When it comes to investing, many people have turned toward the stock market to grow their money. Over time, the stock market has proven itself to be an excellent investment to beat inflation and generate good returns. Meanwhile, we have also heard many success stories of people who invested in real estate and retired early. So, how does real estate investment stand up to investing in the stock market?
Before jumping into the bulletin points I’m about to make, I think it’s important to clarify my own background. First, I’m a full-time software engineer in the midwest with 4-year experience at the time of writing this article. I held investments in real estate, stock, and crypto, but my portfolio is heavily weighted toward real estate, to the point that, with just passive rental income, I can sustain my current living style indefinitely. Before shifting toward real estate, I had invested all my savings in stock instead. And this article is going to explain the two reasons why I pivoted toward real estate and never looked back again.
Leverage without excessive risk
Leveraging is basically borrowing money at a low-interest rate and using the money to make a higher return investment. For example, if I can borrow money at a 4% interest rate and make an investment that returns 8%, I’ll make cash flow income in between my investment returns and debt expense. Leverage magnifies the gain and loss. Leveraging is very common in real estate, which is called getting a mortgage, and the debt servicing risk is very manageable since the property is used as the collateral for the debt, making the interest rate fairly low, sometimes even lower than the real inflation!
You can invest in the stock market with leverage too, such as by opening a margin account. But the stock market is much more volatile than the real estate market, making margin trading much riskier. For real estate, if the market dips temporarily and wipes out all your equity in the property, the lender won’t liquidate the property as long as you keep making the mortgage payment. But if the stocks in your margin trade portfolio dip even temporarily below your equity value, you’ll get a “margin call” to add more equity or your portfolio will be liquidated to cover further losses of the broker.
To compare them apples-to-apples, we really need to look at the Sharpe ratio, which is used to help investors understand the return of an investment compared to its risk. An investment with a higher Sharpe is preferred over one with a lower Sharpe ratio; it means under the same risk level higher Sharpe ratio investment is going to yield a higher excess return or to get the same excess return with a lower risk. Since 1950, the average Sharpe ratio for real estate investment is about 0.8, and stock is 0.27. Not just in the US, similar Sharpe ratios are held true across most other developed countries.
What the Sharpe ratios tell us is that when we were presented with two investment options: stock, say SnP500, with a return of 7% a year, and a real estate building like a rental property, with a 6% cap rate. We shouldn’t simply compare the numbers and say the stock has a better return. Instead, we ought to consider the risk and opportunity to use leverage as well. In the end, we could use leverage, AKA mortgage, to amplify your real estate purchase and return while maintaining a similar risk level compared to the stock.
Ability to affect the outcome
The importance of having the ability to affect my investment outcome cannot be overstated. As much analysis as I can do to study the finance, operation, and market of a public company, none of my efforts are going to impact the operation or managerial decision of the company. There are many people who do prefer this type of investment because it’s much more passive and doesn’t involve a lot of specialized knowledge just to stay in the game. But the passivity does come at a cost. There was a famous quote from the movie Margin Call (USA, 2011):
“There are three ways to make a living in this business: be first, be smarter, or cheat. Well, I don’t cheat. And although I like to think we have some smart people here. It sure is a hell of a lot easier to just be first”.
To be the first means to react quickly to market information once becoming public. So, the so-called passivity is merely an illusion. It means that though my decision won’t affect the outcome of the company, I still have to actively look for signs and information to constantly justify my current position.
Alternatively, I could spend the time and energy on something that can affect the outcome. For me personally, real estate is a perfect investment. There are so many decisions I have to make when it comes to buying and managing a rental property. I have the ability to decide what type of fixture is installed, whom do I hire as the contractors, and when to incur major Capex expenses. Unlike digging reports and balance sheets of public companies, this type of work actually creates value and affects my net operating income, thus the income-based value of the property. Obviously, this is not only applicable to real estate. If I own so many shares to have any material influence on a company’s operation, the same would apply as well. But before I get there, as a retail stock investor, my time is better spent with real estate where I can make a difference than investing in the stock market.
With the experience that I’ve accumulated with managing rental properties, I have decided to take my day job skill and create an online property management toolbox (PortfolioBay), so all other real estate investors can use it to streamline their rental property management and grow their investment quickly.
Conclusion
Like many things in life, the type of investment you make would likely depend on your particular lifestyle, skill, and tolerance to risk. So, it’s definitely not just a right or wrong, yes or no answer. For me personally, real estate has helped me to grow my net worth way faster than I could reasonably expect from investing in the stock market. And using PortfolioBay has helped me to manage all the units with ease and confidence. The real takeaways from this article are the ways to consider an investment opportunity risk vs. reward (Sharpe ratio) and the ability to make a difference in the outcome.
