We’ve all seen the graphs that show the US housing market vs. the stock market. These graphs show that both go up over time no matter how many and how bad the corrections are. However, these graphs typically show the stock market as providing a better return on investment.
That is where the problem lies (double entrendre).
It only depicts the appreciation of the asset. Yet, with a real estate investment, you also get cash flow. When you add cash flow to the appreciation, stocks don’t stand a chance, especially when using leverage. But that’s not it – there are 4 additional ways that you are getting returns that these graphs neglect to portray. I’ve listed them out as such:
Reason #1: Power of Leverage
Leveraging your money is sometimes known as OPM – Other People’s Money. The best way to explain the power of leverage is to use an example. Let’s look at purchasing $100,000 of stocks versus purchasing a $100,000 house.
To buy $100,000 worth of stock, you need to have $100,000. On the other hand, to purchase a $100,000 house, you only need to spend $20,000. The bank is your partner in this deal and will put up the other $80,000. In this case, you will leverage the banks money. Banks are experienced partners. They know what it takes to make a good deal and would likely not partner with you otherwise.
If you bought $100,000 in stock and it increases 10% in a year, you have spent $100,000 to end up with $110,000. This is a good return on investment.
Now, think about a $100,000 house that appreciates 10% in a year. You now have a property worth $110,000 but only spent $20,000. That is a 50% return on investment. By the time you add rental income, you’ve made even more.
Reason #2: Tenants Are Footing the Bill
You may be thinking, “Sure, I have this property by only spending $20,000, but now I am $80,000 in debt. Debt isn’t a good thing.” The truth is that consumer debt isn’t good. However, when you can get someone else to pay a debt you owe, then debt is a great thing.
If you take out a 15-year mortgage, your tenants will pay down the mortgage from $80,000 to zero in 15 years. That means that you will spend $20,000 to cash out on the $100,000 property. But, property in the long run always appreciate, in some markets its not uncommon for property values to double in a decade. In this scenario, you would spend $20,000 to cash out at $200,000. Not all markets have this type of volatility so temper your expectations according to the market that you invest in.
Reason #3: Monthly Excessive Cash Flow
In addition to having your tenants foot your debt bill each month, you can also walk away with monthly cash flow. Here’s how:
- Monthly cost of the property (principal, interest, insurance, taxes, maintenance and CapEx) = $800/month
- Monthly rent charged to tenants = $1,000/month
This means that you have an extra $200/ month in cash flow. For those that wish to leave their day job, get enough of these investments and you can use this cash flow to replace your W2 income.
Rents have been on the rise for a while and with a looming correction around the corner (or not) owning rental real estate could be the perfect inflationary hedging tool in your arsenal.
Reason #4: Appreciation and Forced Appreciation
As we mentioned before, over the long haul despite the cyclical nature of the real estate market, property increases in value.
You can count on real estate to self-correct, which is why a buy and hold strategy is a favorite amongst investors. I’ve interviewed many real estate investors from around the world and when I ask about the crash, a typical response is that those that lost money during the housing bubble may have made one of two mistakes:
- They were over-leveraged
- They got scared and sold at the bottom
Those that made smart leveraging decisions were able to hold their property through the turmoil and came out on the other end with a smile. Those that bought low in 2009 because everyone else was selling came out with a smile as well because there were picking up investments for pennies on the dollar.
Let’s assume that you have $100,000 to spend. Instead of buying one property, you bought five properties, putting $20,000 down on each. You would have spent $100,000 to buy a half a million dollars of property. If it increased by 100% in 15 years, you would have $1 million in assets. That’s the power of appreciation.
Forced appreciation is similar except that you are actively participating in increasing the value of your asset. Let’s assume that there are five houses in the neighborhood that all have a $100,000 value. The property you buy has a $60,000 value because it is not up-to-date.
To achieve forced appreciation, you spend $20,000 adding another bathroom, updating the appliances, and adding fresh paint and flooring. Now you can sell your property for $100,000. With $20,000 in renovations, you make $20,000 in profit.
Reason #5: The Business of Investment Property
Once you decide to buy property for investments, you become a business owner. This means you can pay less in taxes as you use the tax write-offs coming to you. These include such things as:
- Office space in your home
- Lease on your car
- And much more
Savvy investors take advantage of tax breaks and incentives that are not offered to all asset classes, such as stocks and bonds.
You can also take advantage of depreciation. Even though you make money during the year on the property, on paper, you may take a loss. This loss can offset against your W2 income.
(I am not a CPA. Please consult with your CPA to determine the best tax strategies for your individual needs.)
Reason #6: Everyone Will Always Need Somewhere To Live
This is a fact. Because of this fact, residential real estate is one of the safest asset classes. Think about it:
- Bitcoin has only been around since 2009. It is fascinating but unproven.
- With stocks, you have no control of your asset, and it can be unpredictable
Real estate, on the other hand, is proven and provides the investor with control. Everything is quite literally up to you.
Plus, we know the key indicators when investing. These include increased job growth, job diversity, and population growth.
The aforementioned 6 reasons are exactly why we cannot believe everything that we read. I’m confident that the next time someone wants to have a friendly discussion about stocks vs real estate that you will present them with the facts. If nothing else, this may prove to be the thing that gets your money off the couch (stocks) and actively working hard to provide you and your family with future dollars rather than what everyone else does, which is work for money. Happy Investing!