There have been many discussions about whether the stock market or real estate produces better returns. Many proponents of the stock market simply point to the historic returns of the stock market compared to the historic returns of real estate. It is true that the stock market has out-gained the housing market over the years. The problem with this argument is that you are comparing housing prices to stock market prices. If you are buying a home as an owner occupant with cash, then the historic gain of housing prices may be a good indicator of your return. However, real estate investors do not consider an owner occupant purchase with cash a true real estate investment. Real estate investing is not about housing prices; it is about a number of things, most importantly cash flow, which historic housing prices make no account for.
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If you want to compare the possible returns of the stock market to the possible returns of investing in real estate. Using the historic gains of the housing market as an indicator of the returns real estate investors see is an absolutely horrible comparison. The historic housing price average does not take into consideration leverage, cash flow, equity pay down or the tax advantages of rentals.
Why does the historic housing price index work best for owner occupants paying cash?
The historic increase of housing prices since 1900 is only 3.1 percent a year. The stock market return varies based on the source, but I found it to be approximately 9.4%; 4.8% in price appreciation, plus approx 4.6% in dividends. Looking at those figures (which is all many stock market proponents do) makes it seem like the stock market blows real estate out of the water. However real estate investing is completely different from buying a house and hoping it goes up in value.
- Real estate investors should be investing for cash flow, not appreciation. Only counting the housing price increase is like saying stock market investors cannot count any dividends they made on their stocks.
- Real estate investors tend to use leverage or loans to buy rental properties. The overall housing market increase does not take into account using any leverage. It assumes an investor buys a house with all cash.
- Even if an investor buys a house with all cash, they will still make money from the rent they receive. The only situation I can think of that would meet these scenarios is an investor who buys land, never rents it to anyone and holds on to it assuming it will go up in value. However most investors still make some income from land whether it is a CRP, mineral rights or farming.
- Real estate investments can be depreciated and stock market investments cannot. The tax savings from depreciation can equal thousands of dollars a year, blowing that 3.1 percent out of the water on its own.
- You can buy real estate below market value; you can’t do that with the stock market.
The closest thing to the 3.1 percent return is an owner occupant buying a home. But, they would have to pay cash for the property, because as soon as they use leverage they will be putting much less money down and increasing the return on the cash they have invested. There are more problems with assuming an owner occupant paying cash will only make 3.1 percent on the money they invest.
- People have to have a place to live. If they do not buy a house to live in, they will have to pay rent. You cannot take the money you would have used to buy a house and stick it in the stock market. You would have to use it to rent a home, which would give you a guaranteed zero percent return.
- In my market it is more expensive to rent a home than it is to buy a home. Even when you consider the taxes, insurance and maintenance that home owners have to pay, it is usually more cost effective to buy a home.
- When you buy a home with a loan you can deduct the interest from your income taxes. You are also paying money towards your mortgage and you have a house of your own. Life is not all about the exact return you get on your investment. Sometimes you have to think about the fun factor and what the pride of owning your own house is worth.
After looking at real estate investing or buying a personal residence there is almost no situation where you would only make the 3.1 percent increase the housing market has seen since 1900. Having said that there are some more factors to consider when buying or selling a house. When you sell a house you have to pay selling costs, which may include paying a real estate agent. You have to pay title insurance and closing costs. But, if you live in a house for two or more years as an owner occupant you may not have to pay any taxes at all on the profit you make. This goes to show there is much more to real estate returns than the historic housing market average gain, especially if you invest in rentals.
Why does investing in rental properties beat the housing market historic return?
I did not buy my rental properties for appreciation, I bought them for the cash flow they produce. My rental properties have all produced close to $500 a month in cash flow from a $25,000 to $35,000 investment, which produces around a 20 percent cash on cash return. That cash flow is completely independent on the increase of the value of the home. The values of my rentals could go up 40 percent or they could go down 40 percent and that could have no affect at all on my cash flow. There is a chance that a huge down turn in the housing market could cause lower rents. However, the last housing crisis did not cause rents to drop significantly in my market.
The cash flow from rental properties keeps coming in as long as I own the home and it even increases over time! As inflation goes up, so do rents and my income. When my mortgages are eventually paid off, my cash flow increases even more. My rental properties have been like a stock that has a 20 percent annual dividend that will automatically go up with inflation.
Why are my returns so high on my rentals?
It is not easy to get 20 percent returns from the cash flow on my rental properties. One of the reasons I get such great returns is I can buy real estate below market value. I can buy a home that has a fair market value of $150,000 for $120,000. That doesn’t make sense to many, but some sellers want to sell quick, a home needs repairs or other circumstances create opportunity to buy below market value. Stocks can’t be bought below market value. Yes, you can buy stocks that are “under valued”, but that is not the same as below market value. Market value is what someone would pay for something today in an open market. Under valued means someone thinks the market has not valued something correctly based on the fundamental financials. You are hoping that the market changes it’s mind or the asset performs better causing the value to increase in the future.
Being able to buy rental properties below market value allows me to get better cash flow and gain instant equity. When I make 20 percent on the cash flow from my rental properties I do not even consider the returns from buying below market value. On rental property number 11 I bought it for just over $109,000. I made about $12,000 in repairs and the home could have been sold after the repairs for at least $150,000. If you take $150,000 minus the repairs and purchase price I would make $29,000. For those experienced in real estate you know I don’t get to keep that entire $29,000. I would have to pay a real estate commission sell the home, title insurance, recording fees and closing company fees. On a $150,000 sale those costs would equal about $7,000 (I am a Realtor and would not have to pay a listing agent).
I came away with an instant $22,000 in equity when I bought and repaired this house. I spent about $32,000 on the down payment and repairs, which means I made about 65 percent on my investment from buying below market value if I ever decide to sell the house. People may say well you have not realized that return if you do not sell and that is true. However, the same thing can be said for the stock market, except the stock market is not producing 20 percent in cash flow while I hold the asset.
What has the return been on my rental properties?
If you consider the cash flow I make, plus the instant equity I gain when I buy a home I make a great return on my rentals. We have not even considered the increase in value every year that comes with average housing prices or many other factors.
- I put 20 percent down when I buy a rental property and I pay down my mortgage every month. On rental property number 11 I paid off about $1,500 in principle on my loan in the first year. That amount increases over time as the principle goes down and more of my monthly payment goes towards principle and not interest.
- When you consider the tax advantages of rental properties I make even more money. I can depreciate rental property number 11 over 27.5 years, which equates to about $1,050 in tax savings every year.
With those two factors I make another $2,550 a year, which equates to another 8 percent in returns on my $32,000 investment. If you total the returns I make from cash flow, buying below market value, tax advantages and equity pay down I am up to 93 percent. I have not even considered the appreciation or annual housing price increases yet. To be honest my returns will not be that high every year, because I will make the 65 percent only once when I first buy the house.
For more information on how to make these kinds of returns check out my complete blueprint to successful real estate investing.
I hope this article shows that returns on real estate are not limited to the annual housing price gain. If someone tries to convince you that the stock market is a better investment than real estate, because of the annual housing gains compared to annual stock market gains, you can point out why that is a false comparison. Annual housing market gains are a very small part of the advantages of real estate. Here is a great article that shows how real estate increased my net worth by $600,000.