To grow your wealth, which is a better strategy: investing in real estate or building a stock portfolio?
Real Estate vs. Stocks
The main difference between real estate investing and stock investing is that with real estate investing you buy properties and rent them out or invest in REITs (real estate investment trusts), whereas with stock investing you buy a small amount of stock in a company and wait for it to increase in value.
If you're trying to choose one or the other, the good news is that you don't have to choose one or the other — many people do a little bit of both. It's also important to know that you can buy shares in real estate investing without the hassle of actually buying, managing, and selling the properties.
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An Alternative to Traditional Real Estate: REITs
Not interested in flipping houses or building a rental property empire? Luckily, there's an easier option: investing in real estate investment trusts (REITs).
REITs are companies that own (and often operate) income-generating real estate, such as apartments, warehouses, offices, shopping malls, hotels, etc. The most reliable REITs pay large dividends and have a history of growing dividends. Many online brokers offer exchange-traded REITs, REIT mutual funds, and ETFs, which means you can buy them in the same places you buy stocks.
Real Estate or Stocks: Which is More Profitable?
There are many metrics you can look at when trying to decide whether investing in real estate or stocks is more profitable. To answer this question, you need to decide which type of real estate you want to compare to which stocks. The average return on the stock market, as measured by the S&P 500 index, is about 10% per year. Some years it goes up and some years it goes down, but over the long term, if you invest in an S&P 500 index fund, you will average about 10% minus inflation.
From 1972 to 2019, REITs generated an average total return of 11.8% per year compared to 10.6% for the S&P.[0]However, that doesn't mean that REITs will always outperform the S&P 500. Each investment should be carefully considered and aligned with the rest of your investment portfolio, and investing in an S&P 500 index fund and REITs will provide more diversification than investing in just one.
Pros and Cons of Real Estate Investment
Traditional real estate investments can be broadly divided into two categories: residential real estate (such as your own home, a rental property, or flipping a house to resell for a profit) and commercial real estate, such as apartment complexes, office buildings, and shopping malls.
Strong Points
Investing in real estate is easy to understand. While the homebuying process can be complicated, the basics are simple: you buy a property, maintain it (and occupy it, if you own other properties besides your home), and try to resell it at a higher price. Owning a tangible asset also gives you a sense of control over your investment compared to buying part ownership in a company through stocks.
Debt investing in real estate is safer. Also known as a “mortgage investment,” it allows you to invest in a new property with a 20% or less down payment and finance the remaining property costs. Debt-backed equity investing is called margin trading and is very risky and should only be undertaken by experienced traders.
Real estate investing acts as a hedge against inflation: Because home prices and rents typically rise with inflation, real estate ownership is generally considered a hedge against inflation.
There are tax benefits to owning real estate. Homeowners may receive a tax deduction on interest on up to the first $750,000 of mortgage debt. There are also tax benefits, such as an exemption that allows you to avoid capital gains tax on $250,000 of net profit if you're single (or $500,000 if you're married and filing jointly) if you sell your primary residence. If you own and sell commercial property, you may be able to avoid capital gains through a 1031 exchange (if you reinvest the proceeds in a similar type of property). Investment property can also receive tax benefits through depreciation, or the writing off of wear and tear on your property. Learn more about the tax benefits associated with homeownership in this tax guide.
Disadvantage
Real estate investing can be more work than stock investing. Buying real estate is easy to understand, but that doesn't mean maintaining real estate, especially rental properties, is easy. Owning real estate requires a lot more work than buying stocks or investing in mutual funds or other equity investments.
Real estate is expensive and highly illiquid. Investing in real estate requires a large up-front investment, even if you borrow cash. Making money from a real estate investment by flipping is much harder than the point-and-click ease of buying and selling stocks.
Real estate is expensive to transact. Sellers pay large closing costs, which can reduce the sale price by as much as 6% to 10%. This is a big savings compared to stocks, especially considering that most brokers now don't charge commissions on stock transactions.
Diversifying your investments in real estate is difficult. Location matters in real estate investing. One area may be experiencing a drop in sales while another is experiencing a price surge. Diversifying your property purchases by location and type (such as a mix of residential and commercial) requires a much deeper pocket than the average investor.
Investment returns are never certain. Property prices tend to rise over time, but there is always a risk of selling a property at a loss. The uncertainty of the housing market after the 2008 financial crisis and the pandemic are reminders of that. Of course, this also applies to stocks.
Pros and Cons of Stock Investment
There are significant advantages to buying stocks, as well as some important disadvantages, that you should keep in mind before making a purchase.
Strong Points
Stocks are highly liquid. Unlike real estate, where your investment capital can be locked up for years, you can buy or sell shares in a publicly traded company the moment you decide it's time to act. It's also easy to know the value of your investment at any given time, unlike real estate.
It's easier to diversify with stocks. Few people have the time, much less the cash, to buy real estate properties that cover a wide range of geographies and industries to truly diversify. Stocks allow you to build a portfolio of companies and industries with a fraction of the time and money it would take to own a variety of real estate. The easiest way to diversify is to buy shares in a mutual fund, index fund, or exchange-traded fund. These funds buy shares in a wide range of companies, providing fund investors with instant diversification.
There are few (if any) commissions on stock trades. You still need to open a brokerage account to buy and sell stocks, but price wars among discount brokers have driven the cost of a stock trade to $0 in most cases. Many brokers also offer mutual funds, index funds, and ETFs with no transaction fees.
You can grow your investment in a tax-advantaged retirement account. Buying stocks through an employer-sponsored retirement account, such as a 401(k), or an individual retirement account allows your investment to grow tax-deferred or tax-free.
Disadvantage
Stock prices are much more volatile than real estate prices. Stock prices go up and down much faster than real estate prices. The fluctuations can be stomach-churning unless you take a long-term view on the stocks and funds you buy for your portfolio and plan to buy and hold through the fluctuations.
When you sell your stocks, you may be subject to capital gains tax. When you sell your stocks, you may have to pay capital gains tax. However, if you hold your stocks for more than a year, you may be taxed at a lower rate. You may also have to pay tax on any stock dividends your portfolio paid out during the year. (Learn more about taxes on stocks here.)
Stocks can trigger emotional decision-making. Stocks are easier to buy and sell than real estate, but that doesn't mean you should. When markets become volatile, investors often sell even though a buy-and-hold strategy would usually produce greater profits. Investors should take a long-term view of all investments, including building a stock portfolio.
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