Real Estate vs. Other Long-Term Investments

There is no investment quite like purchasing one’s own investment, and the reason isn’t that this is a highly practical way to invest. Of course, that’s certainly a big benefit, as we need a place to live, but the real reason is that our only real contribution to the investment is our down payment.

If we are able to buy a home without a down payment for instance, our return on investment would be infinite, since we essentially did not put up anything for the home and received back the amount of equity that has accrued over a given period of time.

If we “paid” $200,000 for a home and it’s now worth $400,000, even if we have not paid down the principal of the mortgage at all, let’s say we bought it with a line of credit and just made the interest payments, we’re going to at least be ahead $200,000 on the deal from investing what amounts to absolutely nothing.

In this case, since we’re just paying down the interest, these payments will likely amount to less than what it would have cost us to rent a comparable home. So these payments aren’t really a cost, they would add to our net gain by the difference between what we paid to service the mortgage versus the higher amount we would have paid in rent.

Almost all mortgages to buy a residence are amortizing though, but once again, we’d have to pay rent if not for the purchase, and we can assume that the cost of the mortgage plus maintenance would be comparable to the cost of renting it, given that landlords don’t subsidize rent by taking in less than they spend.

The extra benefit in this case would be the amount that we have paid down on the principal of the mortgage. Let’s say in this example it is now down to $100,000 from its initial $200,000. Our net gain is now the $200,000 we made in the property going up in value, plus the $100,000 we paid down the mortgage, for a total of $300,000 made.

We generally do have to put down a down payment to at least get skin in the game, and therefore reduce the risk that we’ll just walk away from the mortgage, so let’s say we had to put down $10,000 at the time of purchase, which works out to 5% of the purchase price.

How This Compares to Investing in the Stock Market

Our investment in the mortgage of $10,000 would now be what we are using to determine the return on the investment. Let’s say it took 15 years to get to the point where we have netted $300,000 from buying the home. That works out to an average return of 200% per year over this period.

This is a phenomenal rate of return and many times greater than what could be achieved in the stock market, 10 times better than the 10% that the stock market has averaged over the very long term. People these days would be pretty happy getting 10% a year on their money in fact, and cannot even dream about triple digit returns like this.

This is not an atypical example as far as the benefits of home ownership go, and it is easy to see how home ownership typically blows away investments such as stock purchases, at least when one approaches home ownership in this manner.

One may further invest in home ownership by looking to pay down their mortgage faster, but this is a different situation, and the rate of return of these additional payments is limited to the rate of interest they are saving on the mortgage.

The increase in property value has nothing to do with prepayments, as the property will increase or decrease in value regardless. It is the initial purchase and our hanging on to the home over these years that has yielded this gain, and in particular, what we had to put up for it, our down payment.

Real Estate vs. Other Long-Term InvestmentsThe home equity that we have built up can benefit us in other ways too,  If we need to borrow money, we can also add in the interest savings that using this equity to borrow against instead of relying on higher rates would provide.

One of the benefits of investing in stocks is the long term reliability of stocks. This tends to be overstated by most investors, as there are certainly risks involved here over the time frame that people invest in, even the long term. A particular company that one buys stock in may have fallen upon hard times or even have gone out of business, with their stock ending up being worthless, in spite of the averages being up quite a bit.

Even if one invests in an index fund, the components of indexes change quite often, and when companies are deleted and more are added, the averages use the active companies. This does not really give us a true picture of, for instance, where the Dow 30 bought in 1970 would be today, because the Dow 30 has changed. People could move their stocks in and out of indexes to match these changes, but calculating indexes this way does distort the picture of long term progress that most investors assume.

Nothing is more stable than real estate gains over the long run though, and although prices do go up and down in the shorter term, the only thing that can be counted on more to go up would be inflation. Inflation itself drives real estate prices up, along with other factors such as a growing population and a limited supply of real estate to satisfy them.

Buying your home is therefore not only very lucrative as far as the returns you can achieve versus other investments, delivering several times more in value, it is also an investment as stable as they come where the long term is concerned.

Other Real Estate Investments

The magic of the results of home ownership does come down to the fact that people have to pay housing costs whether they own or not, and compared to just renting and walking away with absolutely nothing, owning one’s home and using these payments for investment purposes is a far better idea and a huge benefit.

Investing in other real estate ventures, such as buying rental properties, commercial real estate, or purchasing real estate securities such as real estate trusts do not enjoy the huge comparable advantage of owning one’s own home versus renting, and aren’t really that different from other types of investments as far as potential returns and risks go.

Actually buying real estate, rather than securities, is far less liquid than other investments, and there are also significant costs involved in acquiring and dispersing these properties. We could think of this as trading costs, and the trading costs of real estate purchases are high, and it also may take a long time to enter and exit positions.

If one invests wisely in physical real estate purchases, in other words buying the real estate themselves rather than buying into what is essentially a fund buying and selling real estate, one can do fairly well.

Buying real estate on one’s own though is a lot like buying stocks versus buying them in a mutual fund or an ETF. If one is particularly good at investing, one can beat the funds, but with real estate, this is actually less likely to happen than in the stock market.

With stocks, the scale in which funds need to operate limit their opportunities, and with mutual funds, they are limited to being long the market and can’t really even put much of their money in cash, so beating mutual funds is rather easy without these constraints and having a modest level of skill or better.

With real estate though, the scale in which they operate is an advantage, not a disadvantage, and they can invest in a lot of things that are well beyond the ability of individual investors. Real estate trusts are more like precious metal funds, where size is an advantage, and size is really an advantage when it comes to real estate.

How Real Estate Securities Compare to Stocks

The performance of the stock market depends a lot on economic conditions, and this is the case with real estate securities as well. These two types of investments aren’t that strongly correlated though as one may think, as real estate securities are tied into a particular sector of the market, the real estate sector, where stock market averages are more broad based.

In terms of comparing returns, there are periods where real estate securities outpace broader averages, and there are other periods where the stock market averages do better. Overall, returns are pretty similar in the long run, with stocks tending to do a little better due to the more open ended influx of capital into stocks as more people put more of their money into them.

Stocks also enjoy a little more liquidity than traditional real estate trusts, because stocks are traded electronically, while real estate trusts are more like mutual funds. We now have exchange traded real estate funds though which has eliminated this gap.

Real estate securities are really just like a sector of stocks, and not one that generates a particularly large amount of interest compared to some of the other larger sectors in the economy, the large cap companies in stock market indexes for instance.

We’ve moved so far toward an index driven stock market that companies such as those in the S&P 500 get a disproportionate amount of the love when people look to invest more, and this trend will likely only continue given the growth of index funds.

Having a component of your investment portfolio in real estate securities is certainly not a bad idea though, as even though they do tend to underperform stocks a bit, they do add at least some diversity to it. It’s probably not a great idea to be substantially invested in real estate over stocks though.

Buying one’s own home is an investment like no other, with huge benefits, while investing in real estate generally can provide some additional diversity to one’s portfolio, and is at least worth considering.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: [email protected]

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