Tag Archives: Real Estate Vs. Stocks

Stocks vs. Real Estate Debate, Part 3 (answering objections)

It’s amazing how much discussion there is about personal finance…a thread about finance on Reddit’s Slate Star Codex thread got over 80 replies.

In parts 1 & 2, I make an argument for owning real estate over stocks. I assume that someone, hypothetically, has a sum of money saved up (such as $40,000) or as a gift or inheritance, and is deciding whether to rent and invest the $40k in stocks–or–put the $40k on a down payment.

Part 1: The Advantages of Real Estate over Stocks

Part 2: Real Estate vs. Stocks, Part 2 (why homes win, and why rent sucks)

I updated Part 2 to include simulations of how, over the long-run, real estate and no stocks is better than a combination of stocks and renting.

Some objections:

1. Costs of maintenance:

This is correlated with the size, initial condition, and age of the home. Small new homes tend to have less maintenance than big old homes. Maintenance costs are more of an issue if you rent the property out instead of using it as a main residence. In my simulations, I assume the property is a main residence.

2. Inflation going up:

In my simulations, I assume a 30-yr fixed-rate mortgage. The fixed rate is a hedge against higher inflation, although 30-year fixed-rate mortgages may not be available in all countries, such as Canada.

3. Property taxes:

Property taxes are offset by mortgage interest deduction, which is an adequate approximation.

Using a property tax calculator, I obtain a yearly cost of around $4,500:

Using the Bankrate mortgage interest deduction calculator, I obtain a yearly savings of around $4500-6000, depending on state tax rates and income tax:

4. Capital gains taxes:

Long-term capital gains for the sale of real estate is 20%. A roth IRA has the advantage of being untaxed.

5. Capital losses:

An objection:

You aren’t risk-adjusting your estimate. What if the city turns into Detroit? What if your home gets hit by an uninsured disaster? What if you get toxic mould in the brickwork and have to replace the walls?

Real-estate might provide better average returns but for most people it’s going to be a huge percentage of their capital. That means there’s a huge downside – they could lose everything if disaster strikes on that one investment. That’s something the stock market protects against. It allows diversification to mitigate those kinds of scenarios.

You are also making a false comparison – you’re comparing the whole property market to the stock market, when you should be comparing average volatility per property. If I own a single house, the volatility on its price is going to be way higher than the general market and there are a lot more lose-everything scenarios.

Real estate has higher risk-adjusted returns than stocks (a higher sharpe ratio):

Stocks also have risks: fraud, bankruptcy, loss of market share, recession, disaster, crisis, etc. Because a home has tangible value, it can’t go to zero, unlike individual stocks. The worst I have seen is a home fall 50%, which was in certain areas in 2008-2011 (but the typical decline was more like 25-30%), but individual stocks fall 50-90% very often, and sometimes never recover. The S&P 500 lost 50% of its value in 2000-2003 and again in 2007-2009. It lost 20% of its value in 2011 and 15% in early 2016, although it quickly recovered in both instances.

But, yes, the leverage of real estate can magnify losses, but being able to pay the mortgage is what matters. Often, many will ‘walk away’ (strategic default) if the home becomes too far underwater, although this will hurt credit score. When stocks go underwater, however, there are far fewer options than when homes go underwater. The use of long-duration mortgages and small down-payments lessens risk, because less initial capital is at risk.

Home insurance is much cheaper than ‘stock insurance’ (put options).

6. Real estate has poor liquidity:

Obviously, it takes longer to sell a home than to sell a stock, but some real estate markets can close pretty quickly. In the Bay Area, for example, there is often a long list of waiting buyers. Sales can be competed in weeks.

7. Lack of diversity:

As shown in #5, although the S&P 500 is diversified it can still sustain large losses during bear markets and recessions. My simulations assume excess wages are invested in the S&P 500, boosting diversity.

