Is it better to invest in stocks or real estate?
As a real estate investor who often writes for other real estate investors, I hear many sneer at the idea of investing in stocks. “Why would I invest in the stock market when I can earn higher returns, which I can control, in real estate?”
Stocks and real estate each come with their own unique strengths and weaknesses. Fortunately, those strengths and weaknesses complement each other perfectly, making a combined portfolio of stocks and real estate both rounded and resilient.
Advantages of Investing in Stocks
Stocks come with plenty of advantages for investors. These are advantages you should understand as you decide on your own ideal asset allocation.
Strong Historical Returns
Over the past century or so, U.S. stocks have returned around 10% per year on average. That’s nothing to scoff at, especially for an entirely passive asset class.
Granted, “average” does not mean “typical.” One year stocks can soar 30%, then crash 25% the next, then rebound by 35%. The stock market often takes investors on a wild ride, which can spook many into making emotional investing decisions that lose them money.
But if you leave your stocks alone and practice dollar-cost averaging, you basically always come out ahead on stock indexes, given enough time and patience.
Opportunity for Passive Income
Not all stocks pay dividends. But many do, which not only supplements your returns on price growth, but add a layer of stability to your stock investments.
Even better, dividend paying stocks and exchange-traded funds (ETFs) provide passive income that doesn’t require you to sell off any assets. You get paid from your investments, even as they keep growing in value.
You can buy mutual funds or ETFs that include hundreds or even thousands of stocks. With a click of the mouse, you can buy shares of companies in every region of the world, every sector of the economy, and every size (market cap).
That makes it incredibly easy to spread even a small amount of money into many different investments. Which in turn protects you from a few rotten eggs destroying your basket. Anyone who had money invested in Enron understands the value of diversification.
Low Barriers to Entry
Once upon a time, only the relatively wealthy had extensive stock portfolios, usually managed by professional investment advisors.
Today, anyone with $10 can open a free brokerage account and start investing in stocks. And not only are accounts free from monthly or annual fees, but most don’t even charge commissions (transaction costs) on trades anymore.
Beyond the low financial barrier to entry, stocks also come with virtually no skill requirements. If you don’t know what to buy, you can just buy shares in an index fund that mirrors a major stock index like the S&P 500.
In today’s world, it takes no skill and almost no money to start investing in stocks.
Robo-advisors not only help you choose investments, but they automate every part of the process for you.
You can set up automated recurring transfers from your checking account into your brokerage account. Mine take place every week, but you can set yours up for every payday if you prefer.
The robo-advisor then automatically invests your money based on the appropriate asset allocation for you. And as your investments drift from your ideal portfolio allocation over time, they rebalance it back to your target allocation for you.
It also reinvests your dividends for you — all in the background, without you having to lift a finger. That leaves you free to focus on your career and your personal life, without having to think much about your investments after the initial setup.
Stocks are extremely liquid, meaning you can convert them to cash quickly. Or in this case, instantly.
With the click of a button, you can sell your shares. You can then either transfer the cash in your brokerage account to your checking account, or in some cases access it directly.
The same goes for the buying side of the transaction — it happens instantly, with no fees or delays.
Easy Use of Tax-Sheltered Accounts
Nearly every online brokerage allows you to open not just a taxable brokerage account, but also tax-advantaged IRAs and Roth IRAs. Some also offer more niche accounts such as health savings accounts (HSAs) and Coverdell education savings accounts (ESAs).
In contrast, it’s not so easy to buy real estate with a tax-sheltered account.
Risks of Investing in Stocks
Stocks aren’t without their risks. These are the risks you should again understand completely before you invest your hard-earned money.
As mentioned above, stock prices gyrate all over the place.
It’s hard to keep your cool when you watch your life savings plummet by 20% in a matter of days. Such movements lead many investors to make rash, irrational investing decisions that hurt them later.
But beyond the risk of emotional investing, stocks’ volatility creates some very real risk for retirees. A stock market crash early in your retirement can cripple your portfolio (sequence of returns risk), leaving it unable to recover even after the stock market turns upward again.
Further, that unpredictability of returns means you should leave money invested for the long term. If you might need to access cash within the next year, stick with more stable short-term investments instead.
High Correlation Across Regions and Sectors
Another downside from the high liquidity of stocks is that even diversified stocks often crash together. Even when they have little to do with one another.
It happens all the time: the stock market drops in one region, and then as soon as markets open in another region, they drop too. Some of that response is rational; we live in an extremely interconnected world, after all. If home values crash as in 2008, and millions of people all over the world own shares in funds with mortgage-backed securities, then stock markets follow suit and also crash.
But the effect is also irrational too. Investors see stocks drop in one country or sector, then worry stocks will drop elsewhere too, so they sell — causing stocks to drop in completely unrelated sectors or economies.
That limits the value of diversifying among stocks. Even by owning shares in many types of companies in many countries, a worldwide crash can still send all your shares tumbling.
