Real Estate Vs. Stocks: Which is the Better Investment?
New investors want to know: is it better to invest in the stock market or in real estate? To the disappointment of many, there really isn’t an objective, black-and-white answer. What might be a lucrative investment in Big Island property for one could end disastrously for another. Ultimately, the right investment method for you will depend upon the risks you are willing to take, the capital available to you, and the knowledge of market dynamics you possess.
At Craft Realty, we are reaping the benefits of investing in Big Island property. But there are several factors you should consider before diving into one or the other. Read on to learn more about the benefits and drawbacks of real estate investment and how they stack up against those of the stock market.
The Basics
If you’re reading this article, you are most likely a real estate professional or a to-be investor in Big Island property evaluating your options. Though you probably already know about the basics of real estate and the stock market, we address them here to establish a foundation for our later points.
Real estate investment assumes many forms. When we discuss real estate investment, we are typically referring to either buying and holding or fixing and flipping. The former involves purchasing a property that you plan to own long-term and renting it out. Assuming your annual rental income exceeds your mortgage and other housing costs, you stand to steadily accumulate profits over time. The latter, on the other hand, generates a substantial profit in the short term. Fixing and flipping entails purchasing a property, remodeling it to add value, and selling it for a profit. While real estate is, of course, intended as an investment, many investors face unprecedented costs or market-related setbacks that cause major losses.
Stocks represent ownership of a company. When you purchase a share of a company, you are claiming ownership of a portion of that company. The number of shares in your possession determines the percentage of the company that you own. When you purchase shares of a company, you provide that company with capital. In theory, the company grows that capital and generates revenue over time. A portion of yearly revenue, called a dividend, is sent to shareholders at the end of each fiscal year. As the company grows, the value of those shares also increases, providing you the opportunity to profit from the sale of those shares in the future
Risk Vs. Reward
When you make an investment, your primary consideration should be whether the financial risk you are taking is worth the reward. A high-risk, low-reward investment is never a wise one.
Different experts make different arguments as to whether stocks or real estate hold the upper hand in terms of risk, but the general consensus is that investing in the stock market is less risky than investing in real estate. When you purchase a share, you only stand to lose the amount that you paid for that share. However, if you spend a lot of money fixing and flipping a house and find it impossible to sell at a profitable price, you could be looking at losses far greater than your initial investment. A bad investment could end in debt and personal financial crisis.
Buying and holding is typically less risky than fixing and flipping. However, it still holds risks in that it can be difficult to accurately determine your projected profits before buying. It’s easy enough to subtract your monthly mortgage from your rental payments. However, it is almost impossible to accurately calculate your net rental income, i.e. what you stand to profit after taking taxes, maintenance, and operating costs into consideration. What may look like a profitable option to the inexperienced eye could result in significant losses.
Market Volatility
Though it may be difficult to ascertain your projected ROI for Big Island property, buying and holding is actually considered one of the only low-risk, high-reward investments in existence. Rental properties have a Sharpe ratio, a measure of reward to risk, three times that of equities. Furthermore, you’re far less likely to face defrauding when you invest in real estate.
Stocks, on the other hand, are incredibly volatile. The risks might be limited to your initial investment, but the rewards are incredibly difficult to predict. A cheap share might be less risky than a massive fix and flip, but stock market investing is still considered high-risk, high-reward.
Though real estate may also be high-risk and high-reward, the ability to predict your rewards is markedly greater due to the inefficiency of the real estate market. Thus, with the right knowledge of the market, you are more likely to reap those rewards than you would be gambling in the stock market. Real estate is, in most cases, only a significant risk for those who lack proper understanding of market dynamics.
Time
Whether you should choose to invest in Big Island property or in stocks necessitates consideration of your financial goals and the time period in which you hope to achieve them.
