Real Estate vs. Stock Investing

We're going to talk about real estate versus stocks. It's a strange thing I see out there. Real estate investors love to denigrate stock investors, right? They're like, they're speculators. They buy paper assets that are subject to market crashes and the markets get manipulated. And then the stock investors are always poo pooing on the real estate investors, saying they're just people who want a second job, or they're trying to get rich quick and scheming to do it, or people who can't actually calculate a return. And the truth is, with most stereotypes, there's a little truth in there, but it's mostly not true. Both types of investments have their pluses and minuses. You can do either one of them poorly. But if they're done well, they're both likely to lead to wealth. I've found myself on both sides of this argument at times. I found myself defending real estate investing. I've found myself defending stock investing. That's usually a good sign that you're in the right place when you're having defend yourself from both extremes. But let's talk today about a little bit of the advantages of real estate and the advantages of investing in stocks, okay? One of the things to talk about is generating profit from business ownership, right? And this is a problem real estate investors have. They forget what a stock is, right? A stock is not some speculative asset, right? This is not bitcoin. It's not gold. It's not empty land. It's not Beanie Babies, right? When you own stock, you own a company, a business, probably a profitable business, one of the most profitable businesses in the history of the world. When that business makes money, you make money. It's a wonderful thing. Sometimes that money's paid you as a dividend. Sometimes it's just, you know, earnings that are reinvested by the company and it goes up in price. And so I think it's important to recognize that. And too many real estate fans forget about that part of what stocks are. Real estate, when it's run well, is also a profitable business. It has a fundamental return that's derived primarily from rents. If you can increase the rents, it makes the property more valuable. And so that's what you're doing, whether it's stocks or whether it's real estate, you are owning businesses that make money. And that's a good thing for you. Passive income is this catchphrase out there. Everybody wants some passive income. And the funny thing is that people that want passive income sometimes go running toward Real estate. And it's true that more of the return in real estate comes from income than it does from capital gains. But the truth is that the income from stocks is actually way more passive than the income from real estate. It just takes more to invest in real estate to do well, barring an investment that's solely in publicly traded REITs like the Vanguard Real Estate Index Fund, it's just going to take more work. You got to do more vetting. You may have to do significant management of the property, et cetera, but that's the way it is. It's more passive when you're getting it from stocks or bonds or mutual funds, REITs, et cetera, than it is from most ways in which you invest in real estate. But you can get more income from a real estate investment if income is really something you want. Now you better ask yourself whether that's something you really want, because more income is not necessarily a good thing, especially during your peak earnings years. Sometimes it would be better to have your investments grow without actually generating taxable income. Okay, so speaking of income investing, it can be a trap. Now, people fall into this dividend stock investors are the classic example. Real estate investors are sometimes even worse with this. Focusing too much on income is not good, especially when you don't need the income. What you need to focus on is the total return of the investment. The nice thing about both stocks and real estate is some of the return comes from appreciation, the value of the investment going up, and some of it comes from income on both sides. And so just don't get too focused on income. When you focus too much on income, you start making mistakes. Like a classic example is junk bonds. These are bonds where the company is more likely to default, go bankrupt, et cetera, than a typical company. And so it has to pay a higher yield, a higher income on its bonds. So you might go, oh, instead of earning 4%, I can earn 6%. Well, yeah, but your return might not be any higher because the default rate is higher. And so you actually lose more principal even if you're getting more income. And that's the way a lot of income focused investments can be. So don't fall into that trap. Always look at the total return, even if income is a good thing in your view. Okay, tax advantages. Now, there are lots of tax advantages for investors. Uncle Sam definitely wants you to invest. Oftentimes you're investing inside tax protected accounts. You know, 401s, backdoor Roth IRAs, HSAs, 529s, able accounts, whatever. These are all Great ways to invest. It's way easier to invest in stocks inside these tax protected accounts than it is real estate, right? I mean, almost every one of them will at least offer an S&P 500 index fund, right? Low cost, basically free. You get the 500, not quite the largest stocks, but 500 large stocks in the U.S. if you can get a good total stock market fund, total international stock market fund, you can buy all the stocks in the world in 30 seconds and forget about it. And it's very tax advantaged because it's inside one of these tax protected accounts. But even when you're investing in a taxable account, right? Stocks benefit