Is Investing in Real Estate Better Than Stocks?
by Rich Jacobson, CFP®
With the recovery underway in the California real estate market and elsewhere in the U.S. it is interesting and timely to look at returns generated in residential real estate and compare this to returns generated in the equity markets. At this point, many of my clients are inclined to invest in real estate feeling that the time is right to purchase an investment home and that returns going forward will be superior to what they could achieve elsewhere. The question is: is this assumption correct? In an effort to shed some light on the comparable returns, I have assembled data showing year-over-year returns and long term average returns for both residential real estate and equities markets.
The map below shows strong real estate appreciation last year as the housing market continued to recovered from its steep decline. As we know, California, in particular, had strong appreciation last year; the second best nationally only to Nevada. The second chart below, showing long term appreciation, tells a very interesting story. California had, again, the second highest appreciation of housing prices in the nation over the last almost 40 years (second only to D.C., an interesting proxy for the expansion in the size of the Federal Government). The average rate of appreciation in California came in at 6.77% annually over the 39 year time frame. I think many people might be surprised that the long term average appreciation is this low given some of the anecdotal cases we hear about a home purchased for $40,000 in 1975 being worth over $500,000 by the time the house is sold by the next generation. However, this isn’t an especially surprising result taking compound growth into account. In fact, a $40,000 home appreciating at the long term average rate of 6.77% in California would, in fact, be worth almost exactly $515,000.
What is important to remember is that this appreciation is before routine repair and maintenance that must be done on homes, let alone eventual updating and ongoing landscaping and other costs that would reduce the “net” appreciation considerably. In my work conducting financial planning with clients I often counsel them to budget at least $500 per month for these costs in Napa. Other researchers, such as mortgage research firm HSH.com estimate these costs at a minimum of about 1% of home value, very close to my own estimate. So the true value of appreciation in Napa real estate net of these required costs is closer to 5.77%, or less. Good but hardly spectacular.
However, we are not done with annual costs required for a real estate “investment” purchase. Real estate is subject to annual property taxes and direct fees (e.g. bond assessments) that, as a rule of thumb, may average about 1.25% annually of the assessed value of the home. This assessed value in California is limited to the Prop 13 annual increase of 2% so that over the long term, property tax will significantly trail true market value based costs. Over 39 years. for example, property taxes increasing at the annual maximum of 2% would be just $1,082 on a $515,000 home- about $5400 a year less than if it was based on true market value- an 83% saving. Nevertheless, the 1.25% annual property tax and direct fees expense is another mandatory expense of residential real estate and need to be accounted for in determining the real estate investment’s true return. Under the most favorable assumption that a property is held for 39 years the annual percentage cost for property taxes and fees would be 0.25% of a home’s market value by the end of the period. However, given that this is the lowest percentage likely over that time frame and that it takes a holding period of 39 years to achieve I have assumed a more conservative cost estimate of 0.50%. Using 0.5% would reduce our annual net appreciation further from 5.77% to 5.27%.
However, we are still not done. Real estate entails significant purchasing and selling costs in the form of broker commission- typically 6% of the transaction price. This cost is born by the seller and reduces net proceeds received. If we were to return to our “typical” Napa home and reduce the appreciated price from $515,000 by 6% we get a net price of $484,100. This would mean our true appreciation wasn’t 6.77% as we originally estimated but 6.6% over a 39 year time period (and much lower if we used a shorter holding time period). After accounting for the costs I’ve already mentioned, the true net appreciation of owning that home is approximately 5.1% annually. This assumes, of course, that future appreciation will match past appreciation- a questionable assumption given shifting demographics in Napa and California and changes in-migration versus out-migration statistics for high tax states like California that may be expected to affect demand.
Many real estate investors will be quick to point out that an investment home brings in annual rental income. This is true. Looking on trulia.com we see that rents here in Napa for a 3 bedroom home average anywhere from $2100 to $2800 per month in rent. If we assume an average rental of $2,500 per month then the gross rental receipts for the homeowner is about $30,000 annually, or about 6% on a “typical” home. However, renting out a residence entails additional costs not typically incurred by maintaining a principal residence. These would be management fees, rental agency fees and additional maintenance costs for repairs that would normally be done by the homeowner (not to mention lost rental fees during periods of vacancy). The cost of these additional factors fees will vary based on each individual landlord’s situation but typically might total up to 10-15% of the rent collected. This means the annual net “return” on a typical $515,000 residence in Napa in the form of rent is closer to 5%, after these additional costs.
