Stocks and real estate are the twin pillars many consider when seeking to build wealth through investments. While both vehicles historically perform well, the associated risks, rewards, and degrees of involvement are vastly different. Of course, every investment has its risks, and past performance is not a guarantee of future results. Real estate is also less liquid than stocks and may be harder to sell.
When thinking about stock investments, a diversified equity portfolio is typically recommended. Holding various types of investments over time and according to risk tolerance may help minimize volatility and creates consistent returns. Over the past decade, returns have been consistently over 11 percent annually. Considering the inflation rate and related factors, that’s a solid return.
Real estate holdings may also deliver returns, and in most cases, they also increase in value. An 11 percent or better annual return is a realistic expectation in real estate, as it is with stocks. But real estate investors benefit from the one-two punch of cash flow and appreciation as well. These factors may give real estate an edge over the average stock portfolio for the following four reasons:
- You have influence over the metrics. Real estate investors look at two primary metrics when evaluating a property. One is the ongoing cash-on-cash return, which is the annual net earnings from the investment. The second is an internal rate of return (IRR), which includes the cash-on-cash return and any net appreciation proceeds received upon sale, averaged over the length of the investment. Additionally, increasing the net operating income (NOI), total revenue less expenses, also maximizes revenue and adds value to the property.
For example, I might have an annual cash-on-cash return of 10 percent from a property’s rent. If I hold it for five years and it appreciates by 10 percent-;averaged as 2 percent each year-;that’s an annual IRR of 12 percent. I’ve likely already beaten the stock market based on its historical performance before making additional investments to improve the property and possibly increase cash flow and value.
- You may be able to increase the value by investing in improvements. With real estate, you control where, when, and which properties to invest in, what improvements to make, and how those properties are managed. You also decide when and under what conditions to sell. At GSH Group, we own and manage numerous multifamily communities on behalf of our investors. Our strategy is to purchase well-located properties that need updates and invest in those improvements to increase value for our investors and the quality of life for our residents. This strategy allows us to have agency over the process and represents a tremendous value over the life of the property.
- You may earn income in addition to capital growth. Stocks typically offer capital growth rather than a cash-on-cash return. You might average an 11-percent return over 20 years with the S&P 500, but you won’t see those funds as annual income. You’re also exposed to the ups and downs of the general market. Some stocks pay dividends, but typically those are fractional percentages. Real estate can offer capital growth and may also pay you along the way.
Real estate also tends to hold steady through recessionary periods. Where the stock market can swing 20 percent or more in a matter of days, as we’ve recently seen, real estate doesn’t typically experience those dips. Even when times are tight, residents prioritize paying rent and maintaining their homes.
- You can take advantage of tax benefits. Real estate is a depreciable asset, and you may be able to claim that depreciation in value over time on your tax return. With accelerated depreciation, you may also claim the total depreciation over the lifespan of the asset within the first five years of owning the property, greatly reducing your net taxable income. You’re still responsible for paying the capital gains tax if the property is sold, which leads to the strategy of using a 1031 exchange. If you purchase a comparable investment property within 180 days of selling the first, those gains are deferred.
Of course, there are also risks associated with investing in real estate. Real estate is less liquid than stocks, meaning it may be more challenging to get your money out quickly. But, if you’re investing with the goal of earned income along with long-term gains, real estate may be an attractive option for a diversified portfolio.