Real Estate vs. Stocks, Part 2 (why homes win, and why rent sucks)

As discussed in Part 2, in recent years, there has been a ton of interest online in finance. Everyone, but especially millennials, want to know how to make more money quickly, whether to rent or buy a home, who to save for retirement and how much you need to retire, index funds vs. individual stocks, and how to get rich quick…or slowly.

In Part 1, I outline some of the benefits of home ownership versus stocks. If you buy a home for $240k outright, versus paying rent, you effectively double your money in a decade in terms of money saved by not paying rent. But is it really as good as it sounds.

Many people in their 20′s and 30′s are in a situation where they have some money saved up and a job that pays a decent wage, and they are wondering if they should put the cash in an index fund while renting — or — instead of renting, using the cash for a down payment on a home.

Let’s crunch some numbers…

Let’s assume starting in year ‘X’ you earn $2,000 in after-tax income every month, and wages grow at 3% a year. Hypothetically, you also have $43,000 cash, which can either be invested in the S&P 500 or on a down payment. You can either put this $2,000/monthly income into stocks or in a mortgage. Historically, stocks have returned 10%/year (including reinvested dividends). Rent is $2k/month and grows at 3%/year as well. Home prices rise 2%/year. Let’s assume a rent/price ratio of 18, which is the national average (12 months * 18 * $2000/rent~$430k home). A 10%-down mortgage on a $430k home means you put down $43,000. For simplicity, let’s also assume the mortgage interest deduction is offset by property taxes.

Case A: $43,000 initial in S&P 500 + $2000/month invested, compounded 10% a year for a decade. However, gains in rent offset gains in wages, so all after-tax income goes to rent. Total profit is simply 43k*(1.1^10-1)=$68k.

Case B is more complicated. Initial home equity $43,000. Initial home value: $430,000. After a decade, at 2%/year, the home is worth $525,000. Profit: $52,000. The mortgage payment is $2,000/month (adding $150/month extra to take into account other fees), which is offset by income. But wages are growing at 3% a year, which is invested in the S&P 500 like above.

Between years 0-1, total yearly wages are $24,000, all of which goes to the mortgage, so 0$ leftover and 0$ total

Between years 1-2, total yearly wages are $24,700 (wages rise 3%/year), leaving $700 leftover, which is put in the S&P 500

Between years 2-3, total yearly wages are $25,460, $1460 leftover and put in S&P 500; the $700 grows to $770; total= $2230

This is a recurrence relation… Wolfram Alpha is used to tabulate the remaining years. The end of the 10th year shows $46,000 of capital accumulated due to a combination of wage increases and S&P 500 reinvestments.

But this is an underestimate…let’s assume the wage increase is in 10 discrete chunks spread throughout the year in equal intervals, and each chunk is immediately invested in the S&P 500.

So for year 1, wages increase 3% by year-end to 720, so each chunk is $72. We have: 1.1*72 (the first chunk gets all of the S&P 500 gains) + 1.09*72…1.01*72 (the final gets the least). Adding up .1+.9+.8 … .01 gives (n^2+n)/(200). For n=10, the sum is .55, which times 72 is $40, which represents a 5.5% gain after a year on top of the $720, for a total of $760 after one year.

The new recurrence relation, which when evaluated gives $62,000 profit after the 10th year. Total profit $52k+$62k=$114k

$114k beats the $68k by 67%. One of the reasons why home ownership does well is because the mortgage is fixed at $2,000 a month, whereas the rent in the first example keeps growing. This allow the excess income to be invested in the market.

The Advantages of Real Estate over Stocks

I’n the past, I’ve defended real estate ownership as a way to create long-term wealth, versus renting, which gradually destroys your wealth (but more specifically, prevents you from ever creating wealth, because you’re constantly bleeding cash every month).

James Altucher staunchly opposes home ownership, in which I disagree. Another critic of home ownership is Robert Shiller, who is often wrong too.

