How do real estate investments compare to stock market investments?

Investing wisely can significantly increase your wealth, and two of the most popular choices are real estate and the stock market. While both options have their merits, they differ greatly in terms of risk, potential returns, and how they are managed. This post will examine these differences, particularly focusing on single-family homes, which can be an appealing choice for new investors.

NOTE: I am showing examples in this post to illustrate how all of the pieces work together. You should do careful research on the particular scenarios you are considering.

Understanding Real Estate Investments vs. Stock Market Investments

Real estate investments involve buying physical properties, while stock market investments mean purchasing shares in publicly traded companies. One key difference is that real estate is a tangible asset you can see and touch, whereas stocks are intangible and scoreboard-based.

Real estate is frequently viewed as a more stable investment. For example, according to the Federal Housing Finance Agency, residential real estate prices have generally increased by about 3.3% annually over the past five decades. In contrast, the stock market can undergo significant fluctuations, with drops of over 30% occurring during down markets, as seen in early 2020. Understanding these factors can help young investors make better choices.

The Appeal of Single-Family Homes

Single-family homes offer a solid entry point into real estate investing. They provide various benefits that may be particularly compelling to young adults starting their investment journeys.

First, there is a reliable demand for housing. In the United States, more than 80% of households are renters or homeowners. This consistent demand suggests that renting out a single-family home may be less risky than investing in stocks that can be highly volatile.

Second, owning a single-family home can lead to significant long-term appreciation. As neighborhoods develop and new amenities arise, the value of homes generally increases. For example, in many urban areas, homes have appreciated by over 20% in just a few years due to improved infrastructure and demand.

Leveraging Borrowed Money for Real Estate Investments

A standout benefit of real estate investments is the ability to leverage borrowed money. Unlike stocks, where you need to fund your purchase fully, real estate lets you take advantage of a mortgage. When evaluating real estate returns, it's vital to understand that they are based on the down payment rather than the total property value.

Suppose you buy a $250,000 home with a 20% down payment of $50,000. This method allows you to control a valuable asset without the need to pay the full amount upfront. If the property appreciates by 5%, that’s a $12,500 gain, translating to a remarkable 25% return on your initial investment of $50,000. This leverage can significantly enhance your returns compared to the stock market.

However, this is not the full story. Let's look at the rest of the picture.

Tenants Covering Property Costs

Rental properties can produce income that covers your ongoing expenses, such as mortgage payments, property insurance, taxes, and maintenance. This rental income can provide a consistent cash flow, allowing your tenant to essentially pay for your costs.

Imagine a situation where your rental property brings in $2,000 each month. If your total monthly expenses are $1,600, you end up with a monthly net gain of $400—amounting to $4,800 annually—while building equity and generating assets.

This results in an annual cash-on-cash return of $4,800 on an initial $50,000 down payment, equating to an annual 9.6% return... even before considering the tax advantages.

Let's examine how the tax benefits enhance this rate of return.

Tax Advantages of Rental Properties

Investing in real estate offers considerable tax benefits. With rental properties, you can deduct mortgage interest, property taxes, maintenance costs, and property management fees from your taxable income.

For instance, if you earn $24,000 in rent annually but incur $10,000 in mortgage interest, $3,000 in property taxes, and $2,000 in maintenance fees, your taxable amount decreases to $9,000 before considering further advantages.

A significant benefit of real estate is the ability to claim depreciation, even if the property's value increases. The IRS allows you to deduct a portion of the property's value each year—27.5 years for residential properties.

Continuing with the example of a $250,000 house, you can deduct approximately $9,091 annually from your tax liability, effectively eliminating the remaining $9,000 mentioned earlier, benefiting your tax situation despite the property's market value rising.

If you are in the 22% tax bracket, this results in a $5,280 tax benefit on the $24,000 rental income.

Overall, you achieve a $4,800 cash flow plus $5,280 in tax savings, totaling a $10,080 annual return on a $50,000 down payment, equating to a 20.16% annual return.

Building Equity Over Time

Furthermore, owning real estate allows you to build equity while renting out the property. Each mortgage payment increases your ownership share in the asset. After 10 years, more than $30,000 of the original loan principal is paid off, covered by your tenants' rent payments, resulting in $30,000 of additional equity.

Moreover, consider that same $250,000 house appreciating at a conservative rate of 3%. In 10 years, it could be valued at around $336,000. This not only offers potential income through rent but also enhances your asset base. Unlike stock investments that can experience significant fluctuations, real estate generally follows a more stable growth path.

In 10 years, you could own a $336,000 house with a $170,000 mortgage, resulting in $166,000 in equity.

In 10 years, your original $50,000 investment resulted in $100,800 (20.16% annual cash-on-cash return) + $166,000 (total equity) = $266,800.

Comparing to Stock Market Returns

Looking at these factors in comparison to stock market returns reveals real estate's unique advantages. While stocks can yield substantial profits, they often come with higher volatility and risks.

For instance, during the 2008 financial crisis, major stock indices lost about 55% of their value. In contrast, real estate held its ground in many markets, illustrating that real assets tend to remain more stable during economic downturns.

However, assuming average annual returns for the stock market, you could have turned your $50,000 into $140,000. This falls significantly short of the real estate example.

Seizing the Opportunity

Investing in real estate, especially through single-family homes, offers a compelling alternative to stock market investments. The benefits of leveraging debt, enjoying tax breaks, and generating passive income make real estate a captivating option for young investors.

Real estate investments can yield substantial returns from a relatively small initial investment. They also provide stability and a tangible asset that can appreciate over time.

Even with the inherent risks of investments, understanding the unique benefits of real estate can empower individuals to make informed decisions and secure their financial futures. Always conduct thorough research, consider professional guidance, and enjoy the process of investing!