from a few things, right? They benefit from a lower qualified dividend rate, they benefit from a lower long term capital gain rate. They benefit from a step up in basis of death. On the other side, real estate also has some advantages. All those same advantages other than the qualified dividends. When you're getting rents from real estate, those are taxed at ordinary income, but it has one really, well, two really cool tax advantages. The biggest one is depreciation. You depreciate the building, not the land. But that can shield this income that's normally taxed at ordinary income tax rates such that you don't have to pay any tax on it. So many real estate investors are getting significant income from their properties and paying no taxes on it because it's all sheltered by depreciation. And when that depreciation gets recaptured at sale, it's only recaptured at up to 25%. So there's a tax arbitrage there. Kind of like when you contribute to a tax deferred account at your peak earnings rate and then you pull the money out later in retirement when you're in a lower tax rate. There's an arbitrage there when you recapture depreciation, but you don't actually have to recapture the depreciation. You can hold that property until you're dead and then get the same step up in basis that a stock investor would. Even better, you can exchange it for another property, usually a bigger property or more expensive property, and not recapture that depreciation you've already taken, but then get some more value that you can then continue to depreciate. So it's a very, very tax efficient way to invest, to depreciate, depreciate, depreciate, exchange, depreciate, depreciate, depreciate, exchange, depreciate, depreciate, depreciate, die super tax efficient, a very cool benefit of real estate investing. Okay, Leverage, you can leverage these investments. It's a little bit easier to leverage real estate most of the time just because people expect you to buy real estate with debt. And the loans are often fixed and pretty long term. Whereas when you use a lot of leverage with stocks, I mean, you can borrow against your real estate to invest in stocks. You can do that. But what a lot of people do is they use a margin account. And the problem with margin account is you can only borrow so much, usually up to about 50% of its value. Obviously you can borrow more against real estate if you want, but there are margin calls and those can be bad if you don't have the cash to meet them. One big advantage of stocks over real estate is liquidity. Right. Stocks, or hopefully you're investing in them via low cost, broadly diversified index funds. They're totally liquid. You can buy more any day the market's open. You can sell them any day the market's open. If it's an etf, you can sell it every minute the market's open. They're super liquid, Whereas lots of real estate investments are not liquid. You might have to own them for five or 10 or 20 years. It just depends on how the investment is set up. So certainly an advantage for stocks there to make up for some of the other advantages that real estate may have. Both of these investments can be efficient. What do I mean by efficient? Well, the publicly traded stock market is highly efficient. It's not perfectly efficient, but compared to the real estate market, it might as well be. Right? There are many opportunities to outperform and underperform in real estate, depending on your skill level. Now, that's not necessarily a good thing or a bad thing, but the nice thing about investing in stocks is you can just buy index funds and you know you're going to do pretty darn well over the long run. You're going to outperform almost all actively managed investors. But if you want to add value to your investments, probably picking stocks isn't the way to do it. You're much better off spending that time on the real estate side. Now. It's way easier to underperform on the real estate side because you can't just go buy the index fund that owns all the private real estate in the US it doesn't exist. But there's also the opportunity to outperform because real estate is very local, and if you're good at it, you really can add value there. Okay. Volatility is something to consider between these two investments. And stocks seem more volatile, but how much of that is just because they're marked to market every day? That's probably one aspect of it. But certainly your investment in stocks can drop dramatically. That applies to publicly traded real estate as well. I remember in 2008, I think stocks dropped something like 45%, 48%, something like that. Publicly traded REITs, the Vanguard Real estate index fund, from peak to trough, dropped 78% in value. I mean, anything that's traded on the markets, it really can be very volatile. Whereas a private real estate investment that you own that isn't mark to market every day, nobody's out there doing an appraisal, every single day feels a lot less volatile. It might be a little bit easier for you to stay the course. The bottom line, Both stocks and real estate are great investments. Real estate's a little bit more work, but it has a few cool advantages to go along with it. Both have high returns and they have relatively low to moderate correlation with each other. And so I think there's a lot of advantage to having both in your portfolio. You do not have to choose between these. You, you can have both if you want, but you do not have to have both. It's possible to be successful just with real estate, and it's possible to be successful never touching real estate at all. It is an optional asset class. Hope that's helpful to you.

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.