When considering real estate investing and stocks, which is a better investment? And which is the safer option?
The answer is not as easy as it may seem because the best choice for investments varies with personality, risk appetite, preferences, and style. In addition, the specifics of individual investments also matters.
A team of economists from the University of California, Davis; the University of Bonn, Germany, and the German Central Bank, conducted extensive research where they analyzed 145 years of economic data to answer this question.
So, let’s chunk this data down to easily digestible concepts. Ready?
The Rate Of Return On Everything
The lead researchers reported their findings in a paper titled: The Rate of Return on Everything, 1870 to 2015. Studying 16 advanced economies over the past 145 years, they analyzed returns and made comparisons on equity, residential real estate, short-term treasury bills, and longer-term treasury bonds.
With each asset type, they adjusted for inflation and included all returns, not just appreciation. They considered dividend income for equities and rental income for residential real estate.
Findings showed real estate investing had the best returns averaging over 7 percent per annum. Equities weren’t far behind, at just under 7 percent. Bonds and bills came in farther down with much lower returns.
Stock Vs. Real Estate Investing
Equities and real estate performed differently in various countries. Real estate investing proved an important factor-roughly half of the returns on real estate came from rents, while the other half came from appreciation.
It’s important to note that from1980 to 2015, equities have, on average, performed significantly better than real estate. Across the 16 countries studied, equities earned an average annual return of 10.7 percent, decisively beating real estate’s stolid 6.4 percent.
Does that mean we should sell our rentals and buy stocks? Obviously not, and the reasons are multiple.
First, a few outliers: Countries such as Japan, Germany, and Scandinavia threw off average returns from 1980 to 2015. Japan saw real estate markets collapse as its population aged and declined, Germany’s real estate has been in the slow lane for decades, and equities in Scandinavia have exploded.
Still, the most interesting case for real estate lies in its risk-reward ratio.
Of Risks And Rewards
Let’s do a quick theory check.
Treasury bonds are low-risk, low-return. Equities are high risk, high return. This brings us to the economic assumption that there is a high correlation between risks and returns, and the belief that “the invisible hand” of the market will ensure it remains the case.
Why? Because if an asset were low-risk, high-return, we would all plunge in and returns would dry up faster than expected. However, this assumption doesn’t apply for residential rental property.
Real Estate Investing: Low-Risk High Returns
Looking at economic trends throughout history, residential real estate has boasted high returns with low risk. The past 145 years has revealed the volatility of equities versus real estate. Here are a few reasons:
First, real estate is expensive. Before crowd funding came along, you couldn’t invest an extra $100 a month in it, as you could with stocks. The truth is, you can structure leverage (debt) in real estate far more safely than using debt to buy stocks by trading on margin. Still, that usually puts you at 20 percent down considering income, credit, and other lenders’ requirements.
In summary, these prove that real estate investing has a higher barrier to entry.
Second, it’s difficult to diversify for those same reasons. When you consider that purchasing one asset could require $25,000 in cash, it could take a lot of money to build a broad, diverse portfolio.
Third, real estate is an illiquid venture. You can’t buy it and sell it on a whim, and it could take months to do either one. But this explains why it’s so much more stable than equities.
Fourth, real estate investments have traditionally been a terrific inflation hedge to protect against a loss in purchasing power of the dollar.
All these reasons explain why real estate investing is not only a better option, it is a safer bet.
Risk Vs. Return
You can use the Sharpe’s ratio to measure an investment’s risk against its return.
Start with an asset’s return and subtract a risk-free alternative (like U.S. Treasury bills) to get a risk premium. This is the extra return the asset delivers over a risk-free investment. Then you divide that “risk premium” over the asset’s volatility, as measured by its annual standard deviation in value.
A higher ratio shows a better investment and a greater return, relative to risk.
Treasury bonds clocked in at a Sharpe ratio of around 0.2. which is relatively weak. Equities weren’t much better, at 0.27. Their returns were strong, but highly volatile.
But residential real estate averaged an impressive Sharpe ratio of 0.7. And, over time, the ratio for real estate has only grown stronger. Since 1950, it has averaged an impressive 0.8.
Should I Trade My Equities For Real Estate Investment?
Ever heard of the proverb: Don’t put all your eggs in one basket? Well, it applies when investing because It’s always wise to diversify your portfolio.
If you take time to learn the market trends and master rules of the trade, you can use stocks to balance rental properties, because:
- When equities go down, residential real estate almost always goes up.
- Equities are liquid. Real estate is illiquid and has a high barrier to entry.
- Equities also offer passive income. But, ultimately, rental income can never be as passive as dividend income.
- It’s much easier to diversify with stocks than with rental property.
- Residential rental properties offer excellent returns with low volatility.
Bottom line: Build a portfolio of passive income from rentals and dividends. If you invest wisely, rental income will perform for you immediately. Equities will take longer; the stocks you buy today won’t produce significant income for you until 10, 20, 30 years from now. But they’ll grow in value at good rates.