The decision to invest in real estate or stocks doesn’t necessarily have to be either-or and there’s good reason to choose both.
I started investing in real estate just after serving in the military. I worked as a commercial real estate agent and later managed a portfolio of residential rentals from 2001 through 2006.
I’ve been an equity market analyst since so have seen the best…and the worst of both asset classes. While real estate investing offers upside returns from deal-making and a little sweat equity, it’s far from the passive income strategy many believe it to be.
Stocks offer advantages as well with higher liquidity and lower transaction costs. It’s difficult to build a diversified portfolio of property types and regions without several hundred thousand dollars in real estate investments. Not so with stocks where you can invest easily across the major sectors for less than $100 in commissions.
With my experience in both asset classes, I get asked often which I prefer for long-term returns. Investors are still understandably uneasy about real estate investing after the 2008 crash and want to know if it’s worth it to put money in the asset and how to invest without the headaches of property management.
Real Estate versus Stock Returns
Despite the steep drop in property prices when the bubble burst in 2008, real estate has still outperformed stocks over the last 20 years.
The NAREIT Equity REIT index of commercial property REITs plunged 60% from August 2008 to February 2009 but that hasn’t kept the index from providing a solid annualized return to investors. By comparison, the SPDR S&P 500 ETF (NYSE: SPY) fell 42% over the same period but has underperformed the real estate index since the recovery started in 2009.
Real estate has benefited from historically low interest rates over the past decade, providing cheap money on highly leveraged properties. Stocks have also benefited from lower rates but not to the extent as property investors.
With inflation stubbornly low, we haven’t seen much from real estate’s role as inflation protection. There have been times in the past, notably in the decade to 1987, that property’s inflation-hedging powers have been extremely evident. The NAREIT index jumped an annualized 20.5% over the period versus an 11.7% annual return in stocks.
The Problem with Traditional Real Estate Investment
Beyond the solid returns, real estate also offers tax-shelter benefits from depreciation and interest expense deductions.
The problem with traditional real estate investment, buying properties directly, is the transaction costs and headaches from management. It can easily cost tens of thousands in commissions to buy a property and individual investors usually have a tough time managing more than a few rental units.
Managing your own real estate properties can be made easier with a real estate investment group but there are still the constant repairs and tenant hassles that are impossible to manage for anyone juggling a full-time job along with managing their properties.
Even for investors that are able to devote their time to property management, it’s difficult to build a portfolio of properties that reduces risk from any particular property type or region. Investing across the five property types and in at least three regions would mean having to buy a minimum of 15 properties.
Are REITs the Answer for Individual Investors?
Real estate investment trusts (REITs) offer a bridge between traditional real estate ownership and stock investing. The companies hold hundreds of properties, usually spread across the United States, and sometimes offer diversification in property type as well.
REITs trade like stocks so transaction costs are low. The companies avoid corporate taxes if they pay out the majority of cash flow as distributions to investors, meaning yields are usually much higher than other stocks.
The downside to REIT investing is that you don’t get the control or tax benefits you get in direct property ownership. I still own several rental properties as well as equity ownership in some real estate crowdfunding deals to benefit from the tax shelter of real estate investing.
There are hundreds of REITs as well as some good investments in REIT funds.
The Vanguard REIT ETF (VNQ) holds a diversified mix of 157 individual REITs in different property types. The fund pays a 4.44% yield and charges a low 0.12% management fee. I like the Vanguard sector REIT but am wary of retail real estate and the fund’s 18.7% exposure to properties struggling against the rise of ecommerce.
There are many REITs to choose from in the individual property types and low trading costs make it possible to put your own diversified portfolio together.
Office space should continue to do well as the economy picks up and corporate tax reform is enacted. Storage space offers one of the highest margins in real estate with continuous demand growth from downsizing baby boomers and low costs to manage the properties.
Boston Properties (BXP) owns 170 office properties on the east and west coasts with an expansion underway in Los Angeles. The REIT only pays a 2.4% yield but price appreciation has been solid with an additional 5.4% annualized gain over the past five years.
Public Storage (PSA) is the leader in its space with 2,300 storage facilities in 38 states as well as exposure to the European market through an equity partnership. The REIT pays a strong 3.8% yield beyond an annualized 10.7% price appreciation over the last five years.
Is it Really Real Estate versus Stock Investing?
It isn’t really the case that you need to pick stocks or real estate rather what percentage of your wealth to put in each. There are advantages in each asset class and diversification benefits in the combination.
Investing in only the real estate index over the last 20 years would produce nice returns but with annual volatility of 20.4% over the period. That’s more risk that a lot of investors might be able to stomach and well over the 15.1% volatility over the same period in stocks.
Combine the two assets though in a 50/50 weighting and you would have lowered your overall risk to just 15.8% and still produced a 7.1% annual return!
I’m not suggesting you split your portfolio 50/50 in real estate and stocks but you get the idea. You’ll also want to invest in bonds and other assets in amounts depending on your age, need for return and risk tolerance.
The debate over real estate versus stock investing will always be hotly argued with good points on both sides. While real estate offers a better inflation hedge and solid cash flows, stocks are more liquid and generally lower trading costs compared to direct real estate ownership. Investing in REITs can help bridge some of the barriers for individual investors and make for a great addition to a diversified portfolio.