For the last few weeks, I’ve been scouring real estate sites on the lookout for properties that might make good rentals. With all the stories about foreclosures and short sales, you’d think that good deals could be had at every corner right? One of the benefits of being smart with credit and not accumulating a lot of debt is being able to put that to good use in the darker times. I was hoping this was one of those times (as the stock market was a year ago).
Unfortunately, while there seem to be decent deals out there, the struggle I have with investing in real estate is that it comes with significant transaction costs, significant time requirements, and significant risks because it’s difficult to diversify.
Cash Flow vs. Asset Value
There are two ways to make money when it comes to investing. You either earn a nice return every month (or quarter, or year) off the cash flow or you earn a nice return on the sale of the asset (or some mix of both). With a rental property, you can earn it off the rent you collect each month or you can earn it off the gains when you sell the property. A common strategy is to just have the rent cover the mortgage and then bank the gains when you sell the property. With stocks, you can make your money off dividends or you can make it off appreciation of the stock’s price. Once you boil down any investment into those terms, it becomes easy to figure out which you’re more comfortable with.
With real estate, the cash flow is taxed at ordinary tax rates as income (whatever you don’t offset with expenses). With stocks, the cash flow is taxed at long term capital gains if they are qualified dividends. On the sale of either asset, it’s short term capital gains if you’ve held it for less than a year and long term if you’ve held it for more than a year.
Both Offer Good Prices
We’re in a unique point in time when real estate and stocks are relatively cheap. Real estate prices were walloped, and continue to be depressed, following the economic meltdown and the “Great Recession” that followed. Stocks, as much as they’ve soared in the last year, are still much lower than their peaks right before the banking crisis. The Dow Jones Industrial Average peaked at 14,168.53 on October 9th, 2007. It’s barely over 11,400 today. Relative to their highs, both are much cheaper than a few years ago.
Transaction Costs & Liquidity
Here’s the big difference between the two and why I think dividend stocks trump real estate. The cost to buy and sell stock is $5 and the market is liquid, which means you can get into and out of a position within minutes. That and the stock market provides far more information than the real estate market because of sheer transaction volume and SEC reporting requirements.
Have you ever tried to sell a house? First, you need to pay 5-6% to the seller and buyer real estate agent. The process takes a long time, the asset is huge (relatively), and the marketplace just simply doesn’t provide as much information as you’d probably like (annual report for a property showing income? assets? cash flow?).
Leverage is often touted as the reason why real estate investing is so powerful. You can put 20% down and reap the benefits of renting out 100% of the home. While that’s certainly attractive, you can get that kind of leverage (and more) on the stock market as well through options. Leverage is not something only available in real estate.
When I compare the two, it just seems like investing in the stock market is the winner?