The Investment Showdown
In the ongoing debate between stocks and real estate, the ultimate question shouldn’t be which one is better. It should be which is better for you. Stocks aren’t for everyone, just as real estate isn’t for everyone, but to help you differentiate between the two and to help you make up your mind, we will dive into the most relevant factors that should drive your investment decision.
Before digging into the meat of the matter, I want to clarify that when I’m referring to real estate as an investment, I’m referring to commercial real estate and not to residential real estate like your home. That’s because I don’t think a home is an investment. It’s a depleting asset that drains your wallet from the day you buy it until the day you sell it – with you constantly throwing money at it to furnish it, upkeep it and maintain it.
I know people get excited about the equity from their homes when they sell it, but what happens to that equity when they go to look for replacement housing? It disappears into that new property that has also appreciated during the time they owned theirs.
Now that we’ve established commercial real estate (CRE) as the only type of real estate worth mentioning in the world of investments, I will go one step further and establish that when discussing CRE investments, I will be referring to private investments – including direct investments and investments through private equity funds and through real estate syndications – and not to REITs.
REITs are traded on the stock market and correlated to the same market forces as the stock market and the broader economy, so in my mind, they’re more closely related to stocks.
Stocks are far more accessible in terms of investment costs. Stocks can be bought for as little as a fraction of a share – for literally pennies. And on the popular online trading platform Robinhood, trading is free – making it even easier for investors to start investing than ever before, which millions took advantage of for the first time in 2020.
Commercial real estate typically requires a minimum capital commitment starting at $10,000+ depending on the investment vehicle – with direct investments requiring the highest capital commitments and private equity and syndications falling somewhere below.
While almost anybody can trade stocks, only qualified investors – often meeting accredited investor status – can invest in private real estate through a fund or syndication.
Stocks are highly liquid. They can be bought and sold at the swipe or click of a smartphone screen. CRE is not liquid. Properties take time to place and sell on the market. Indirect investments are even more illiquid as typical holding periods are usually a minimum of five years or more.
Stocks are highly volatile – inextricably tied to the latest news cycle and social media and internet buzz, whereas real estate is uncorrelated to the broader markets because of its illiquidity. Therefore, while stocks can tumble 30-50% within a matter of days, CRE does not follow the same patterns.
This is where things get a little murky. I’ve come across other articles that compare stock market returns with CRE returns. The tendency is to compare average stock returns as measured by a broad market index like the S&P 500 or the Dow against average annual returns from real estate.
In the past 20 years, the S&P 500 has averaged a return of 6.99%. An investor wishing to receive average annual stock returns could invest in an S&P 500 index fund and expect to make around 6.99% per year. However, they would have to invest over 20 years to iron out all the highs and lows. Investing short-term during a protracted bear market stretch can drag down the average annual return without the benefit of bull years to balance out the down years.
Here’s the problem with using the S&P 500 to measure the average annual returns of stocks. Only a small percentage of investors invest in index funds for the long term. Most individuals who invest in the stock market invest in mutual funds directly or through their 401(k)’s, which consistently fail to beat the market because of management fees. Despite the ubiquity of mutual funds, it’s estimated that 25% of individuals who invest in the stock market are retail investors who do their own stock picking.
How do retail investors fare? Over the past 20 years, the average retail investor has averaged returns of 2.5% per year. Inflation has averaged 3% during this same span – meaning the average retail investor has lost an average of 0.5% per year when factoring in inflation.
What about returns on CRE? Average annual returns on CRE are difficult to pinpoint because any stated returns often don’t take into consideration overall tax benefits and leverage.
Detailed information about CRE returns is elusive, but at least two sources peg average annual returns at 9.5%. An additional source cites average returns of private equity funds that invest in CRE. Since this is how the ultra-wealthy predominantly invest in CRE, the numbers are worth examining. According to data gathered from research firm Prequin, the average return from funds with $200 million in assets under management was 11.2%.
On an average annual basis, it’s clear that CRE is superior to stocks, but when considering tax benefits and leverage, the returns are even more superior.
Average annual returns don’t tell the whole story when comparing stocks and CRE. Leverage takes CRE returns to a different level. When comparing returns between stocks and CRE, the question shouldn’t be about the average annual returns, but what can you make from a dollar invested in stocks vs. a dollar invested in CRE? If that’s the question, then the returns aren’t even close when leverage comes into play.
Unlike stocks where borrowing is hard to come by because of its speculative nature, a CRE investor can leverage secured bank lending to magnify returns. This can be accomplished whether investing directly or indirectly. A passive investment fund or syndication that leverages bank lending passes on the leveraged profits to its partners.
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 maximum 25%, let’s consider two scenarios with starting capital of $1,000,000 each.
In Scenario 1, an investor can buy a CRE asset entirely for cash for $1,000,000 or in the alternative, as in Scenario 2, the investor can leverage the same $1,000,000 to take out four loans to acquire four different assets, each with a down payment of $250,000 to acquire four $1,000,000 assets. Assuming an average annual return of 9.5%, let’s compare the returns on investment in both cases after five years:
Scenario 1 –
Initial Investment: $1,000,000
Annual Return: $1,000,000 x .095 = $95,000
Total Return: $1,000,000 x .095 x 5 = $475,000
Total Cash-on-Cash Return Rate: 47.5%
Average Annual Return: 9.5%
Scenario 2 –
Initial Investment: $1,000,000
Annual Return: $4,000,000 x .095 = $380,000
Annual Debt Servicing (3.5% APR): $140,000
Net Annual Return: $380,000 – $140,000 = $240,000
Total Return: $240,000 x 5 = $1,200,000
Cash-on-Cash Return Rate: 120%
Average Annual Return: 24%
The power of leverage in Scenario 2 results in returns that exceed the unleveraged returns in Scenario 1 by a factor of 2.5 times
Recession and Inflation Hedge.
Inflation is on everyone’s minds these days as the trillions of stimulus money pumped into the economy have resulted in price jumps in consumer goods not seen in more than a decade. As a recession and inflation hedge, stocks are terrible. Since stocks are highly correlated to the broader economy, an economic downturn will also result in a bear market.
On the other hand, CRE investments are less correlated than stocks, and a portfolio diversified across different segments and geographic locations will ensure continued cash flow with sub-performing properties compensated by performing properties.
As an inflation hedge, stocks are also terrible – moving in the opposite direction of rising prices. The cost of borrowing will also often increase, making it more expensive for public companies to operate and expand. Tangible assets like CRE – especially in sectors such as housing that are considered essential – typically see rents and property values that keep pace with inflation. This is why certain segments of CRE are ideal inflation hedges.
Stocks aren’t for everyone, and CRE investments aren’t for everyone. If you’re a short-term investor who values liquidity and likes to time the market, CRE investments aren’t for you.
On the other hand, if you have a long-term investment window and seek above-market returns insulated from market volatility and inflation and you’re willing to commit your capital for a minimum of five years plus, then CRE might be for you.
You know where I fall in this debate, but weigh the costs and benefits of each and make up your mind.
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.