Most people invest in real estate, perhaps quite logically since this is a very easy business model to understand. Equity (stocks) is perceived as riskier and thus less desirable as an investment. The aim of this article is to give some pros and cons with both asset classes (I’m considering direct investments – not mutual funds). There is no “best” investment as this boils down to preferences and goals. However, these two asset classes might complement each other because, as I wrote in the last article about diversification, you can own several asset classes and theoretically increase returns while lowering the volatility of your whole portfolio.
Below is what I consider relevant issues to contemplate before you invest:
Where can you expect the most capital gains? This question is tough to answer, but the research I have seen indicates that stocks have performed better than real estate over long cycles (unleveraged), for example this research. That makes sense. Except for the land, why should an apartment or house appreciate in value? It’s a perishable good that literally ends up as rubbish if it’s not properly maintained. The only two reasons why it tends to increase are because of the opportunity cost of building a new house and the value of the land. When the cost of building new real estate increases, the alternative is to buy a cheaper and older apartment (and this increases its value). Because of this, real estate tends to increase at a rate in line with inflation. The value in a building is the cost of its materials and labor, plus a tiny profit margin. Costs and labor are of course the main components driving inflation.
If we include leverage the answer obviously changes. While very few use leverage in the stock market, it’s the opposite in the real estate market: Leverage is very common.
A Norwegian student named Johan Skorge Skaaret wrote a very interesting master dissertation (in Norwegian) about the real estate prices in Norway from 1899 to 2011. His conclusions are that real estate over this period as a whole has produced low returns:
The chart includes real estate prices in 4 of the 5 biggest cities in Norway adjusted for inflation. I suspect most investors believe that the price surge since the early 1990s is normal, when it most likely isn’t.
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Two Norwegian students wrote an interesting master dissertation (in Norwegian) about real estate and stocks as an investment between 1996 and 2013. Their conclusions can be summarized in this table:
|Period||Real estate annual returns
||Stocks annual returns
The assumptions are a “standard” apartment used in the statistics of the Central Bank of Norway (Norges Bank). Maintenance, taxes and rental income are included. Stocks are measured in the form of the main index of the Oslo Stock Exchange.
The results in the table are annualized returns without leverage. Because most banks willingly lend up to 90% of the purchase price for real estate, the table above indicates real estate has been a better investment, given you survived the real estate crash at the end of the 80s. Many didn’t.
Leverage makes you fragile
Direct investments into real estate require much equity, which most investors haven’t. Thus, you go to the bank to ask for leverage. In Western countries, almost everyone borrows money for purchasing real estate, while for example the markets in Eastern Europe are much more conservative with less debt. Banks lend to real estate investors, but not to stock market investors. This is further amplified by recent banking regulations which tilt even more lending to real estate instead of businesses.
But when you borrow money you are not “free”. You live at the mercy of the lender, which normally has the first rank on your property in case you default. It makes you fragile (to borrow a term from Nassim Nicholas Taleb). History shows that real estate doesn’t just appreciate decade after decade. Debt can be wonderful when it magnifies returns, but at the same time it increases the likelihood of default.
Both developers and investors are often crunched at the same time, which adds fuel to the fire. The first principle in investing is survival. Based on this, I’m against any financing of investments above 40% of equity. Sooner or later many real estate investors will be squeezed. Personally, I believe there is a real estate bubble in many Western countries fuelled by cheap debt and investors which have never experienced a real crash. Don’t bet central bankers will come to the rescue endlessly.
You can easily buy “the market” in stocks, while the real estate market is much more fragmented. There is no reason why a property in Rochester, New York, should return the same rate as in for example Daytona, Florida. Each property is unique in terms of both location, architecture and standard. One apartment in the countryside is a completely different matter compared to one in the city center. Stocks are mostly valued in terms of its valuation and its future earnings potential.
Averages are generalizations that sometimes are deceptive. Why is that? Because averages are weighted according to market capitalizations they rarely reflect the performance of the “average stock”, which is better reflected in the median.
In January 2017 Hendrik Bessembinder published a very interesting study called Do Stocks Outperform Treasury Bills? This is the main findings in his study:
- Only 42.1% of common stocks have a lifetime return that exceeds short-term treasuries from 1926 to 2015.
- About 50% of stocks deliver negative lifetime returns.
- The median (not average!) life of an individual common stock is only seven years.
- 96% of Monte Carlo simulations underperformed a value-weighted index, 99% underperformed an equal-weighted index and 72% underperformed short-term treasuries.
- In other words: the results are skewed to just a few stocks. Out of 26 000 stocks, just 86 were responsible for over half the value creation. 1000 stocks accounted for all wealth creation above treasury bills. It’s the few outliers that make all the returns, not the average or median stock. Large capitalization stocks had much more staying power, and consequently a much better chance of beating Treasury Bills over a decade.
The findings are somewhat depressing. It explains quite well why most private investors fail in the markets (ample research shows this) either by overtrading or picking the wrong stocks. The results are a bit counterintuitive because we have been told that stocks have been the best asset class over the last century. Sadly and obviously, picking the right stocks over this period has been difficult, and hence a pretty good method NOT to generate wealth is done by investing randomly in individual stocks. As a group stocks perform well, but that is because of a few great winners, which of course only hindsight can tell us. The best choice is for most people to invest in a diversified mutual fund. If you do want to pick individual stocks, you must make sure you know what you are doing.
I believe real estate offers better odds at hitting “winners”. It’s not so exciting as the stock market and requires patience, but the chances of making mistakes are less. Why is this?
