bond rates will go up as investors price in future inflation. Stocks will need to have higher yields (higher dividends per dollar value of stock) in order to compete with the higher bond yields. Earnings also will not increase as much as one would think, since the cost of doing business will go up with inflation as well, eating into profit margins.
In the 1970’s, the stock market went up and down wildly and ended up with a return of about zero for the decade. Adjusted for inflation, stock investors lost more than half of their money.
Foreign stocks and stocks of commodity-producing companies will do well. But this is NOT the S&P 500. Investors will need to make intelligent choices and not just blindly throw their money at the market. This makes stock investing more dependent on skill. It makes stock investing more like real estate.
The biggest advantage of real estate is that if we have higher inflation, property values will tend to track with inflation. They will do even better in Oklahoma, which has an economy that benefits from higher food and oil prices. And you can borrow at a fixed rate for fifteen to thirty years, paying down your loan later with dollars that are worth less.
I could go on, but I think we get the picture.
March 25th, 2010 at 1:22 pm
Deprecation, Cashflow positive, potential appreciation, tax benefits, write off expenses, outsource property management, use IRA or other investments to buy. Incredible real estate deals on the market now.
We are buying a 125K house for 85K that needs little work, in high demand area and will sell as is for 105-110 quickly! Projected gross profit 17K for little work. That’s 14% cash on cash, 121% yield, 120% IRR. May not be big net profit but it has good yield (return over short period of time). Best part… we are NOT using our own money! Private Investor will receive a nice annualized interest return (and they don’t have to do anything but sign paper work and wire funds). We’re doing all the work.
March 25th, 2010 at 1:23 pm
Probably should mention: Since we are using investor funds and not our own, our return is infinite!
March 25th, 2010 at 1:44 pm
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March 25th, 2010 at 5:16 pm
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March 25th, 2010 at 5:16 pm
That’s the Big Ticket-Leveraging Your Money. When you buy $50,000 in stock you pay $50,000. But when you buy $50,000 in real estate you can use the banks cash and let your tenant pay the bank back for you. The author of that article is really missing the big picture.
March 25th, 2010 at 6:20 pm
Ron – Yes, I forgot about some of the benefits you mentioned.
One note of interest: This was the first of nine articles in a series written by Marlys Harris, Money Magazine senior editor. I’m definitely going to have do another post on some of the other articles in the series based on my scan of her data and conclusions based upon that data.
March 25th, 2010 at 6:39 pm
The really odd thing about this series of articles by Ms. Harris is that it breaks out these aspects of each investment, such as transparency, cost of the transaction, leverage, etc. and does a side-by-side comparison of the stock market versus real estate.
It doesn’t make sense to make this type of comparison. It’s likes trying to compare a the organs of a human with those of a dolphin to determine which are better. Each of the bodies is a holistic system of components that work together. Removed the heart or the liver, etc. in either a human or a dolphin and the systems fail.
The organs of either have different characteristics because one is designed for land and one is designed for water.
The aspects of a real estate investment versus a stock market investment are similar. These aspects are integral for either. It doesn’t make sense to break them apart like Ms. Harris has done.
To me, it makes far more sense to talk about these investments in light of what they allow the investor to achieve by utilizing the upside of each one.
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March 30th, 2010 at 1:10 am
I have not read the articles by Ms. Harris, but I assume she has a background in finance. If so, then she is probably aware that the appropriate way to compare investment returns is not by absolute percentage gains, but by Sharpe ratios: absolute returns adjusted for volatility.
Why is this the case? An asset that generates the same return with much less volatility can be leveraged. It can be bought with borrowed money to generate a much higher net return with the same risk, all other things being equal. (Of course, one of the problems with modern finance is that all other things are NOT equal, but that’s beyond the scope of this discussion.)
Here’s an article containing a table of Sharpe ratios for real estate benchmarks compared with stock benchmarks. See page 5:
http://cisdm.som.umass.edu/research/pdffiles/benefitsofrealestate.pdf
Asset Performance 1990 – 2005
NCREIF real estate index:
Annualized return 7.87%
Annualized standard deviation 3.68%
Sharpe ratio 1.01
S&P 500 Total Return Index:
Annualized return 10.55%
Annualized standard deviation 14.32%
Sharpe ratio 0.45
Lehman U.S. Aggregate Bond Index:
Annualized return 7.36%
Annualized standard deviation 3.88%
Sharpe ratio 0.83
Based on Sharpe ratios, which measure risk-adjusted returns, real estate beats out bonds by 22% and stocks by an astounding 124%.
One may ask: “Well, the risk-adjusted returns may be higher, but don’t you get the same absolute returns?”
My answer: Just look at the volatility. The S&P 500’s standard deviation is 389% as high as the real estate index’s standard deviation.
Why not simply leverage the real estate until it generates an 11% return? It wouldn’t take much leverage to do that, as those who own property know very well. And it would generate that 11% return with much less volatility than the stock index.
That is, in fact, exactly how we buy real estate. That is, in theory, how we should buy stocks, too. But there’s a reason almost no one leverages, and that is due to the volatility.
Real estate: 1. Stocks: 0.
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March 31st, 2010 at 10:44 pm
Good stuff Darren. Those are some very interesting stats on stocks versus real estate. That’s one of the best explanations I’ve seen for the risk introduced by the volatility in the stock market versus real estate.
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