Little Control Over Returns
When you buy a share in a company, technically you can show up in shareholder meetings and put pressure on company executives.
But when was the last time you did that? And even if you show up to the next meeting, you probably don’t own enough shares to force executives to take you seriously.
For most of us, we control only two things about our stock investments: when we buy and when we sell. So we simply buy and hope for the best.
Advantages of Investing in Real Estate
In many ways, real estate provides mirror image pros and cons in your investments.
Consider the following as you explore adding real estate investments to your portfolio.
Strong Passive Income
While real estate usually appreciates over time, and often impressively, it’s inherently a more income-oriented asset than stocks are. Unlike companies, which grow out of nothing to (hopefully) produce profits, real estate has inherent value that people pay for the privilege to use.
Investors can rent out properties to long-term tenants, or to short-term vacationers. People pay money to use the asset day-in and day-out, which creates passive income.
So, real estate tends to pay higher income yields than stock dividend yields. This produces income that arrives each month without having to sell off any underlying assets.
Opportunity for Appreciation
It should go without saying that real estate doesn’t always go up in value. Anyone who lived through 2008 should know that all too well.
But real estate does usually go up in value. Even during recessions and stock market crashes, real estate remains remarkably resilient. See for yourself:
The rise in home prices doesn’t necessarily keep pace with the rise of stock prices, but then again, real estate generates higher ongoing income than most stocks do. Taking both income yield and appreciation into account, for both stocks and real estate, real estate actually outperformed stocks over a 145-year period in a joint study between several U.S. and German universities.
Protection Against Inflation
Real assets — physical assets with underlying value — protect your portfolio against the ravages of inflation.
Because they have inherent value, it doesn’t matter what currency you buy with, or the value of individual currency units. People will pay the true value, which adjusts to reflect the currency’s value.
Put another way, if inflation surges 10% one year, buyers will simply pay 10% more for homes, because the real underlying value hasn’t changed. Real estate is worth whatever buyers and renters are willing to bid for it.
Diversification from Stocks
Real estate markets have a low correlation to stock markets. That means just because one asset dips in value, it doesn’t mean the other necessarily will follow suit.
That’s the entire point of diversification: to hedge against the risk of one asset or asset class crashing on you. If one pillar of your investment portfolio falls, you don’t want the others to come crashing down too.
The housing bubble and subsequent Great Recession represented an exception to this rule, because the housing collapse largely caused the recession and stock market collapse. In most stock market crashes, real estate values barely budge.
Note that publicly-traded real estate investment trusts (REITs) do largely correlate with stock markets however, because they trade on stock markets. Don’t expect these REITs to provide true diversification from stocks.
Real estate comes with inherent tax benefits.
All of your property expenses are deductible as business expenses, so you can deduct them and still take the standard deduction. That includes mortgage interest, repairs, maintenance, property taxes, insurance, property management fees, your home office, travel, and every other conceivable expense.
You can also depreciate the cost of the building itself, along with any capital improvements to it. In real estate depreciation, you spread the tax deduction over 27.5 years.
Real estate investors also have many ways to defer capital gains taxes. So even when you go to sell, you may be able to reduce, avoid, or defer paying taxes on your profits.
For more details, read up on ways to reduce your taxes as a real estate investor.
Note that you can also invest in real estate through a self-directed IRA if you really want to. Personally, I find it more trouble than it’s worth, when you can more easily use your IRA to invest in stocks. But it’s an option on the table.
Whether you flip houses or invest in income properties, you can accurately predict the returns on any given property. If you know what you’re doing, that is.
You know the purchase price, you know the after-repair value or the market rental income, and you can forecast expenses with precision. The more experience you have, the better your accuracy for forecasting expenses. Once you know how to do it reliably, you can avoid ever making a bad investment again.
Control Over Returns
Unlike stock investors, real estate investors can control their own returns.
Landlords can mitigate their risks and earn strong returns through industry best practices. These include thorough tenant screening, buying rent default insurance, semiannual inspections, and proactively tackling property repairs and updates. They can “force equity” through renovations and property improvements.
In contrast, stock investors can only buy and hope their shares go up in value.
Risks of Investing in Real Estate
For all those advantages, real estate investing comes with plenty of challenges.
Keep these in mind before you shell out tens of thousands for a down payment. Note that in the context below, I’m not focusing on flipping houses, because that’s an active business model rather than a long-term investment.
High Cash Requirement
The median home price in the United States is around $375,000 at the time of this writing, per the Federal Reserve. Even if you borrow 80% of that, you still owe a down payment of $75,000, which says nothing of closing costs and any needed property upgrades. That could easily leave you with an initial investment of $100,000.
Hardly chump change.
Of course, you could buy cheaper properties. But even at $100,000, that still leaves you with a $20,000 down payment plus closing costs.
Paying $50 for an ETF share seems awfully affordable in comparison.
Which explains the rise in popularity of real estate crowdfunding platforms. For a minimum investment of $10 in the case of GroundFloor or $500 in the case of Fundrise you can diversify your investments into real estate.
