Real Estate Or Stocks
This debate never gets old. Clients frequently ask me whether real estate or stocks are the best investment.
My answer is, “It depends on your goal.”
For most people, the goal of investing is financial freedom. Financial freedom is more than just replacing your existing income. Financial freedom is the ability to maintain your current standard of living for as long as you live. To achieve this, you need an income that meets three requirements:
- The income must outpace inflation: If the income does not outpace inflation, you will not be able to maintain your standard of living, and sooner or later, you will be back to being a daily worker.
- Income persistence: Your income must last throughout your life.
- Income dependability: The income must continue, even in bad economic times.
How do stocks and real estate meet the income requirements for financial freedom?
Stocks
Stocks (mutual funds, CDs, bonds, etc.) are for capital accumulation. The concept is to accumulate sufficient capital and then draw it down over the remainder of your life. This is problematic for financial freedom for the following reasons.
- If you live longer than expected, you will run out of money. A nightmare feared by many.
- You need additional capital to offset inflation and potential market crashes throughout your remaining life.
- During bad economic times, stock prices plunge. Withdrawing the same amount for living expenses magnifies the loss of your working capital.
If you need $10,000/Mo for 30 years (assumed remainder of your life), how much capital will you need to accumulate? Assuming no inflation and no market crashes:
- $10,000 x 12 x 30 = $3,600,000 in after-tax savings.
However, this is not realistic because inflation and market crashes are a fact of life. Plus, you can not assume that you will always pick the right stocks over an extended period of time.
I regularly hear people say that over a xx-year period, stocks outperform real estate. One thing they missed is that because you will be living off the stocks, you cannot wait xx years to withdraw the funds; you will have to withdraw/sell every month, regardless of the market state. And, every time you sell, your working capital decreases. You will also have to withdraw more to cover taxes.
What about dividend-paying stocks? Inflation, market dynamics, and taxes complicate the calculation of the total capital required to generate $10,000 per month for the rest of your life. It will require millions, an amount most people don't have.
The one big advantage of stocks over real estate is liquidity. In most cases, you can convert your portfolio of stocks to cash in a day.
Real Estate
Real estate is a combination of recurring income plus capital accumulation. Let’s stack it against the requirements for financial freedom:
- If you purchase property in a city where rents exceed inflation, you will have the additional dollars needed to maintain your standard of living throughout your life despite inflation.
- Rental income is a near-perpetual income you can pass on to your children and their children.
- If you purchase properties that target a reliable tenant segment, your income will not be disrupted by economic turbulence, as demonstrated by our clients’ unchanged rental incomes during the 2008 financial crash and COVID.
Prices and rents are determined by supply and demand, which is largely driven by population growth. Where you have rapid population growth, you have rapid rent growth and appreciation. Real estate does not experience the rapid fluctuations seen in stocks.
Real estate has a powerful wealth generation tool, and that is leverage. Consider this: you can acquire $1M worth of real estate by putting down $250K. When the real estate appreciates 50% (Btw, it took Las Vegas investment grade properties 4.25 years during the “quiet” 5 years before COVID to appreciate 50%.), you’ve tripled your equity. If you put $250k into stocks and when (if) the stocks appreciate 50%, your equity increases by 50% minus taxes.
Another advantage of investing in fast-growing cities is the opportunity to use cash-out refinancing for the down payment on additional properties. This strategy is how I, along with many of our clients, have expanded our portfolios with minimal capital injection.
For example, if your goal is $10,000/Mo, how many properties will you need to buy? If I assume each property provides $300/Mo net cash flow:
- $10,000 / $300 ≈ 33 properties
How much do you need for the down payments on 33 properties? If you purchase property in a fast-growing city, you can use the increasing equity every few years through cash-out refinance for the down payment on your next property. If you use this approach, how much capital will you need to acquire 33 properties?
I will assume each property costs $400,000, and you are putting 25% down. The down payment for the first property will be:
- $400,000 x 25% = $100,000
If the property is appreciating at 8%/Yr, how long will you have to wait until you have sufficient equity that the proceeds from a 75% cash-out refinance will cover the down payment on another $400,000 property?
If I assume appreciation is 8%/Yr, I can calculate the net proceeds from a 75% cash-out refinance using the following formula.
Net Proceeds = $400,000 x (1 + r)^n x 75% - $300,000
Where:
- r: Annual appreciation or rent growth %
- N: The number of years into the future
- $300,000 is the loan payoff
- 75% is the refinanced amount.
The calculations for the net proceeds are as follows:
- Year 1: Net Proceeds = $400,000 x (1 + 8%)^1 x 75% - 300,000 ≈ $24,000
- Year 2: Net Proceeds = $400,000 x (1 + 8%)^2 x 75% - 300,000 ≈ $49,920
- Year 3: Net Proceeds = $400,000 x (1 + 8%)^3 x 75% - 300,000 ≈ $77,914
- Year 4: Net Proceeds = $400,000 x (1 + 8%)^4 x 75% - 300,000 ≈ $108,147
So, after four years, you will have the down payment for your next property; sooner if the market appreciates faster.
Using cash-out refinance, the total capital required is greatly reduced.
As you accumulate properties and equity, you can also sell some properties to pay off the mortgages on other properties. This increases the cash flow of the remaining properties and reduces the number of properties you need to reach your income goal.
There are additional advantages to real estate that stocks do not offer. For example, tax benefits:
- 1031 exchange: You can sell one income property, buy a replacement income property, and defer capital gains taxes.
- In many cases, depreciation alone will reduce or eliminate taxes on your rental income.
The big fault of real estate is liquidity. There is no way to convert real estate to cash instantly like you can with stocks.
Summary
I view stocks (mutual funds, CDs, bonds, etc.) and real estate as completely different investment vehicles.
- Stocks: Stocks are for capital accumulation. Once you've accumulated enough capital, you sell shares monthly for living expenses. At the end of the drawdown period, you have no more shares.
- Real estate: Real estate provides a nearly perpetual income stream plus equity growth. If you purchase properties in a good investment city, rent growth will exceed inflation, enabling you to maintain your current living standard throughout your lifetime. Also, as your properties appreciate, you can grow your portfolio using cash-out refinance, which will increase your rental income with minimal additional capital.
