Real Estate vs Stock Market Investing

[Mike Griffin]

Does anyone have an opinion as to why one should invest in real estate versus the stock market? Real estate investing seems exciting but investing in the stock market can be a more passive way to grow wealth long term. Do most people do a blend of both?

I’m brand new to real estate investing. No investments yet, just started educating myself so I am thrilled I found this community (and the podcast and YouTube videos). Real estate investing has always interested me, specifically flipping or rentals. I’m an architect so this seems like a natural realm to use my familiarity with construction, scheduling and permitting for investing and wealth building.

Maybe I just need to decide what focus is right for me. Maybe flips are better for me because those are one and done, and rentals are sustained work to manage properties and tenants.

I’d appreciate all your thoughts. Thanks.

[Arie Van Gemeren]

I worked as a financial advisor at a major Wall Street bank for years, and am now involved in venture capital + real estate (on my own) so have thought a lot on this question. I was once an equity research analyst and so there was a time I believed unfailingly in the superiority of stock investments, and then through meeting ultra-wealthy investors as an advisor came to see that many held a LOT of real estate and had done extremely well, which eventually led to something of a conversion on the matter.  Here are my thoughts, and they're worth precisely what you're paying to read 'em: 

As others have already said, the real question is what exactly are you trying to achieve. If you want to achieve "market-like" returns with the stock market over the next 30 years and not focus on investing, then I'd just buy the S&P 500 and call it a day. Take your money today, and assume average stock market returns (8-10% annualized) and see what that looks like in 30 years time and I think you'd be impressed. Compounding is an impressive force. And, I think, unless something goes really wrong with the West / Capitalism, you can in general rest assured that inflation will continue, and businesses will continue to grow, and therefore a stock portfolio should make money (with enough time). 

However, there's a saying we often used in the advisory business - it takes concentration to create wealth, and diversification to preserve it (which again goes back to goals - if you just want a decent retirement, investing in the S&P 500 at an early age is fine. If you want to build wealth, then I think real estate can be a solid way to go, but there are risks.)  

I think it must be stated that real estate is riskier in many ways (and also less risky in some ways - you own the asset, people need a place to live, etc.). Take a diversified stock portfolio (SPY) versus a single building. You have the POTENTIAL to make more money on that building, but also the POTENTIAL to lose a lot based on "idiosyncratic risks - a fancy term for one-off things that might not affect the economy at large", i.e. an earthquake, a riot, a flood, a fire in that building specifically, mold, etc. So from this perspective, it's much riskier than owning the US economy. What are other significant risks that get people?

• You make mistakes estimating costs, or have overly optimistic assumptions that will get you out of a bad opening situation (if your model depends on significant rent increases from prevailing rent rates [i.e. it's already market rent in the building] then I think it's more akin to speculation) then that could fail, and you could end up feeding cash into your project, which leads to ...
• Not maintaining sufficient reserves. If things do go south (which they do) and you can't keep alive during the lean times, you'll get your face ripped off
• And lastly, I think, taking on undo interest rate risk / refinance risk. Ask anybody whose balloon payments hit in 2008/2009 and couldn't refinance their building or who have to refinance into a much worse interest rate environment 

So it must be stated that you don't face many of these above with the stock market (assuming you aren't investing "short-term" money with the intention of "making a quick buck" and then get crushed if the market goes into a correction).  Anyway, all the major risks aside, why do I personally like real estate more? 