Combining appreciation and rent, then, the best case expected long-term return for Napa real estate is approximately 10%, assuming no additional expenses for updating the home, cost of insurance and significant repairs (e.g. new roof) that would be needed over a longer time frame. In my estimation, assuming that none of these additional expenses are applicable is unrealistic for any prospective real estate investor. It would therefore be prudent to account for these costs by assuming a more conservative combined return of 9%, rather than the best case scenario of 10%.
I have ignored financing cost from this analysis even though many people use leverage to purchase an investment property. The reason for this is that investors could theoretically use these same borrowed funds to purchase a portfolio of equities rather than a home and so it is immaterial to the comparison whether borrowed funds are used for purchasing real estate or stocks. Nevertheless, from a budgeting standpoint, it is something that should be carefully considered since it directly affects monthly cashflow.
Tax benefits taken in the form of depreciation also have been ignored since depreciation is recaptured at time of sale and simply represent a tax deferral rather than a permanent tax benefit (ignoring estate tax rules for step-up-in-basis and 1031 exchange considerations which are beyond the scope of this analysis.
So what was the average annual return of a single major stock market index, like the S&P 500, over the same time frame (1975-2013)? In January of 1975 the S&P 500 index stood at just over 83. At the end of December last year the S&P500 index ended at 1848, a calculated price increase of 2391%, or an annualized return of 8.6%.1 This is the appreciation in the value of the S&P 500 index price only, but what about income? Stocks can and often do generate dividends. Historically, the S&P 500 stocks have averaged between 3-4% annually. If we look at the period from 1975 to 2013 the dividend yield from the S&P 500 index would have added over 3.2% to annualized return, for a total return of 11.86% (assuming dividends were reinvested). More recently that figure has been closer to 2-3% annually. If we assume that stocks going forward are likely to yield 3% in dividends then investors might expect a total annualized return closer to 11% going forward.
Of course, although stocks have no maintenance costs and no updating and insurance costs etc. there may well be management and/or advisory expenses of about 1.0-1.5% a year. Add to this expected trading costs of 0.5% annually and we have a combined approximate cost to the investor of about 2% of the value of the portfolio. This would reduce the total net return to the investor to about 9% annually.
In the case of stocks, tax treatment may allow for superior results to the extent that long term capital gains rates and qualified dividend tax rates remain below ordinary income rates for investors. In addition, stocks allow an investor to choose the nature of their investments and shield themselves from current taxation, to an extent, through the strategy of keeping gain unrealized instead of realizing gain. However, just like real estate, much of this is a question of timing of taxes as opposed to tax reduction and, in any case, a detailed analysis of this falls beyond the scope of this presentation.
What we see then is very similar results from investing in real estate compared to investing in equities, over the long term. Such conclusions sometimes also reflect shorter term trends. The typical 3 bedroom house in Napa increased in value by an impressive 25.5% last year (trulia.com) even as the S&P 500 index increased by an even more impressive 26.39%.
So why do so many households and investors believe that investing in real estate produces superior returns and is a better option? There are probably many reasons for this misconception but I would suspect that one would be that real estate is an “illiquid asset” that won’t show you the net market value on a daily basis like stocks will. This leaves the purchaser of real estate with the sense that their investment is stable when a mark-to-market daily valuation may, in fact, show considerable volatility. There is also the tangible versus intangible factor. Investors can see and feel a house. They often look at shares in companies as intangibles that have little to no inherent value- something akin to a Bitcoin proposition. Finally, to a certain extent, the often expressed preference for real estate may be one of those durable myths that span generations. During the Great Depression and during every subsequent market correction, many investors would be distressed to see their portfolios decline sharply whereas they could always count on the roof over their heads (as long as the mortgage was paid!). This may have created the sense that a real estate investment was more secure and reliable than stocks. Such attitudes, once formed, can persist for very long periods of time, even when investors have recent and vivid evidence that holding illiquid investments like real estate can produce tremendous financial stress during periods of serious economic downturns (e.g. 2008).
The bottom line, is that real estate investing in Napa or California seems to be pretty much a wash compared to investing in a broadly diversified stock portfolio. It is not clear that one is superior to the other and investors need to carefully consider their need for liquidity, their willingness and ability to invest time in the maintenance of the property, their risk tolerance for daily stock market valuation, along with many other factors before deciding on the best course of action for themselves.
1 Data generated using the S&P calculator at dqydj.net/sp-500-return-calculator/ using data originally provided by Dr. Robert Shiller. Note that values in the S&P index used for the calculator are average values for a quarter and not necessarily based on any single day’s value.
The Standard and Poor’s 500 (S&P 500) is an unmanaged index of 500 common stocks that is widely used as an indicator of market trends. The performance of this index does not reflect any fees or charges associated with investing. It is not possible to invest directly in an index. LD49381-03/14