August 23, 2022

A Case Study: Investment Real Estate vs. Investing in the Stock Market

A thought that I hear a lot, especially in the military is that investing in real estate by purchasing properties and renting them out from base to base is the best way to grow wealth. I have heard this so many times and wanted to do some research to confirm or deny this claim, so I did some calculations to compare residential real estate to the stock market.    

Some things that I hear:  

  • Your renters will pay off the mortgage
  • You can just take equity out and buy another home  
  • Renting is throwing away money

These all have a bit of truth to them in ways, but there is always more to the story than first meets the eye. Here are some considerations that I don't think people think about when deciding to keep property to rent out:  

  • Vacancy expense: Every month your place is not rented, you are losing money
  • Property manager fees: this is usually around 10% of rents, as well as there is typically a leasing fee of one month of rent or a flat dollar amount  
  • Tax, Insurance, and HOA Fees: These are all monthly costs that add on to the cost of a mortgage and are things that you do not get back as they are going to other entities and not building your equity.  
  • Maintenance Fees: This is the inevitable cost of home ownership. It could strike at any time. You could go 7 years without any significant expense and then have one event that costs $10,000. It is easy to look quickly at rental income compared to a house payment but maintenance is something that is inevitable and will eat into any house that is "cash flowing".  
  • The Sleep Factor: After deciding to own property to rent to others, you are now a landlord. With that comes the headache of having to depend on others to pay rent on time, as well as take care of your property. I know you likely have a property manager, but these are things that are not a burden if you are investing in the stock market.  
  • Liquidity: You have an asset that is extremely illiquid compared to a diversified portfolio of stocks and bonds. If you want to sell this someday, it will likely take time, energy, and money for you to do so.

After going through some of these things you may think that they are all not enough to deter you from having a successful investment property. Let's walk through the numbers. I have attached a spreadsheet with my work. Here are my assumptions, the highlighted cells are things that are changeable and are not controlled by a formula. Feel free to change these numbers to numbers that you think are more accurate using the spreadsheet at the top of the post.  

How I Came Up With Assumptions:  

  • House Cost: I found that the median single-family home in the U.S. costs $428k per this article: Average House Price by State in 2022 | The Ascent by Motley Fool.
  • Loan/Down Payment Amount: Assumed 80% finance and 20% down  
  • Closing Costs: 3% of the sales price  
  • Interest Rate: 5% which is the national 30-year mortgage average as of this writing  
  • Starting Rent: I found that the average rent for single-family homes is around $2,500 here: Single-family rental market shows little sign of cooling - HousingWire
  • Rental Increase Rate: Assume to increase rents at 5% per year.  
  • Prop Manager Fee: Standard 10% of Rents  
  • Cost of Home Ownership (Tax, Insurance, HOA): Assumed to be 30% of rents. There was no good broad estimate of this so this is a ballpark.  
  • Maintenance cost: 1% of home value per year, very conservative based on a google search.  
  • Avg. Vacancy Rate: 5%  which seems to be a common assumption.
  • Real Estate Appreciation Rate: 4%
  • Stock Market Return: 10%  

Here are the results after 30 years:  

If we were to continue the above simulation for another 20 years, the investment account would continue to outperform Real Estate. This is because, at the end of 30 years, you have a paid-off investment property that appreciates at 4% (this is a generous historical average) with a dividend (rent after taxes) of about 2.7% of the home's value. This is very similar to the stock market, but with a much lower appreciation rate. The property hasn't even been cash flow positive for several years due to expenses. This is why I would rather have an investment portfolio of a given amount rather than a piece of paid-off property of a given amount. That investment portfolio will likely outperform that piece of property in most long-term scenarios.

I do think that the above results could be flipped around with different assumptions, and if you bought the right property in the right area and real estate may come out to be the winner. The numbers aren't as important as the process of laying out all of the costs involved and running the numbers to see if a property makes sense for your situation.

Setting aside the math, I think that all things equal one needs to consider whether they are willing to become a landlord or not. This is a decision that should not be taken lightly and you need to know the pros and cons of such a decision before jumping into something. Residential real estate can be incredibly profitable if done correctly. It is not easy, and it's not for everyone. It is an attractive option to many because real estate is tangible and fun to talk to others about. It is something that people can touch and feel and understand, instead of just a number on a screen like an investment portfolio. I hope this analysis helped you think through some of the pros and cons of investing in real estate instead of the stock market and helps you to make an educated and informed decision regarding your investments going forward.  

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