"Give me a lever long enough and a fulcrum on which to place it, and I shall move the world." - Archimedes
Last week, the Dow Jones Industrial Average broke the unprecedented 20,000 point barrier. To give some historical perspective, in January of 1987, the Down Jones was at 2,000, thereby showing an increase of approximately 7.7% over 30 years, which is not too shabby. This brought to mind a debate that I hear quite a bit: stocks vs. real estate.
STOCKS VS. REAL ESTATE
Let me start this discussion by saying that I do not have an emotional connection to one or the other. Rather, I pick the one that I see provides the best opportunity to increase net worth and provide cash flow. This brief discussion will give some insight into my thought process.
So, the stock market has appreciated at a average rate of approximately 7% over the last 30 years. Conversely, real estate’s historical appreciation average for the whole country is somewhere in the 3-5% range during that same time frame. When you look at these numbers alone, stocks appear to be the clear cut favorite. Consequently, those who favor stocks often use this data to support their investment vehicle choice.
However, while this data has merit, it is incomplete. There are two major pieces of that puzzle that are left out of this figure:
- Tax benefits &
- Leverage (aka debt).
THE POWER OF LEVERAGE
I will save the discussion of tax benefits for a later time, and today I will talk about leverage. Without leverage, real estate is an OK investment. It is good, but far from great. However, with the proper use of leverage, real estate becomes an amazingly powerful investment with astronomical returns. This is an issue that I have touched on briefly before in my blog, and that I discuss with much more depth and detail in my class.
To give a brief example, if you had $10,000 cash, typically the most that you can buy in the stock market is $10,000 worth of stocks as banks typically do not give loans to buy stocks like they do with real estate. (note: I am talking about long term investments, so I am not including buying on margin which I look at as being more speculating than investing). If the $10,000 in stocks got a 7.7% return, you would have $100,000 at the end of 30 years (assuming tax free growth), which is pretty good.
However, with real estate (unlike with stocks) you can take $10,000 and buy a $100,000 rental property. Assume that you put the $10,000 as a down payment and got a 30 year amortized mortgage for the remaining $90,000. Further assume that you purchased this property with break-even cash flow and there was ZERO appreciation. Then, at the end of 30 years you would have an asset valued at $100,000!! Which is the same as the stocks that appreciated at 7.7%.
However, if the real estate appreciated just:
- 3% over those 30 years, you would have an asset valued at $245,000, which is 2.5 times more than the stock investment (or 10.7% on the initial $10,000)!
- 4% would be $331,000, which is 3.3 times more than the stock investment (11.7% on the $10,000)!
- 5% would be $446,000, which is 4.5 times more than the stock investment (12.7% on the $10,000)!
So, while at first glance, it appears that stocks have a higher return, when you examine further, you find that there is more to the comparison than the simple appreciation data. Therefore, when choosing your asset class, it is important that you thoroughly investigate all aspects of that class to determine which is best for you.
Thanks for your time and please comment below with any thoughts or questions that you have on this subject.
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