There are a number of reasons to be attracted to real estate as an investment asset class, especially now. The stock market has been on a nauseating ride in 2020, with Covid-19 acting as the black swan catalyst. Thus, the longest bull market in history came to an end after an 11 year run. When the continuation of monetary and fiscal stimulus is no longer sustainable, it’s anyone’s guess as to what kind of valuations await for equities. The Federal Reserve has put us into uncharted territory by printing money and keeping interests rates ultra-low, thereby driving down bond yields. Many analysts are calling for expected returns in the low single digits over the course of the next 10 years. This environment will make it very difficult to achieve retirement goals.
As investors weigh these conditions, many have sought out alternative investments and adjusted their portfolios. Frustrated by the wild swings that seem to be manipulated by computer algorithms and insiders, many have turned to real estate as one of those investments. Over the last decade it has become increasingly easier to access real estate, either through direct ownership or by investing as a limited partner in a real estate syndication.
Real estate, like stocks, offers both capital appreciation and pays income. However, there are a couple of key advantages real estate has over stocks. Let’s explore those.
LEVERAGE
The power of leverage is a huge advantage of real estate investment over stocks. Let’s say you have $20K to invest.
Scenario 1: Invest the $20K in a diversified total market ETF or mutual fund. Let’s say after 1 year, your initial investment has grown to $22K, a nice 10% return . Pretty good if it keeps churning through the power of compound interest year after year.
Scenario 2: Invest the $20K in a $100K (20% down) property. After one year, your property has appreciated 10%, the same percentage gain as scenario 1, and is now valued at $110K. You have gained $10K in equity with only investing $20K, a 50% return! I’ll take that, thank you.
The power of leverage is huge. If you can find properties where you can add value through renovation, raising rents, or lowering costs, you can see appreciation beyond market factors, as specially with commercial properties. If you don’t want to find properties yourself, investing with operators who have a proven track record of forcing appreciation is a great passive alternative.
INCOME GENERATION
Another major advantage of real estate investing is income generation. Stock market growth comes from appreciation through GDP growth (3%), inflation (2%), and dividends (2%) all averages. Add up the percentages and this is what gives you the historical 7% return of the stock market (no dividend re-investment). Dividends would be the comparable to rental income when comparing stocks to real estate. Appreciation of real estate has typically been lower than stocks. However, the income derived from real estate blows away any income that stocks produce.
The S&P 500, a solid indicator of the overall US equity market, produces about a 2% dividend. You can find some decent equities that spit out a 4%+ dividend, but as dividend yields increase, typically so does the volatility of the stock’s underlying price. These companies have to raise their dividends to attract investors willing to take on additional risk. You can find 12% dividends and beyond. If the stock price didn’t move at all, you’d have a nice 12% return. However, these stocks typically fall in price and your overall return doesn’t look anywhere near the dividend percentage.
With real estate, you have a nice, income producing asset. There are a number of ratios that serve as tools to evaluate real estate and the expected return it will yield. One that helps measure income is Cash-on-cash (COC) Return. COC measures how much money you initially invested, versus how much cash flow you expect to generate in the first year. So if I buy a property for $70K, put $30K into it, my cost basis is $100K. If I expect cash flow to be $10K after subtracting operating expenses and debt service, my COC is 10%. This is completely achievable in many markets. That surely blows away a 2% dividend, eh?
TAX ADVANTAGES
Lastly, I’m attracted to real estate due to the tax advantages. Full disclosure……I’m not an accountant, but I’ve made sure to find a good one through networking and I suggest you do the same when you build your real estate team. I’m not going to go in depth into tax treatment of capital gains, but depending on whether it’s a short-term (under 1 year) or long-term hold, you have to pay capital gains tax when selling a stock. This varies by income level as well. Short-term gains are taxed as ordinary income, so the rate would correlate with your tax bracket. Long-term gains and dividends can be taxed up to 20% plus a 3.8% Medicare tax due to the Affordable Care Act, again depending on your tax bracket.
With real estate, you are taxed on your rental income. However, you can write-off the depreciation of the property to offset the income. With residential you can write-off the property over 27.5 years. A commercial property can be written off over a 39-year life. This is a huge advantage. For example, if you have a 10 unit apartment building that is valued at $300K (land excluded), you can write off $7,692 a year off the income the property generated. This will shelter your rental income nicely. You can even accelerate the depreciation via cost segregation, which has amazing benefits if used properly. Many syndicators are using this tool to show paper losses that can have a profound effect sheltering taxes for their limited partners.
In addition to taxes on annual income, you are going to be taxed upon the sale of the stock or real estate asset if it has appreciated in value. Again, with stocks, your best bet is to hold longer than 1 year and sell with a long-term capital gain. Your only tax shelter for capital gains on this sale would be another stock that you lost money on and sold to offset the gains. With real estate, you can utilize a 1031 exchange. A 1031 exchange allows you to sell a property and pay no taxes on appreciation, so long as the money is used to buy a similar type property. This is a big benefit in allowing you to continue to grow your real estate empire and let tax-deferred dollars compound.
Wrap-up
Real estate can be an attractive asset class for any investor. The power of leverage, income generation, and tax advantages make real estate an intriguing alternative to stock market investment at a time when the markets are very unpredictable.
Stocks DO still hold key advantages over real estate, though.
Your money is certainly more liquid. Real estate is seen as illiquid because you cannot readily sell your property or your position as a limited partner. With just a few hundred bucks to put to work, it’s simple to dollar cost average into a stock position. It can be much harder to come up with a down payment for a property or a minimum for a syndication deal.
It’s much easier to diversify your equity investment portfolio than with real estate holdings. Additionally, properties take upkeep and maintenance, there are tenant issues that arise, etc., etc. All you have to do is click a button on your mouse to enter and exit equity positions.
Passive income is certainly there with real estate, but it only comes after much effort and time has been invested, if you plan to buy-and-hold properties directly. If you don’t want to deal with tenants and toilets, syndications are a more passive route. There is still work, however, as you have to vet operators, understand income statements, evaluate pro forma projections, and study the geographic markets of the assets. .
Predicting the future is tricky business. Every asset class has its cycles and no one has a crystal ball. Diversification allows for a balanced portfolio and better sleep at night. Make real estate a core portion of your portfolio to weather uncertainty and grow your wealth.
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
