Stocks vs. Real Estate

TruePoint Capital

Stocks or real estate? Which offers a better return?

This is a hard apple to apple comparison because stocks and real estate are vastly different, but we’ll take a stab. For purposes of this exercise, we will limit our data analysis to the last 20 years.

From a pure growth standpoint, some will argue that stocks offer better returns than real estate when comparing the S&P 500 and median home prices.

In the past 20 years, the S&P 500 has grown at an average annual rate of 6.16%. According to economic research conducted by the Federal Reserve Bank of St. Louis, the median home price has increased 4.94% during this same time.

Seems like a no brainer between stocks and real estate, right? Not so quick. We’ve all heard that a home is not an investment. According to these numbers, that adage holds especially true.

After accounting for inflation, which averaged 2.2% during the 20-year period, the inflation-adjusted returns for real estate was 2.94% compared to 3.96% for stocks.

Does that settle the question? I don’t think so. I don’t think it’s a fair comparison since no true real estate investor will buy a home just to sit on it and bank on appreciation down the road. This is no different than a day trader that buys stock hoping to sell it down the road for more than what they purchased it for.

If we’re comparing the returns of a buy-and-hold real estate investor, the more appropriate counterpart on the stock side would be the returns of a retail investor that speculates on stocks by buying and selling based on appreciation.

And according to JP Morgan Asset Management, the average annual return earned by a retail investor for the 20-year period between 1999 and 2018 was 1.9% – a -.3% return when accounting for inflation. In this scenario, real estate beats stocks by a margin of 2.97%.

As you can see, comparing the returns of stocks vs. real estate is not simple because real estate is not like stocks. That’s why very few people in the real estate space act like day traders by speculating with real estate prices.

Real estate is also less correlated to the broader markets like stocks are and can be a good source of diversification.

The biggest differentiator between stocks and real estate is that fact that real estate – particularly commercial real estate – can generate cash flow along with the potential for capital gains from appreciation.

Additionally, real estate provides tax benefits, including depreciation, that stocks can’t offer.

True real estate investing has the potential to provide significantly better returns than stocks over time, especially when taking into consideration the income, appreciation, and tax benefits.

On top of all of its financial advantages, real estate – because of its tangible nature – lends itself (no pun intended) to exponential returns from leverage. Unlike stocks where borrowing is hard to come by because of its speculative nature, an investor can leverage significant amounts of financing for real estate without adding much additional risk because the loans are backed by hard assets.

Because lenders typically finance investment properties with down payments of just 20–25% of the sale price, investors can take advantage of leverage to multiply their earnings. Assuming a down payment requirement of the max. 25%, let’s consider two scenarios with starting capital of $100,000 each.

In Scenario 1, an investor can buy one property for cash for $100,000. In scenario 2, an investor can leverage her $100,000 by taking out four loans with a down payment of $25,000 each to acquire four $100,000 properties. Assuming the average annual return of 9.5% for commercial real estate for the past 20 years, let’s compare the returns on investment in both cases after five years.

Scenario 1
  1. Initial Investment: $100,000
  2. Total Return: $100,000 x .095 x 5 = $47,500
  3. Cash-on-Cash Return Rate: 47.5%
  4. Average Annual Return: 9.5%
Scenario 2
  1. Initial Investment: $100,000
  2. Total Return: $400,000 x .095 x 5 = $190,000
  3. Cash-on-Cash Return Rate: 190%
  4. Average Annual Return: 38%

The power of leverage in Scenario 2 allowed the investor to quadruple her average annual return.

Leverage is a powerful tool for the real estate investor, but it wouldn’t have the same effect without the fixed income component of commercial real estate.

Now imagine the possibilities when that fixed income is leveraged to acquire even more income-producing properties. 

Returns then become exponential. Now you begin to see what ultra-high-net-worth investors and institutional investors have known for decades. By reallocating large chunks of their portfolios away from stocks and more towards commercial real estate to generate recession-resistant uncorrelated returns, nothing beats commercial real estate.

When taking into account fixed income, appreciation, tax benefits, and leverage, the choice between stocks and commercial real estate isn’t even close.

Exponential risk-adjusted returns?

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