Saturday, January 13, 2007

Should you invest in Real Estate or Stocks?

It's the common perception today that "investing" refers to stocks. If you have ever employed the services of a Financial Planner they simply talk about what percentage of your investments should be in Bonds Vs Stocks or what kind of Mutual Fund you should buy. We are all urged to "diversify" but that term simply refers to securities. Have you ever been told to diversify into real estate other than owning your home?

One of the interesting things to consider when answering this question is what does the business world think about the risk of investing in real estate Vs the Stock Market? That answer is quite easy to answer. Just think about how much money a bank will loan you on a house Vs how much they will loan you to invest in a stock and the relative interest rate of each loan. From what I know, the maximum margin loan you can get on your brokerage account is 30%. On a piece of real property the amount is 80% or more in some cases. Interest rates on margin accounts are typically over 10% Vs less than 6.5% on real property. So the business community is telling us that stocks are an extremely risky investment while real estate is a very safe investment.

Think about how many homes are demolished Vs how many companies go out of business. It is estimated that 80% of companies go out of business within 5 years. And you can insure your real estate against nearly every risk - can you insure your stock portfolio?

So it seems like a no-brainer to invest in real estate from a risk perspective. But there are many other great reasons to do so:

  • Real estate markets are slow to react to changes in the economy and you are not going to lose 50, 90 or 100% of the value of your investment overnight. I once bought WorldCom stock and "made" lots of money on paper. Of course, when WorldCom went bankrupt, I lost every penny I invested. My brother made a killing working in a dot-com start up and retired a multi-millionaire from the company stock he had in 2000. By September 2001 his retirement account had less than $100,000 in value and he had only had an expensive TV to show for it.
  • Real estate allows you to use leverage more than any other investment. For 95% of the population using leverage to buy stocks is far to risky. So when you buy $100k worth of stocks you invest $100k. With real estate (outside of your home) you generally can take that same $100k and buy a property worth $500K by putting 20% down and getting a loan for the balance. Leverage multiplies the gains you experience on your property. If all you gain is appreciation, your 20% down payment will take a 5% property appreciation and turn it into a 25% return. Try getting that from your stock portfolio year in and year out!
  • The real estate market is not efficient and so you can purchase property at below market value and create instant equity. The stock market is very efficient so when you buy stocks you get exactly the value you pay for. Real estate prices can be effected because the investment is not as liquid as cash or stocks and people have situations in their lives which force them to take less than the actual value of the property. This means you can gain instant equity if you are a patient investor.
  • Real estate offers tax advantages that are not possible with stock investments. For example, the IRS allows you to depreciate the property (even though it is gaining in value) and offset the income from rental. If you are an active investor you can establish a real estate business and gain even more tax advantages and offset losses against your ordinary income. Our tax laws favor real estate investment and business investment. The laws give little or no tax advantage to stock investors and employees.
  • You can control your real estate investment's value. Think about how much control you had with your investment in Enron or my investment in WorldCom. Not much at all! But with real estate I can do things to my property to increase its value - painting, increasing the rent, adding a carport, etc.
  • You can pull out money from your property without paying taxes! Impossible you think? After you have improved the value of your property, just refinance. Since you haven't sold the property there are no taxes due.

I purchased a property, my current home, 2 years ago for $34K less than the previous owner had paid (a re-lo company) 9 months previously. The appraiser at closing still valued it at the previous sale price, so the bank gave me a 90% loan with no PMI. I borrowed the down payment from Capital One - so a "nothing down" deal. I was able to secure a $47k HELOC from a bank on this house 1 year later. I bought a second piece of property last spring for $82k using that HELOC and put $16k worth of upgrades. I've got the house sold on a lease-purchase deal that will net over $30k of profit. So what is my return? Impossible to calculate since I have yet to put any personal money into the house. Mathematically it is infinite.

So should you put all your money into real estate? For me the answer is no. Sometimes the real estate markets are booming and sometimes the stock market is booming. Since it impossible to predict the future, the best option is to have you money truly diversified into both. Of course, with my 401k the company forces me to invest in stocks or bonds, so I have no choice at the moment.

An argument people make for stocks is that you can invest tax free in an IRA or 401k. But few people know that you are not limited to stocks. One neat thing you can do to take advantage of tax laws and real estate is to use a self-directed IRA. If you have a 401k from a previous employer you can roll it into a self-directed IRA. You can put savings into a Roth IRA and invest the money into real estate. The profits will grow tax free. The best of both worlds.


mOOm said...

You can borrow up to 70% of the value using margin. Some retail brokerages charge high margin rates - Ameritrade will lend to me at 10.5%. My Australian broker lends at 8.9%. Interactive Brokers lends at 6.876% currently. Using futures and options you can borrow even more at lower effective interest rates.

The key thing in investing is to invest in investments that you understand and are comfortable with whether that is real estate, or stocks or whatever. There is no magic bullet.

I hold very little of my portfolio in individual stocks of non-financial firms. A few percent. Most is in different sorts of funds. I mainly trade stock indices.

mOOm said...

PS - your 25% return is before interest, property taxes etc etc.

There are lots of tax advantages to stock investments too... and others for professional stock traders.

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