Rental Property vs Stocks: Pros & cons of each asset class

Both stocks and rental property have done extremely well over the last 10 years or so. But recently, the performance of these two asset classes is becoming increasingly disconnected.

Many investors today are concerned that stock prices are no longer driven by fundamentals, with nearly $100 billion projected to be pulled from hedge funds this year alone. On the other hand, single-family rentals (SFRs) have generated consistent annual returns of 10% or more from a real asset that can be seen and touched.

While there’s no simple answer to whether rental property is better than stocks, there are some fundamental differences between the two that every serious investor needs to know.

Real Property vs. Paper Property

Buying a share of stock is like buying a very small piece of a company. For example, Amazon has about 504,000,000 shares of outstanding shares. So, if you spend $30,000 to purchase 10 shares of Amazon, you own about 0.00000002% of the company.

In the old days, when the price of a stock went up, it was usually because of strong sales, higher net income, or a valuable acquisition. Today, chief financial officers have mastered the art of buying back stock to increase share prices instead of investing in their businesses. 

The Harvard Business Review (HBR) recently reported that the 465 companies in the S&P 500 Index in January 2019 that were publicly listed between 2009 and 2018 spent $4.3 trillion on stock buybacks during that 10 year period. Buybacks that enrich investment bankers, hedge fund managers, and senior corporate executives are done at the expense of common stock shareholders and the company’s employees.

Rental property, on the other hand, is completely different. With real estate investing, you own something real, such as land, physical property, and the cash flow from rent the tenants pay. 

Income-producing real estate has operating expenses, such as maintenance and repairs, property manager fees, and property taxes, and insurance. By investing in the right type of rental property using conservative leverage, single-family rental property can generate cash-on-cash returns of 12% or more.

Unlike owning stocks, rental property investors receive numerous tax advantages from the IRS, including operating and business expense deductions, depreciation expense, and deferral of capital gains tax.

Pros and Cons of Stocks

Investing in stocks requires very little money. There are even online stock trading platforms that allow you to buy fractional shares of a stock. So, instead of paying $3,000 for a single share of Amazon you can purchase $1,000 worth of a partial share of Amazon.

While stocks are highly liquid, you also have very limited control over what the CEO of a company says or does. A mis-sent tweet or an unexpectedly bad quarterly earnings report can easily cause share prices to plummet by 10% or more during a single trading day.

Here’s a closer look at some of the pros and cons of owning stocks and bonds instead of real estate:

Pros

• High level of liquidity
• Very easy to diversify among different companies and industry sectors
• Convenient choice for retirement accounts
• Many exchanges offer free transaction fees
• Trade 24/7 with an internet connection from anywhere in the world

Cons

• No control over what a publicly traded company does with your money
• Stock market is more volatile than real estate
• Not all publicly traded stocks pay a recurring dividend
• Ease of trading leads to emotional investment decisions
• Capital gains from stocks cannot be tax-deferred

Pros and Cons of Rental Real Estate

Many beginning real estate investors are surprised to learn that it’s possible to invest in real estate with very little money as well. You can purchase shares of a REIT (real estate investment trust), contribute money to a real estate crowdfund, or participate in a limited partnership.

Leverage is another way to invest in real estate without tying up a large amount of your investment capital. By making a small down payment, you gain direct control over income-producing real estate and the various tax benefits rental property provides.

Now let’s take a look at some of the biggest pros and cons of investing in rental real estate instead of traditional stocks and bonds.

Pros

• Passive rental income cash flow is similar to stock dividends, only in much larger amounts
• Residential real estate is easy to understand for owners, lenders, and tenants – because everyone knows what a house is
• Tenant rents can be used to pay property operating expenses and the mortgage, with cash profit left over at the end of each month
• Annual returns from single-family rentals are much less volatile than stocks and bonds
• Real estate is a hedge against inflation, with increases in property prices outpacing the annual rate of inflation
• Leverage (or the use of debt to buy real estate) makes it easier to diversify an investment portfolio by several rental properties instead of putting all of your investment dollars in one building
• Direct control over when and where you buy and sell, leading to better returns and lower risk than stocks and even bonds
• Tax benefits include deducting operating and business expenses from gross cash flow, and using non-cash depreciation expense to reduce taxable net income
• Capital gains taxes can be deferred by conducting a Section 1031 tax deferred exchange