Diversifying your portfolio to include real estate is all well and good, but if you have to lay down $75,000 for each property, that makes it hard to diversify your real estate assets.
Even if you manage to buy a few investment properties at those numbers, that still amounts to just a few individual assets. Compare that to owning shares in thousands of companies by just buying into an ETF.
High Skill Requirements
It takes no skill whatsoever to invest in stocks. You can open an account with a robo-advisor and let them select an appropriate, diverse portfolio for you. Or you could just buy shares in one large-cap U.S. fund, one small-cap U.S. fund, and one international fund and feel pretty good about your portfolio.
By contrast, buying rental properties directly takes far more skill and knowledge than most people realize. They make the mistake of thinking that real estate investing is intuitive, simply because it’s physical and tangible, and because they’ve “been around it all their lives.”
That cavalier attitude is precisely what gets new real estate investors into trouble. They don’t bother to learn how to calculate cash flow accurately, often going so far as to just assume that landlords’ profits equal the rent minus the mortgage payment. That’s a narrative common among anti-landlord activists and would-be landlords alike, and it’s entirely false.
In the industry, investors refer to the 50% rule — that your non-mortgage expenses average around 50% of the rent.
Beyond learning to evaluate properties’ profitability, new investors need to learn how to find good deals, how to manage and negotiate with contractors, and how to manage tenants (or manage property managers). The combined skill sets require months or even years of effort to learn.
All of which, again, explains the rapid rise in popularity of investing in real estate indirectly.
High Labor Requirements
You don’t just have to learn the skills needed to invest in real estate profitably. You also need to practice those skills on an ongoing basis, which means work.
It takes work to find good deals, to keep contractors in-budget and on-schedule, to screen tenants, to keep recalcitrant tenants making their payments on time, to inspect rental units regularly, and to maintain and repair physical properties. Consider it more of a side hustle or a hobby business than a passive investment.
Real estate is notoriously illiquid. It costs tens of thousands of dollars in closing costs and several months to sell a property, and nearly that much to buy one.
Contrast that against the instant, free ability to buy or sell stocks.
If stocks are long-term investments because of their volatility, real estate is a long-term investment because of its lack of liquidity.
How to Balance Stocks vs. Real Estate in Your Portfolio
Everyone approaches their investment strategy a little differently. As an avid real estate investor and stock investor, here’s how I approach my combined strategy.
First, I invest in stocks primarily for their growth potential and real estate for its income potential. I consider any dividends I earn from stocks or appreciation I earn from real estate to be icing on the cake.
Because I plan to reach financial independence at an early age, I plan on living primarily on real estate income and “passion income,” and not selling off stocks for many decades to come.
Second, I max out my tax-sheltered accounts with stocks. I don’t bother trying to get fancy with real estate in self-directed IRAs, when I invest in stocks anyway. Real estate comes with plenty of innate tax advantages — you don’t need to pile them into tax-advantaged accounts too.
Third, I automate my stock investments and rarely think about them or market fluctuations at all. The market goes up, the market goes down; it helps me either way because market corrections merely offer a chance to buy stocks at a discount. In that way, I don’t let stocks’ volatility affect me emotionally or impact my investing strategy. I save my investing labor and mental energy for real estate investments, which require far more of both.
But that’s only true of my direct ownership investments. I also invest money indirectly in real estate, largely through real estate crowdfunding, which I can automate and again save my time and effort for more challenging — but potentially more rewarding — direct property purchases.
What About Bonds?
I substitute real estate into the role that bonds play in other people’s portfolios. That means I don’t have to put up with bonds’ low returns in today’s perpetually low-interest environment, and my investments don’t have to lose money to inflation.
I can get away with this for several reasons. To begin with, I’ve developed the skills necessary to invest in real estate. I also lead a modest lifestyle relative to my income, with an enormous savings rate. That, in turn, will help me reach financial independence decades before actually retiring.
That means I won’t have to worry about sequence of returns risk — just one of many hidden benefits of pursuing financial independence at a young age.
If you’re just getting started with investing your money to build wealth and passive income, start with stocks. Open an account with a free robo-advisor, set up automated weekly or biweekly inbound transfers, and let it all work for you in the background.
Once that’s running smoothly for you, open an account with a real estate crowdfunding service. I’ve had good experiences with GroundFloor, Fundrise, and Streitwise, but start with one and just invest a small amount to dip your toe in the water.
As you build comfort, set up automated recurring investments and branch into other crowdfunding platforms for even more diversification. For example, Streitwise focuses on commercial real estate, Fundrise largely invests in apartment buildings, and GroundFloor is a lender that secures short-term hard money loans against single-family homes.
Only consider direct real estate investing if you’re truly interested in it as a side business. It will take time and effort on your part, and comes with higher risk in the beginning as you learn the ropes.
But for those willing to put in the work, investment properties can generate strong returns with excellent tax benefits.