• Emotionally, I like it - it feels like I'm running my own business. This is entirely my own thing, and nothing to do with the broader question here
• Generally more simple: I think it has been well proven that the vast majority of humanity cannot pick individual stocks, while it seems (SEEMS) to me that more people are able to find deals in real estate.  Why?  The reasons you can find a deal in RE abound - older owner is tired of managing the building, couple got divorced, somebody in financial distress, etc etc. These are all opportunities to create value. The business also seems to reward hustle and creativity. Hustle and creativity in stock market investing is sometimes referred to as "insider trading". 
• Easier modeling: if you understand the fundamentals of real estate valuation, and are conservative (i.e. estimating a higher cap rate exit than when you entered, for instance, higher expenses than you estimate, lower rent increases than you think you could get, and still like the deal) then it's an easier job to estimate the potential return for an investment. Personally, I think doing this with stocks is more of a guessing game than with R/E.  And if you're really conservative and the numbers STILL look really good, you can feel pretty confident you found a strong deal 
• Leverage: it's a double edged sword, and I noticed in the comments people mentioning borrowing on margin to buy stocks. All true, but find me a margin borrower that doesn't issue margin calls. What's unique I believe in RE is that you can get fixed rate financing (with multi-family perhaps only for a set time, but if you set it long enough you can mitigate interest rate risk) and have no risk of an early margin call on your investment. What this means is that you can hold a leveraged position through bad times (assuming your loan doesn't balloon pay in the middle, which is a big if) and benefit from leverage over the lifetime of your holding.  On this note, it was common in my experience to poo-poo real estate returns as "inflated" because of leverage, and oh to make them "risk-adjusted" one should just "leverage" stock returns too. But this is missing the point of margin calls entirely, which makes them in no way an apple to apple comparison 
• Value-Add Potential: comes back to control, but you can directly influence the value of your investment in some way which you can't do - again, rewards hustle and creativity. 
• Tax benefit: I've worked with a lot of people who had built incredible wealth through founding and taking companies public. The universal issue? big capital gains taxes at the end to actually use their money (or they could borrow against the money - fair enough). In RE you have interest rate shielding, plus depreciation shielding, plus you don't necessarily have to pay capital gains taxes. 

So, in total, if you take the leverage factor in real estate and couple it with depreciation protection for income PLUS the fact that you don't necessarily have to pay capital gains taxes on your gains in order to recycle them into the next property, and determine the annualized return on real estate ASSUMING YOU PAID TAXES as you might have in a stock portfolio, I think the numbers will end up speaking for themselves (assuming you find the right deals - BIG assumption). 

Buffet was quoted in this chain somewhere. Berkshire's annualized performance is around 20.8%.  I doubt most of us can replicate that. Baupost (less well known, but look up Seth Klarman and his book - Margin of Safety -one of the most impressive books I've ever read, and he's known as the Oracle of Boston) posted maybe 19.1% annualized returns. Those are two of the most impressive investors of all times. I think achieving these returns for most of us is way out of reach. Yes, an individual project might do that, but you have to maintain that with "the capital under your control" for an extended period of time. That is not easy, in the slightest. However, there's a realm between stock market returns of 8-10% annualized (pre-tax) and Berkshire (20.8%) which is still a lot. If you invested $100k today in the S&P and earned a 10% annualized return in 30 years you'd have $1.74mm.  If you invested $100k in RE and earned a "yes, levered, but not counting tax benefits" annualized return of 15% in real estate then you'd end in year 30 with ~ $6.61mm.  

One final anecdote for this "numbers" section, which is extremely simplified but I think demonstrates my point. Let's assume you have a 10 unit building, and you have a 75% LTV loan on the building. The building is valued at 5% cap rate (I live int he West Coast, so bear with me). You bought it for $1mm and so the NOI is $50k. Total gross rent is $100k. You increase rents by 2%. Total gross rent = $102k, and assuming (big assumption) expenses stay the same your NOI is now $52k. at a 5% cap rate, your building is theoretically now worth $1.04mm, which is a $40k gain on your initial investment of $250k, which is a 16% return for that year (on equity). There are a lot of ways to pick this apart, but a 2% increase in rent being magnified through to the value of the building (without considering tax benefits, equity paydown, etc.) I think demonstrates that the numbers (if done right) can be significantly better.

Given I'm on a real estate website I doubt there'll be many detractors, but the biggest detraction to what I just said is this - everybody talks about their good deals and not their bad deals. The "average" return of all investments is what matters, and the inability to "find" the right deal while you're sitting on cash also hurts your return. But sitting in the stock market for the long term means you're always invested, you're not searching for that deal, and so real estate working out right depends on probably even better returns because unless you have a VERY robust pipeline of deals you probably have a lot of dead-time, and we all eventually have deals that don't work out for us (and therefor hurt our "overall" return). Somebody could probably use what I just said to make a very strong argument for the stock market.