- Stocks have a short life, but real estate usually lasts for decades and centuries (as long as it’s properly maintained). Even poorly maintained they last for many decades.
- Apartments and offices “always” serve a need and demand.
- Real estate is a business model that is less likely to be disrupted.
- Available land is given and often in short supply in cities.
- It serves as an inflation hedge. Rent can be passed on to tenants.
- Rent is basically “always” higher than the treasury bills.
But of course be aware of the old saying: location, location location…..
Yield on investments
Real estate as an investment produces an annual income in the form of rent. This can be a pretty stable income, which can reduce the risk of doing behavioral mistakes like buying and selling at the wrong time. For most people, this is a pretty important factor, and you can more or less rely on this income. But this does not guarantee a steady rising income.
Not every stock pays a dividend. History has shown that dividend-paying stocks have produced better returns than non-payers (before taxes).
Rental income and dividends are usually taxed at different rates, but of course, this varies from country to country.
Work and hassle:
Owning and managing your own real estate means work and hassle, unless you outsource, which of course comes at a cost. It’s not pleasant when the tenant calls on a Sunday morning to inform you about a leakage! You can of course buy a basked of publicly traded real estate companies to avoid this workload. Owning a stock requires “only” thinking.
Much of the historical gain in the stock market has come from the reinvestment of the dividends. Dividends are easily reinvested, albeit at a lower marginal rate of return, while the reinvestment process in real estate is a bit more tricky. You can’t reinvestment unless you have a big chunk of money.
Real estate is easy prey for cash-starved governments:
Most Western governments are indebted. Immovable real estate is an easy target for increased taxation (expropriation) by cash-starved governments. Italy has, for example, increased the real estate tax a lot over the last decade, and my guess is that this trend is likely to continue all over EU. In the long run, most costs are ultimately passed on to the tenants, but there is a limit on what you can pass on. The tax means the government is your “silent partner”.
Taxation of movable capital like stocks is almost always sourced to the resident’s country. This makes taxation much more difficult.
Real estate needs to be maintained to keep its value. How much? Probably around 1% of the value – per year. For example, in my native Norway, it costs almost 20 000 EUR to renovate a bathroom. You can hardly do anything yourself as most need to be done by licensed craftsmen. This eats into the profits.
Tenants enjoy strong consumer rights/protection:
In most countries, you can’t just kick out the tenants if they don’t pay. The consumer rights are skewed toward the tenant, not the owner. You risk having many months with no rental income, even years, before a “problem” is sorted.
Taxes on rental income is difficult to defer:
By investing in stocks or mutual funds you defer most of the profits to the date of realization, either by retained profits in the companies themselves or via a tax-deferred account. In real estate, most of the gain comes from cashflows which are of course taxable in the year they are received. This of course is a headwind in terms of compounding. Because most people have a hard time understanding the long-term effects of compounding, deferring taxes are underappreciated by real estate investors. I have previously written about the compounding effect.
The chart below compares a 5% annual return with and without yearly taxation of the return (20% tax rate):
The long-term effect of deferring taxes is enormous and grows bigger as time goes by.
The cost and hassle of buying and selling real estate are tedious and costly. Brokers, photographers, red tape and the government all want a piece of the pie. Most countries have a stamp tax which varies from 0-10%. For example, in Norway, the stamp tax is 2.5%.
Opposite you can buy and sell stocks for free, only paying the “hidden” cost of slippage. Ironically, I believe this only lowers the expected return for retail investors as they are being tempted to buy and sell more frequently in trying to outsmart the market. Just a few countries have a stamp tax for stocks (UK (0.5%) and Hong Kong (0.2%) for example), and the rate is much lower than for real estate.
Additionally, it takes a lot of time to both buy and sell an apartment.
The stock market has daily quotes, but no such thing exists for the real estate market. The daily price information is, of course, positive for the liquidity, but on the other hand, too much information makes us do foolish things. I believe a lack of daily pricing makes a long-term mindset. Lack of volatility is to the advantage of the real estate investors.
You can sell a stock with the push of a button, while selling real estate takes a minimum of some weeks, sometimes months.
I believe you are more likely to be a victim of asymmetrical info when buying real estate. The seller obviously knows a lot more about the property than the buyer. In certain countries, the seller is liable for any hidden defects for up to five years. You need to pay insurance to cover yourself for this, which of course is yet another cost.
Easy to understand the real estate business:
Many businesses are complicated and difficult to understand. Opposite, real estate is very simple. You have a physical structure that needs to be maintained and equipped, and you rent it out for a fee. This is a simple business model everyone understands. One famous Norwegian real estate investor (Ivar Koteng) said ten years ago that even lobotomized people can make money in real estate, and you must be pretty dumb NOT to make money.
Inflation has been subdued for almost 40 years, but real estate should produce a very good hedge if inflation picks up, probably better than stocks. Most rental agreements are adjusted yearly.
Property is often uncorrelated to the overall stock market. In Practical Speculation by Victor Niederhoffer, Niederhoffer claims there is a quarterly negative correlation between REITS and stocks. But keep in mind that REITS are publicly listed and probably reacts before any prices in their underlying assets change.
Every country has a unique tax-system that may benefit one asset over the other. For example, Norway has a wealth tax that benefits real estate over stocks.
I’m no investment advisor, so every investor needs to make his own pros and cons of where to invest. However, even though real estate is an easy business to understand, I believe real estate is riskier than people generally assume, and it requires substantial work or management costs. I believe an allocation of both asset classes is the most rational thing to do.
Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.