Usually, the same people who advocate the conspiracy that the government is under-reporting inflation are also opposed to home ownership, but if the rate of rent exceeds inflation (which it obviously does), wouldn’t a 30-year fixed rate home mortgage be a good hedge against rent inflation, especially considering that rents are increasing at a faster rate than mortgage interest?

Regarding the stock market vs. real estate debate, a common argument is that stocks outperform real estate, and this is true over the long-run, but there are major advantages of real estate that stocks do not offer:

1. Cheap, significant leverage. A fixed 30-year mortgage on a $200k mortgage with $20k-down and a 740 credit score is 4% (10-1 leverage). Stock brokers will charge clients 6% a year to get maximum 2-1 leverage leverage. So that means, a 1% gain in the $200k home = $2k profit, vs. $400 profit from a 1% gain in your 2-1 stock account. (I’m excluding interest in both instances.)

2. Stability. Stocks are much more volatile than real estate. Only once in the past 100 years did the US housing market make a significant correction (2007-2011), but the S&P 500 has fallen 20% or more during multiple occasions: 1973,1987,1998,1999-2002,2008. On a risk-adjusted basis (returns vs. variance), real estate is better, even if the absolute returns are less than stocks.

3. Tangible value. Stocks can go to zero (which is why indexing is such a good idea). A home can’t just vanish.

4. More negotiating power. If you use leverage in a stock account, you have virtually no negotiating power if the trade goes badly…the broker will simply close your positions, usually at the worst possible time, to protect their own capital (because you’re using the broker’s funds when buying stocks on leverage). With real estate, however, there are is often generous financing and assistance if you are unable to pay. This is because banks lose money when homeowners default, so they generally want to work with the homeowner. Whereas stocks can be sold in seconds, eviction and then resale of the home can take years.

5. Shelter. Rent is very expensive, and it adds up over many years. If you put all your money in stocks, you will still need somewhere to live. $2,000/month in rent adds up to $240,000 after a decade.

Using the example above, if you purchase a home for $240,000 outright instead of renting, after a decade, you will have indirectly ( in terms of opportunity cost) made 2x your money on the home in terms of not paying rent, even if the home didn’t appreciate.

6. Income. Real estate can be rented out, boosting returns, although stocks can pay dividends.

From James Altucher : What are the most useful money investment and saving tricks?

A) Don’t buy a house.

Lets say you buy a $500,000 house.

You put $150,000 down (30%). You pay another $30,000 real estate commissions.

You put another $50,000 into maintenance (I’m making it up but that seems very conservative).

That’s $230,000 GONE.

The down payment is equity…it doesn’t just vanish, as astute readers in the comments noted. The typical maintenance rate is about 1% a year…buying a $450k home that immediately requires $50k in maintenance seems exaggerated. $30,000 in commission is also exaggerated.

In the ownership case, you might gain money if the house gains. But from 1890 – 2004, housing prices gained 0.4% a year over inflation. There are much better investments. And your investment is tied up in an asset that is 100% illiquid (i.e. you can’t get your money out).

This .4% figure is cited a lot, and it’s wrong. Here is Case Shiller home index over the past 40 years, including the housing bubble:

It doubled, representing a compounded return of 1.7% a year, more than triple the .4% figure.

What we have is a failure to do math.

Homes in many regions of California and New York have increased 3-4x since 1996, for an annual compound return of 7%. Unless you bought at a really bad time (2005-2007), almost anyone who holds real estate comes out ahead after a decade, versus renting. Of course, there is no guarantee these gains are sustainable, but there are also a lot of fundamentals behind the enduring resiliency of the Bay Area housing market.

Also, the major purported advantages of renting–inexpensiveness and flexibility–may also be oversold because you very often need a very large deposit and a credit check in order to rent.

What if you wait 20 years and pay off your mortgage? Then good for you. But average house turnover in the United States is four years.

But it doesn’t matter…some people sell their home for a profit before they pay off the entire mortgage…that’s how ‘house flipping’ works.