When it comes to investing, should you put your money into the stock market or real estate? This article will discuss the pros and cons of each so you can make a more informed decision.
First, a few definitions and assumptions: when I say “investing” in real estate, I’m not talking about owning your own home. I’m talking about buying investment property such as an apartment building. I’m assuming that you’re buying a stabilized property at a 5 cap or greater. “Stabilization” means a completed property that has achieved an occupancy rate of at least 80%. “Cap rate” (aka capitalization rate) is the ratio of a rental property’s net operating income (defined below) to its purchase price. Please note that the cap rate formula does not include any mortgage expenses. Since every investor uses a different combination of down payment and financing, the cap rate formula looks at the property alone and not the financing used to buy the property. This assumption lets you focus on the merits of the property’s financials, and allows you to compare the risk of one property or market to another. For purposes of this article, I am also assuming that you will not be doing any major renovations and that you know how to properly manage the asset so it will continue to operate with the same or better occupancy and cashflow.
With the advent of online brokerages like Charles Schwab, E-Trade and Ameritrade, buying a stock is as simple as a few clicks of your mouse. Since there is no minimum investment required, anyone with some money to spare can buy stocks. The price of a stock is generally determined by a multiple times earnings. Let’s say a company has one dollar in earnings and a current multiple of 10. You would therefore pay $10 for one share of that company’s stock. If market conditions cause the multiple to go up to 11, then the stock price will rise to $11. If the company’s earnings increase and the multiple stays the same, the price of the stock will go up accordingly.
One thing to keep in mind is that when a company’s revenue goes up, there is also a corresponding increase in expenses called “cost of goods sold”. For example, Apple’s costs of goods sold is 38% so for every dollar increase in sales, only 62% of that sales increase is reflected in Apple’s share price.
If you own stocks for a year and the value does not change, at the end of the year you have nothing to show for having owned those stocks. Some stocks do pay dividends, however a typical dividend is just a few cents per share; you would need to own thousands of shares for any significant income, which would then be taxed. The amount of the dividend can fluctuate depending on the financial health of the company and the general state of the economy. Since dividends pay so little, the only way to derive income from stocks is to sell them for more than you bought them. At that time, not only do you no longer own the investment, you are taxed on the profit. If you owned the stock for less than a year, you will be subject to short-term capital gains tax, with 2020 rates ranging from 12% – 37%, depending on income. If you owned the stock for more than a year, you will be subject to a more favorable long-term capital gains tax of 15% for middle wage earners ($39K – $441K in income) and 20% for those earning above $441K. Though a handful of states don’t tax capital gains, most states do levy taxes on capital gains, usually at the same tax rates as for ordinary income.
As a stock investor, you have no control over price fluctuations, market conditions, a company’s financial health, etc. Recent events demonstrate just how quickly things can change. The stock market had been riding high for several years, then fears about the coronavirus caused a huge drop in valuation in just a few days across all sectors and industries.
The one big advantage to owning stocks over real estate is liquidity: you can sell your shares at any time and have the money credited to your account in seconds.
Now let’s talk about real estate. The proper way to value real estate is to look at the type of asset (multi-family, retail, office, etc.) and determine a cap rate or yield for that asset type in that location. The first number you need is the Net Operating Income (NOI), after which you can determine the capitalization rate (cap rate) and yield, as follows:
NOI: Income – Expenses
Cap Rate: NOI / Sales Price
Yield: NOI – Debt (loan payment) / Down Payment (your investment)
For the most part, all expenses in real estate are fixed costs — there is no “cost of goods sold” — which means for every dollar increase in revenue, there is no associated expense. Assuming a 5% cap rate, an increase in rent of one apartment unit by one dollar per month increases the value of the property $240 dollars ($1 x 12 months / 5% cap rate = $240). If you have a 100-unit building, the one dollar rent increase per unit increases the value of the property by $24,000.
With a real estate investment at a 5% cap rate, you’re getting a 5% – 6% return whether you sell the property or not. If your yield was 5% going into the transaction, even if the value of the property goes down, you will still get a 5% return (income), assuming rents haven’t decreased. Unlike stock prices, which can go down just as easily as they can go up, rents don’t usually go down. It can happen, but rents typically stay the same or go up.
When it comes to taxation, real estate is far superior to stocks. As I said above, dividend income or profit from the sale of stocks is taxed at the capital gains rate or as ordinary income. Income from rental properties is offset by depreciation, which is a percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. If your cash flow goes up, which increases the value of the property, you can refinance the loan and take the increased value as cash, which is a non-taxable event. You can’t do that with stocks.
When selling your investment property, you have the option of doing a 1031 exchange. The term “1031 exchange” comes from section 1031 of the IRS Code. This strategy allows you to defer paying capital gains taxes on the sale of an investment property by investing the profits from the sale into another property of equal or greater value. There is no limit to how many times you can do a 1031 exchange, thereby “deferring” capital gains taxes indefinitely. There is no way to roll stock profits into other stocks without paying taxes.
The biggest risk in investing in rental property is accurately predicting what your future expenses will be and knowing how to properly manage the asset. If you can overcome these risks, I believe real estate is a much safer investment and will make you more money in the long run than investing in the stock market. You will also get to keep more of your earnings in real estate because of the beneficial taxation.