This is an argument that has been going on a long time, and the answer you receive is going to depend upon who you ask. I am not going to try to answer the question, but I am going to compare and contrast the two investment vehicles for their strengths and weaknesses.
A successful investment in real estate or the stock market is the art and science (and sometimes, luck) of buying low and selling high. Your big gains don't come from income: You don't buy stocks for the dividends and you don't buy real estate for rental income (or in the case of your residence, no income - but then, you do have a roof over your head. Try to use your stock portfolio to keep you warm and dry). Your big gains are realized when you sell.
Here is the first contrast between the two types of investments: In the stock market, the big profits are made by knowing when to sell. In real estate, you set yourself up for the big returns by buying a property right. (The sell decision is usually not so hard to make.) Following are six factors that affect the performance of each as an investment:
1. The power of leverage. Real estate has a huge advantage here. Investors purchasing stock can make use of leverage via options and buying on the margin (2:1 leverage). However, investors generally pay 100% of a share price for a stock (zero leverage), while real estate investors typically put down only 5 to 20% (leverage of 20:1 to 5:1). Consider a $100,000 real estate purchase. The investor puts down $20,000, borrows $80,000, and achieves control an investment worth $100,000 with no risk of a margin call. Assume that the investor sells two years later for $120,000 net after closing costs and has not paid down any principle. The investor nets $20,000 ($10,000, or 50% return on investment per year). In contrast, the same $20,000 invested in stocks with no leverage and sold two years later would have to double in investment value to $40,000 to achieve the same ROI. (A caveat: leverage can also work against you in declining markets as your investment may become worth less than what you owe.)
2. The power of liquidity. Stocks win here. The liquidity of stocks allows the investor the option of a quick sale to either change to a better performing investment or to protect investment value in a declining market. Real estate - not so liquid, as we all know.
3. The power of tax deferral. Real estate wins here, no contest. Sell your stocks, you will pay taxes on the gain. Sell your real estate investment, and you quite possibly could defer paying taxes on the gain indefinitely, or possibly never (‘cause you died.) Two vehicles for achieving tax deferment are utilizing Section 1031 of the IRS code (like-kind exchanges) or having your real estate investment held by your self-directed Individual Retirement Account. The savings from the tax deferrals provide the opportunity for wealth building as a result of the effects of compounding. Other sources of tax savings are depreciation and deductible expenses (property taxes, interest, insurance, repairs, etc.) for qualified investments. And from your home, you may claim an exemption from capital gains taxes for the first $500,000 of profit (joint return).
4. The power of cash flow. Rental properties may provide a positive cash flow (cash remaining after all expenses are paid) that could be used for any purpose, including reinvestment. Stocks also may provide dividends that may be either cashed out or reinvested. However, your home or a vacant residential lake lot or a vacation home that you don't rent out have a negative cash flow. I'll call this one a wash.
5. The effects of transaction costs. Stocks win hands down. Stocks can be bought and sold in large and small amounts, and the cost for each trade is insignificant compared to the transaction costs of a real estate sale. The comparatively large transaction costs of the real estate sale may consume a significantly large portion of the profits.
6. The effects of volatility. Volatility can work for you or against you. Overall, real estate has a great advantage here. Sure, stocks have the potential for large and lucrative returns in a near-term time period, but they also expose you to the risk that your investment potentially could go to zero. A real estate investment is the tortoise to the stocks hare. A real estate investment will not go to zero. Banks know this, that is why they are so anxious to loan you mortgage money; they feel secure with the property as collateral, a physical asset with real value.
There is another parameter that is significantly different between the two investments that doesn't affect performance per se, but does affect the investor: transparency, which has a negative correlation with risk. I believe that it is generally easier to analyze the worthiness of a real estate investment than it is the worthiness of a stock investment. And less transparency equates to greater risk.
Which is the better investment - real estate or the stock market? I will leave it to you and your financial advisor to decide.
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This post is available as a printable Word document at http://www.vincehoehn.com/Printable_Reports/page_2230815.html along with many other topics of interest to both buyers and sellers.