- As investors, we must be primarily concerned about risk and return, not asset class.
I often get a question from people that have a decent amount of money about where to put that money as they know I specialize in investing, and especially the stock market.
They’re often surprised when I tell them to invest in real estate and to leave the stock market to those who can take advantage of the volatility and greater risks especially now that stock valuations are extremely high, or to do both as an excellent diversification strategy.
In today’s article, I’ll compare real estate and stocks from a current risk reward perspective as that’s the most important perspective for an investor to have. We must consider ourselves investors first. A proper investor isn’t all that concerned about asset class, their top concern must always be risk reward.
Let me first answer the question as to what is better, real estate or stocks. Well, my answer is none and both. It all depends on the risk return ratio of the specific investment at that specific moment in time.
Risk Reward For Stocks
The best way to explain the risk reward for stocks is to use an example.
If you invest in Berkshire Hathaway (NYSE: BRK.A, BRK.B) now with a CAPE ratio of 28.8, you can expect long term returns to be around 3% and growing alongside the company’s internal growth rate, which is around 5% per year. This means that your yearly return on investment will probably be 3.15% in year two, and around 5% after 10 years.
The S&P 500 is a little bit more expensive and the earnings growth is slower, so expect earnings of around 3% or 4% coming from the stock index.
What’s the risk for BRK or the S&P 500? Well, there is no risk in the long term while it’s possible to experience declines of 50% in a bear market and then wait a decade or more for your current purchase price to be reached again.
On the positive side for stocks, you can just buy them and forget about it. If you need to trim your position, you can always sell part of it, or even sell everything in a very short period of time at no cost. However, investors usually sell at the wrong time, thus the best thing to do would be to consider stocks as illiquid as real estate in order to prevent panic selling.
Risk Reward For Real Estate
Rental yields vary significantly from street to street, so it isn’t as easy to take an average as it is for stocks but if you take a look at an online real estate platform, you can easily spot cities or districts where rental yields range from 3% to 5%, which is in line with what stocks offer. With a bit more effort, and especially if you are handy or know how to spot a bargain, those returns can easily jump to 7% or even more. Real estate is the same as stocks, there are cheaper properties out there that will lead to higher returns in the long term.
With stock returns being similar to real estate returns, we have to focus on the risk and on which asset class is riskier.
Figure 1: Shiller real estate index. Source: FRED.
Real estate prices fell 27% as a consequence of the financial crisis and took a while longer to recover than stocks did. Nevertheless, given the stability of the home price index shown above and the smaller decline after 2008, we can say that investing in real estate carries less risk than investing in stocks. Thus for less risk, you can easily find an equal return to what stock offer in real estate.
On the negative side for real estate, I know it’s a management intensive business but to be honest, so are stocks, especially if you do proper research and try to find the best risk reward portfolio balances for your own financial goals.
Adding Leverage To The Puzzle
The fact that real estate is less risky than stocks allows you to buy real estate by leveraging up to 80% of the value at a relatively low fixed long-term interest rate. Additionally, you don’t run the risk of getting a margin call if you keep paying your monthly installments.
For example, investment mortgages can be found offering a fixed 30-year rate for less than 4%. You have to invest a 20% down payment and pay related costs like closing costs, property tax, and all the other legal charges that are attached to purchasing real estate, and will perhaps some refurbishment costs. However, stocks aren’t much different with expense ratios of above 1% per year for the more complex investment vehicles.
Figure 2: Non-owner-occupied mortgage rates. Source: FREEANDCLEAR.
If you are able to find a good deal, you can find a structure that creates an immediate return on your down payment but for the sake of being conservative, let’s imagine that the rent from your tenants precisely covers your mortgage and all other costs for your investment property. I’ve done a little return on investment calculation on such a deal.
Figure 3: Real estate return calculation. Source: Author’s calculation.
Thus without any direct cashflows, assuming there will be no inflation and real estate prices remain flat for 30 years (all being highly unlikely, especially as rent is expected to go up while your mortgage payments remain fixed), your yearly real estate leveraged investment return would be 5.5%.
By just assuming the value of the property will double in 30 years, your return is already at 8%. If you manage to earn a miserable $100 per month on the imaginary deal above, you can add 2.4% to that return, thus you’re already at 10.4%.
As an investor, I always look at risk versus return and I must say that at this point in time, a real estate investment seems much better than a general stock index investment. Therefore, if you’ve made lots of money by passively investing in stocks over the last 8 years, you might want to consider diversifying into real estate and increasing your portfolio diversification by adding emerging markets, India, and precious metal exposure, especially gold. Additionally, invest only in stocks that offer returns of above 10% for the same risk as real estate. If not, you’re doing a great financial disservice to your future self.
Keep reading Investiv Daily as we’re always analyzing financial markets in order to find the best risk reward investment opportunities out there, including stocks that offer returns much higher than 10%. As an example, those who followed our tip to invest in zinc back in June 2016, or copper in November 2016, are now already sitting on triple digit returns.