Choosing where to invest hard-earned savings is quite a challenge. At a high level, the objective is simple. Which asset will provide the highest risk-adjusted rate of return? Answering this however requires a deep understanding of the return possibilities from real estate versus stocks, which we will explore below.
Sources of investment return
Let’s compare how the return is created for real estate versus stocks. Return is generated by:
The asset earning cash and distributing it to owners
Stocks receive a dividend which is a cash payment that the business pays out to shareholders out of their earnings.
Real estate earns rent which the owner can pocket after paying any expenses.
The asset earning cash and using it to increase its value
For businesses, cash can be used in many ways to increase intrinsic value. One way could be to repurchase shares. This means for remaining shareholders, their stake in the business, and thus the value of their shares increase. Another way could be to expand profitably, such as by opening new stores or factories.
Value increase is achieved in two ways with real estate.
- The first is similar to the stock example. A property owner may invest in a swimming pool or landscaping to increase the value of the property.
- The second is through supply-demand effects, not by actually deploying the cash earned from the investment. With stocks, supply and demand forces play a very small role in the long-term wealth created. However, since properties are inherently an asset that all humans require, a significant portion of its value change is impacted by this economic force. This in turn is influenced by interest rates as well as the general economic growth of the property location.
Looking at the numbers
The other element to consider with property investing is that a loan is cheap and easily accessible. This can boost your returns significantly.
So to compare these two asset classes as investments, we need to calculate the return incorporating this leverage element. Throughout this article, we will be using our Real Estate Investment Return Calculator, which does exactly that.
Let’s discuss this with the example below. Let’s assume this investor can afford to lay out $100,000 today along with another $24,000 per year from their savings. Out of the $100,000 initial outlay, $80,000 of it is the deposit, and $20,000 of it is a land transfer tax.
These assumptions are roughly in line with historical figures.
After factoring in these assumptions, the investor would earn 10.5% return over the first 10 years. We can see that after 10 years, the investor will own a property worth $606,329, with $100,000 originally invested and another $24,000 contributed every year. Their total contributions amount to $316,000, leaving them with an asset that earns $27,000 a year in rent.
Can this be beaten with stocks?
This question boils down to whether we can generate more than a 10.5% annualised return in the stock market. According to Vanguard, the S&P500 stock market index has returned 8.23% p.a. between 13/11/2000 and 31/12/2021. This is the return that would’ve been earned in stocks without any effort beyond contributing to the fund regularly.
To earn more than 10%, the stock market indices are unlikely to do the trick. Choosing stocks in this case would mean we believe we can deploy $100,000 initially as well as $24,000 annually at a rate of return above this 10.5% benchmark.
This process is not as simple as buying any stock that has a dividend yield above 11% for example, because we need to consider the durability of these earnings over time. To achieve this rate of return, we need to identify either funds or individual stocks that have high-return potential. Picking stocks involves an entire set of analyses that we discuss in other sections of this website. The value investing style of stock picking is the process by which Warren Buffett earned his tremendous wealth.
As we can see above, the majority of funds fail to beat the market. Earning this premium return plus having the confidence to contribute so much per year is no easy feat, but that doesn’t mean it isn’t possible!
Conclusion
Overall, choosing the investment vehicle to drive financial success involves a careful analysis of which works best for each individual scenario.
A property has fewer considerations than a stock does. If purchased in a good location, there will always be demand for the home and rent that it can earn. Businesses on the other hand can go bankrupt, slowly decline in prevalence over time and are often global entities that are more difficult to understand. However, property requires time and potentially substantial money for maintenance, compared to a stock certificate which just sits in your brokerage account.
As a result, investors often feel more comfortable with property than they do with stocks. Separating from the math, psychologically, many people would feel more comfortable contributing large portions of their income to real estate, compared to stocks, due to their tangible nature.
At a base level, simply comparing stock index funds to property, the returns will likely be quite similar over time.
This being said, the assumptions above are no guarantee. Also, the return was only calculated over the first 10 years.
Ultimately, both asset classes have pros and cons and there is no single answer regarding which is the better investment. The drivers of return on property are the rental yield plus the capital gain. Similarly, stock market returns comprise of the earnings growth of the businesses in the fund/the particular stock, plus the dividend yield it generates. In a growing economy, both of these sources will likely be strong.