Stocks can sometimes generate short-term gains, although they are more commonly treated as a long-term investment. But it is incredibly difficult to determine exactly what those gains will be due to stock market volatility. The same is true for fixing and flipping, although short-terms gains are much easier to predict due to the inefficiency of the market. Because real estate is an illiquid asset, you can’t sell it quickly to beat market fluctuations. The benefit of illiquidity is that market conditions change more slowly. Whereas the stock market might fluctuate violently in the short term, fixing and flipping is likely to produce more predictable, immediate gains.
Buying and holding is the least risky investment option precisely because it is a long-term investment. It is true that it yields many short-term costs. For example, closing costs on buy and hold Big Island property tend to be incredibly high, and unforeseen maintenance expenses seemingly appear out of nowhere. You wont generate cash quickly by renting out a property for a year. But because real estate appreciates more reliably than stocks, you can typically count on hefty profits in the long run.
Capital and Leverage
Stocks are more accessible to those with meager capital. You can invest in stocks for very little if you’re only purchasing a few inexpensive shares. Real estate, on the other hand, is incredibly capital intensive. If you’re going to buy and hold, you need enough money to make a down payment on a mortgage. It is also wise to keep money on hand for repairs and other unpredictable expenses. To fix and flip, you need enough money to make a down payment and remodel the home. If you’re credit score is low and you’re cash flow is limited, real estate investment might not be an option.
But what real estate requires in the way of capital largely compensates for what it offers in return: leverage. Put simply, leverage is the ability to profit off of the appreciation of an asset whose value exceeds your initial investment. In practice, leverage means that you can make a down payment that is only a fraction of the value of a Big Island property and profit from the appreciation of the full value of the house.
When you invest in stocks, you are only able to profit from the appreciation of your initial investment. For example, if you purchase $10,000 in stocks and they appreciate by 5%, you profit $500. When you invest in real estate, however, you benefit from leverage. You may invest $10,000 and make a down payment on a $50,000 dollar home. If that home appreciates 5% in value, you make five times as much as you would have if you had invested that $10,000 in stocks.
Taxes
When it comes to taxation, real estate investment has the upper hand over stocks. When you invest in Big Island property, you can deduct the interest on your mortgage, operating expenses, and property taxes. You can also file for additional deductions should your property depreciate. While it is true that operating expenses and other costs constitute a loss in the short term, filing your taxes will negate these expenses in the long term, cutting your cumulative losses. Stocks, on the other hand, possess far fewer benefits in the way of taxation. You must pay taxes both on dividends and capital gains. Thus, your profits are actually less in the long term than they are month-to-month.
Inflation
Real estate also trumps the stock market in inflation protection. Historically speaking, real estate tends to rise at a rate that is just slightly above the inflation rate. Thus, you are unlikely to face losses if the value of the dollar decreases because the increase in your house’s value should almost perfectly offset that decrease. Furthermore, your mortgage rate does not change with inflation. The real value of your mortgage might decrease while the real value of your property remains stagnant, creating a greater profit margin.
Stocks, on the other hand, do not provide a great hedge against inflation. Though stocks do rise with inflation, they do so in a less linear, predictable manner. Losses due to inflation are therefore more common in the equity market.
What Does the Hard Data Reveal?
Economists from the University of California, University of Bonn, and Central Bank of Germany conducted an analysis of the average returns on various types of investments over the last 145 years, adjusted for inflation and considering dividends and rental income. They found that real estate averaged just over a 7% return per year, whereas stocks were just below 7%.
Of course, observing the nuances of the data always reveals a different story. In the past 30 years, equities outperformed real estate by over 4% in the United States. It is important to remember, though, that steady gains can be offset by major losses when analyzing average returns. It is likely that lower returns on real estate in the US are the result of overly confident newbies’ mistakes and other sociopolitical factors. The superior returns of real estate on a global scale demonstrate that, broadly speaking, real estate investment is a more profitable endeavor.
Again, the best option for you comes down to your needs and skills. If you don’t have a thorough understanding of real estate markets, equity investing might be a safer route for you. If you have a healthy understanding of market dynamics and sufficient capital, you could stand to profit immensely from real estate investment.