While the American stock market has allowed untold millions of investors to build wealth with shares in public companies, it’s far from the only lucrative investment opportunity in the United States.
Real estate offers a similar history of long-term returns, often at a lower risk level. Is real estate the best investment you can make, or are stocks still king in the investment world?
The Advantages of Real Estate Investing
The biggest single advantage of investing in real estate is the comparative lack of volatility.
While the prices of stocks, commodities and even bonds fluctuate cyclically based on macroeconomic conditions, the price of real estate over time has proven much more stable. Since the end of the Great Depression, the only housing crash in the United States has been the 2008 financial crisis.
Price stability, however, isn’t worth much without solid returns. Fortunately for real estate investors, the property market has an excellent history of generating strong compounded returns.
Historically, real estate has averaged an annualized return rate of about 10.3%. Keep in mind that this is only slightly lower than the long-term S&P 500 average return of 10.7%.
Given the right investing strategy, real estate can also be a better tool for generating income than stocks. The S&P 500 index currently yields about 1.3% in dividends, resulting in investors who own the index earning a reliable but modest income from their shares.
In real estate, investors can expect gross yields of around 7-8% in rental income from their properties. While net yield is lower after taxes and expenses, this still makes real estate a generally superior income investment compared to a weighted index of American large-cap companies.
A final advantage of real estate as an investment is its historical resilience to inflationary pressures. Because rents typically keep pace with or surpass inflation, rental properties are among the best hedges against periods of high inflation.
In addition to producing an inflation-resistant stream of income, real estate investments financed with fixed-rate mortgages can actively become less expensive when inflation runs high. This second benefit notably holds true for both investment rental properties and primary residences.
Where Stocks Still Win
As attractive as investing in real estate can be, it still comes with some substantial downsides when compared to the stock market.
First and foremost among these is liquidity. Modern stock transactions take place almost instantly, allowing investors to move money quickly when needed. Selling a piece of real estate, on the other hand, is a long and drawn-out process that can take weeks or even months.
Stocks also have the advantage of being much more accessible to investors with small amounts of capital, allowing younger investors to take full advantage of the power of compounding returns.
In the United States, the average age of first-time home buyers is 36. As such, average investors buying even very small amounts of stock can potentially realize nearly two decades of additional compounded returns compared to those investing in real estate for the first time.
Since the age of first-time home buyers mostly reflects those buying primary residences, it’s also worth considering that younger real estate buyers aren’t earning rental income in the way older investors are.
While buying a primary residence is still a very worthwhile investment, it likely won’t produce the same returns that a property bought purely as an investment will.
Over time, the slight differences in the average rates of return also make stocks the better wealth-building investment. This is especially true in the modern era, when returns on real estate have been slightly lower on average than their historical rate.
In the period since 1980, for example, stocks driven upward by technological progress and accompanying productivity gains have generally outpaced real estate investments.
Finally, stock portfolios are generally more scalable than real estate investments. Once an investor has researched a stock investment and purchased shares in a company or ETF, little further action is required.
Properties, on the other hand, require maintenance, upkeep and management. As such, while a stock investor may continue to put money into shares over many years and scale his or her portfolio, real estate investors generally require the help of property management companies to scale up.
While both useful and convenient, property managers add an extra layer of expenses that can reduce a property’s net rental yield.
Who Is Real Estate Investment Right For?
Although stocks still have an edge in performance and ease, real estate can be an excellent addition to many investment portfolios.
Due to its low volatility, real estate is well-suited to investors with a low tolerance for risk. Investment properties can be a useful tool for these investors to earn returns nearly similar to the stock market with less risk of loss.
Investors seeking stable, reliable income may also want to look at real estate. Holding stocks for growth and real estate for income can be a good strategy for pursuing both goals simultaneously. This is especially true for those looking to safeguard their investment income streams from future inflation.
Finally, investors looking to diversify their portfolios can benefit from real estate holdings. Real estate can offset the volatility of stocks, creating a more balanced and resilient portfolio. Allocation models often recommend increasing the share of real estate in a portfolio between the ages of 40 and 60 to create a less volatile portfolio closer to retirement.
The Middle Ground: REITs
Investing in real estate comes with greater logistical difficulty than buying stocks. For investors who want exposure to real estate without having to maintain properties, real estate investment trusts (REITs) can offer a decent middle ground.
These trusts trade publicly and can be purchased like stocks. Unlike most public companies, however, REITs must pay out 90% of their earnings to shareholders in the form of dividends.
It’s worth noting that low-risk investors will likely want to focus on equity REITs. These trusts own and manage physical real estate assets, tying their value directly to the underlying value of the properties they own.
Another type of REIT, known as a mortgage REIT, invests in financial instruments connected to real estate. Although mortgage REITs often pay higher dividends than equity REITs, they also carry considerably higher risk levels.
Ultimately, exposure to real estate via actual property ownership or buying REITs is a good way for many investors to diversify their portfolios and generate more investment income. The right strategy will vary from investor to investor, but real estate can be a useful asset class in many different investing strategies.
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