For savvy investors, shares and property have always been two popular investment vehicles. Both asset classes are important to a balanced portfolio and therefore both are worthwhile investments. Although both vehicles are great investment opportunities, there is a great disparity between the positives and negatives of each investment.
Shares vrs Real Estate?
Depending on who you ask, different investors will favor different investment vehicles. It all depends on your financial goals and choosing the best strategy and investment opportunity to accomplish those goals. Some real estate investors believe that real estate is a better investment than the stock market because real estate generally is not as volatile as the stock market. As you probably know, stocks can plummet in price for any reason, at any time, regardless of the fundamentals of the actual company that the stock represents. Anything can affect the mood of Wall Street and consequently have a negative effect on stock prices.
Historically, global events such as natural disasters, corporate insolvencies, white-collar crime, and a variety of other issues can quickly lower the value of the stocks in one’s portfolio, leaving investors at the mercy of the market. For the perspective of the real estate investor, there are too many things outside of the fundamentals of a company’s financial health that affect the value of the underlying stock. This lack of control and fundamental valuations, cause many real estate investors to view stock investing as too “risky” and thus the lesser of the two investment vehicles.
One thing to consider when analyzing either investment class is that Real Estate is a Physical Asset. It is a material investment that you can see and touch. Rarely will it ever disappear and rarely will the value decrease down to zero. Stock shares of a corporation are nothing more than a piece of paper giving you ownership in the underlying company. But the physical asset of a stock certificate is simply a piece of paper, which has no real intrinsic value outside of its interest in the ownership of the issuing company.
The intrinsic value of real estate is much greater than that of stocks because of its tangibility. Real estate can be used in everyday life and it is essential to the well-being of mankind. Everyone must have a house to reside in and businesses need a central location to provide their goods and services to the community. Outside of its investment potential, you can actually use real estate in a variety of ways, however, you cannot “use” a share of stock in Microsoft or Apple.
What about Leverage?
Both investments allow for leverage which can be a double-edged sword is not used correctly. Leverage is the use of credit or borrowed funds in order to increase one’s buying capacity and rate of return from an investment. Real Estate investors can put up 20-30% of the purchase price of a property and borrow the remaining 70-80% of the required capital. Because real estate allows for higher leverage, if done correctly, an investor can typically realize greater gains than that of the stock market.
Let’s say that you have $20,000 dollars to invest in real estate. If you were using leverage, you can generally leverage that $20,000 into a $100,000 property. So your $20,000 will serve as a 20% down payment on a $100,000 property and you will get a mortgage for the remaining $80,000. If the property appreciates at 3% ($3,000) over the course of a year, that is an unrealized gain of 15% on your invested capital of $20,000. In addition, if the property was generating rental income, your returns would be even greater than 15%.
This is just a quick overview of how leverage can increase the returns of a real estate investment. It doesn’t take into account additional costs that would generally be associated with the investments such as closing costs, loan costs, etc. You also have to take into account that real estate investments are generally illiquid and in order to realize your full returns you would have to sell the property or refinance the property in order to realize partial returns. These additional costs would surely diminish the returns on the investment, but hopefully you can see how leverage, if used responsibly, can have a positive effect on your investment returns.
Stocks generally can only be leveraged up to the amount of your own contribution if you are trading on margin. In essence the broker will loan you money up to 100% of your contribution and charge you interest on the borrowed capital. So if you have $20,000 to invest, you can generally purchase $40,000 worth of stock. Assuming you purchased $40,000 worth of stock and it appreciated 3% ($1,200) over the course of a year, that is an unrealized gain of only 6% on your invested capital of $20,000. However, just like with the real estate investment, you still have additional fees that will take away from this gain. You will still be responsible for paying brokerage fees and interest on the borrowed capital in your margin account that will diminish your investment returns.
In both examples, you have seen the benefits of leverage when an investment opportunity produced positive returns. When the returns are positive, leverage allows you to have a greater return that if you hadn’t used any leverage. However, the risk in using leverage when an investment loses money is that your losses will generally be greater than they would had not any leverage been used.
Stocks offer more liquidity than real estate, allowing investors to cash out for a stock position almost instantly in the age of the internet. However, real estate is an illiquid investment and it normally takes weeks, if not longer in order to liquidate your position in a real estate investment. The trade off in this is that real estate allows you to have control over your investment, where stocks do not provide this opportunity. When you invest in a property, you can determine the strategy to implement in order for the property to generate the returns you are looking to obtain. Stocks in contrast, do not allow the investor to have any control in how the stock will perform. Investors are at the mercy of the company’s directors and management staff and can only hope that the company’s officials implement strategies that allow the company to generate more profits and in return increase the value of the stock.
Overall, both Real Estate and Stock Investing are great vehicles for healthy returns and an increase in wealth. Your investment goals and risk tolerance will play an important part in determining which investment is right for you.