edited in 2021
What do you think of when asked about investing? Do you think about your 401k from work? the stock market? your house that you recently bought? These are all common ways a person can invest and have their cash grow with time assuming the economy is good and continues to perform well. Here we will explore the qualities of stocks and real estate as investment vehicles. What their advantages and disadvantages are and how a person can go about investing in these instruments for long term wealth.
Many people are invested in stocks through mutual funds and index funds provided by their employer’s 401k. I will start with stocks since it is more common than real estate as a wealth building vehicle. Both of these investment vehicles have the capacity to generate cashflow and appreciation for wealth generation. Here we will compare stocks and real estate on the characteristics of liquidity, fees, barriers to entry, leverage, control and taxes.
Stocks – are a derivative asset generated when a company wants to raise capital though the public market and represents the value of that company. Stocks have the ability to appreciate overtime. If you take the S&P500 index fund as an example, it has grown in value over the decades, with some bumps along the way (COVID-19 bear market being one of them). Stocks have some great characteristics to them.
Real Estate – is a physical asset that can be land, or buildings. It derives its value from being one of the needs for survival – shelter. We’ve all lived in some sort of real estate entity and are familiar with what it is and how it can appreciate over time and depreciate in value. Liquidity Liquidity is determined by how easily a person can move to and from cash into investment. High liquidity means it’s easy to liquidate the investment and low liquidity is the opposite. Stocks have very high liquidity and can be easily bought and sold on the stock market. This can be done with a click of a button on a brokerage account or a simple call to your brokerage agent. On the other hand real estate has low liquidity. If you have ever bought a personal residence you know it can take anywhere from 30-60 days to close on a property. Stocks high liquidity can be a double edged sword. It is highly advantageous in the case when you need your money out of the market for an emergency. The downside is that you can easily sell into fear and watch the market bounce back without you. The same is true for real estates low liquidity, if you need cash in an emergency it will take a while to get your house on the market, find a potential buyer, wait for the buyer’s due diligence and loan for the closing. The low liquidity does allow you to sit back and not watch the value of the asset like a hawk, alleviating you of some mental burden. From a liquidity standpoint, stocks have the advantage.
Fees Stocks have a very low fee structure. With the advent of the internet, the cost of stock trading and investing has decreased substantially. Now you can buy stocks with little to no fees at all on multiple trading platforms. Real estate on the other hand have many fees. There’s a fee for the buyer’s and seller’s agent. If you need a loan you will pay a fee for that. Inspection of the property is another cost. Then there’s the cost associated to getting title and the deed. From a fees standpoint stocks win without much competition.
Barrier of entry is the ease for a person to get into the investment. Stock investing has a low barrier of entry you can get into stocks easily by contacting a brokerage firm and putting some money in an account. In a few days the money clears and you can go buy any stock you want especially with fractional stocks recently introduced. Stocks are even easier to get in now that fees are nearly nonexistent as mentioned previously. Real estate on the other hand has a high barrier of entry due to the fees mentioned previously and the amount of capital needed to buy a property is several times that of a stock on the stock market. This inefficiency in real estate does present opportunities to those that are willing to work for it.
Leverage is the ability to borrow capital to increase potential returns. Stocks themselves have limited leverage, especially in tax advantaged vehicles. You can get margin on stocks or you can use options/futures this allows you to buy “more” of the underlying stock, but generally this can not be done in a tax advantaged vehicle (you can buy options in IRAs, but margin is not available). If you over leverage in stocks through margin you will have to put up the capital if you are in losing positions. Real estate is generally leveraged through getting a loan from the bank. Many times, commercial loans can be non-recourse. This means only the asset is at risk and none of your personal assets are at jeopardy. If the real estate increases in value you can potentially refinance for your original down payment amount and have infinite leverage. From a leverage standpoint, real estate is advantageous with possible infinite leverage.
Taxes Income from stocks are taxed at capital gains if held for over a year and as regular income if held for less than a year. Stocks can be held in a taxed advantage vehicle such as an Traditional/Roth IRA or 401k. Traditional IRA/401k allows for income to go in tax free and taxes are deferred to a later time at retirement when taken out, while Roth IRA/401k contributions are taxed going in and tax free coming out at retirement. Early withdrawal in these vehicles incur a fee. Income from real estate on the other hand can potentially be tax free. This is due to tax depreciation which is a paper loss from the useful life of the asset. Investment real estate is a business, all businesses have equipment. The useful life of the equipment cost can be written off as a loss for the business overtime. In the case of real estate the equipment is the building and all the furnishings associated with it. Even if the asset is appreciating in value the IRS sees it as equipment and therefore can be written off against the income. This phantom loss decreases the taxable income, potentially to zero. These losses can be passed thru to your W-2 income if you meet the conditions (less than $75,000 if single, less than $150,000 if married). If you were to sell a real estate asset, you can use a 1031 exchange to buy another property without paying any taxes on the profits from the sale. From a taxes standpoint, real estate is a better investment.
These are some of the comparable characteristics between stocks and real estate. Real estate does have other potential wealth generating aspects that are not mentioned in this article. If you are interested in how real estate can help you reach long term wealth please look at my other article 7 Ways You Build Wealth From Multifamily.
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