Cons

• Real estate is less liquid than stocks, taking much more time to buy and sell
• Higher transaction costs with real estate agent sales commissions, escrow fees, and other closing costs
• Self-managing property and dealing with maintenance and tenant issues can take a lot of time and actually decrease property values
• Increased liability for tenant and guest accidents, if the correct insurance coverage and property ownership structure is not used
• Investment property can be more difficult to analyze than stocks, at least until you have a system in place and a local team in each real estate market

Is Rental Property Really Less Risky Than Stocks?

At first glance, it appears that rental property is less risky than stocks. But is that really the case?

Two help answer that question, we can look at two metrics:

Volatility measures the distribution or scattering of returns over a given period of time. Generally speaking, the higher the volatility of an asset is, the riskier it is because there is a lower probability of receiving forecasted returns.

Some well-capitalized professional investors in the stock market, such hedge funds, attempt to make volatility work in their favor. While a pro-volatility strategy may have worked in the past, investors today appear to be shunning volatility in favor of predictability. As Reuters recently reported, investors have pulled out $33 billion from hedge funds in the first quarter of this year alone. 

Much of that money may end up being invested in the residential rental property market. According to commercial real estate firm SVN, the single-family rental home market in the U.S. is poised for near-term growth opportunities.

Looking at the chart below, it’s easy to understand why:

Using data from various sources including the S&P 500, the U.S. Census Bureau, and Zillow, we see that single-family rental property has generated annual returns of between 10% and 18% over the past 25 years. The only exception was the Global Financial Crisis of 2008, when returns barely dipped below 0% for a couple of years.

Stocks and bonds, on the other hand, have had much higher levels of volatility since 1992 through 2017. In some years, stocks generated annual returns of 30% or more, but also losses of almost 40% in some years. Bonds had somewhat lower volatility than stocks, ranging from returns of 25% in some years to losses of nearly 10% in other years.

For investors seeking strong and predictable returns, single-family rentals provide comfort among the volatility of stocks and bonds.

2. Reward and risk ratio of stocks, bonds, and SFRs

The reward/risk ratio is used to help predict the potential for profit of an investment compared to the potential for loss. 

If the reward/risk ratio is greater than 1.0, there is more potential reward than risk, and vice versa. So, everything else being equal, an investment with a reward/risk ratio of 1.1 has less risk  than another investment with a ratio of 0.9.

The chart below compares the reward/risk ratio of single-family rentals (SFRs) to stocks and bonds over the past 25 years. Average annual returns of the three asset classes for the period between 1992 to 2017 were divided by the standard deviation (the measure of variation between values) and then compared to one another:

As we can see from the above chart, single-family rental property is the only asset among these three that has a reward/risk ratio greater than 1.0. Even bonds, which are often touted as the “safest” type of investment, have more risk than reward over the past 25 years.

When Stocks Might be The Better Choice

For short-term investors looking for a high level of liquidity, stocks are definitely better than real estate. Day traders, who move in and out of positions several times a day in the hope of making small incremental gains, could never apply their high-risk strategy to investment property.

Researching stocks can also take less time and effort than analyzing income-producing real estate, has a lower cost of entry, and is more of a passive investment. 

However, if you’re willing to devote a little extra time, investing in rental property can be much more profitable than stocks, and with a significantly lower level of risk:

• Build equity and increase your net worth with appreciation over the long term
• Generate passive income while using monthly rent from tenants to pay your mortgage and operating expenses
• Owning real, physical assets is a good way to diversify away from paper stocks and bonds
• Low correlation between stocks and real estate
• Real estate is a proven hedge against inflation, with property prices rising faster than the average rate of inflation
• Financing real estate is easy, allowing you to control an income-producing average with relatively small down payment
• Property operating and business expenses can be fully deductible, while depreciation can be used to reduce taxable net income
• The IRS only allows real estate to be used in a 1031 tax deferred exchange to defer the payment of capital gains tax
• Providing workforce housing to middle-income families is a way of giving back to the community and helping the local economy