Index Funds vs. Real Estate

TruePoint Capital

When comparing stock market returns with real estate, Wall Street mavens love to point out the returns of an index fund (i.e., a fund that tracks the S&P 500) vs. the returns from residential real estate.

They’ll argue that an S&P 500 index fund has historically produced total returns in the 9–10% range over long periods, while real estate prices have only managed to outpace inflation barely. They’ll say that since 1940, the median home value in the United States has increased at an annualized rate of 5.5%. 10% is better than 5.5%, so stocks are better than real estate, right? Not exactly.

Comparing Wall Street’s index funds to residential real estate is not an apples-to-apples comparison. Ironically, Wall Street should try to shoot down real estate since its entire aura and mystique revolves around Manhattan’s small but valuable strip of real estate.

Why is comparing index funds to residential real estate, not an apples-to-apples comparison? Because, unlike stocks, most residential real estate is not an investment. For most people, it’s a residence – offering no monetary returns unless it is sold to extract underlying appreciation.

The problem is, once a home is sold to extract appreciation, a replacement home must then be found to take the place of the first home. The replacement cost is higher because all real estate has appreciated – not just the first residence. The reality is, a residence is a black hole for your money while you own it – with the annual costs of upkeep in the thousands for most homes.

Investors jumped on the index fund bandwagon when Warren Buffett uttered the following quote on an investor call in May of 2020:

“In my view, for most people, the best thing to do is to own the S&P 500 index fund,” which would track the S&P 500.

Is Warren Buffett saying an index fund is the best investment anyone can make? No. You wouldn’t know it, but he’s saying that most investors are terrible at picking stocks, so their best option is to invest in an index fund.

How do I know this is what Warren Buffett thought when he blabbered about index funds? Because he said it out loud when he said the following quote:

“Diversification is protection against ignorance. It makes little sense if you know what you’re doing.”

You can’t get more diverse than an index fund. So why does Warren Buffett say most people should invest in them? Because he’s saying that most investors don’t know what they’re doing, they might as well go with an index fund, which has proven to appreciate over time. Does that mean you should choose index funds over stocks? No!

Investment real estate – especially commercial investment real estate and not residential investment real estate – offer three distinct advantages that stocks can’t offer. These advantages should be taken into consideration when comparing stocks with real estate. These advantages are:

  • Leverage. A $100,000 investment in an index fund may give you an annual return of 9%, and a $100,000 property may only give you a yearly return of 5.5%, but through leverage (i.e., bank loans), the $100,000 can be used as a down payment to acquire a $500,000 property. An annual return of 5.5% on $500,000 would result in an actual annual return of 27.5% on the original $100,000 investment, even with a conservative interest rate of 4% for debt servicing, that still results in an annual return of 23% compared to the 9%-10% from an index fund.
  • Cash Flow. Rental income is another source of return that should be factored in when comparing index funds with real estate. Wall Street pundits rarely discuss the power of compounding through the reinvestment of this cash flow because the supercharged returns from reinvested cash flow blow stocks out of the water.
  • Tax Benefits. Tax benefits like depreciation, business deductions, capital gains treatment, avoidance of self-employment taxes, and tax deferral in certain situations allow investors to keep more of what they make through real estate – adding another layer of returns onto a commercial investment property.

Suppose stocks are a clear-cut winner, as Wall Street would want you to believe.

Why do ultra-wealthy investors allocate most of their investments to private investments and commercial real estate instead of stocks? It’s because the real world returns – as experienced by the ultra-wealthy – trump the returns from stocks. That’s why the ultra-wealthy favor private investments and commercial real estate, while the average investor prefers stocks.