Residential Income Properties vs. Stock Market Investing

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Here is an interesting question. Is there risk investing in Residential Income Properties? The answer — of course there is. Risk is all around us, every single day. No risk, no gain. There is risk involved in taking a shower or driving to work on a busy highway. The challenge is how to control and/or minimize the exposure to risk. However, if we to compare Residential Income Property investing to stock investing, the risk of investing in Residential Income Properties is far more controlled and manageable than buying a stock of company “XYZ” in which one has no control over its performance. This doesn’t mean that one can’t make a fortune investing in the stock of company “XYZ,” but the risk is significantly higher and totally uncontrollable by the investor.

Fundamentally, real estate investments including Residential Income Property investments beat stock market investments in three major areas. These areas are leverage, volatility, and taxes. On the flip side, investing in real estate requires more time and more attention than investing in stocks.

Leverage:

Leverage is borrowing money to amplify the outcome of a deal or a transaction. It turns good investments into great investments. In terms of real estate, by buying a Residential Income Property one is assuming a significant portion of the investment on borrowed money, which translates into leverage. The cash-on-cash (COC) return on the down payment, closing costs, and other out-of-pocket expenses is higher than it would be without the use of this leverage.

The same thing can be achieved with stocks or mutual funds by buying them on margin but the limit is 50% of the total investment. In addition, the interest rate on transactions using a margin account is far greater than mortgage rates, which makes the whole investment costly. It also makes investments somewhat riskier because by using margin the investment becomes subject to a margin call, and if the call cannot be met within 24 hours, the stock may be sold to cover losses. Real estate investments avoid this kind of risk taking.

Volatility:

As for volatility, real estate prices in all classes are far less volatile than stock prices. It would be virtually impossible to see a property lose 20-30% of its value in a day or a week. In Residential Income Property in particular, the value of the property is based on net operating income (NOI). It is almost impossible to draw such a loss in a day, a month or a year, owning a Residential Income Property, unless everyone moves out of the building in one single day or in one week – which is not likely to happen.

So long as people need a place to live and so long as the property is occupied by paying tenants, there will be no reason to assume this kind of loss in cash flow. On the other hand, an owner of a stock or a mutual fund is not in control of his investments because he has relinquished this authority to someone else. A stock price can go to $0.00 one morning and there is nothing to be done. A dividend distribution can go to 0.00% one day and there is nothing to be done. But this can hardly happen to a building with twenty or thirty units. Even if the building burns down, collapses, or is damaged in an earthquake, the owner still collects from insurance on the loss. This is not the case when owning stocks or mutual funds. The investor collects nothing on the loss of the investment. The value of a real estate portfolio or a building will not go to $0.00 at any time, even without any collection of rents and insurance proceeds, because of the ownership of the land beneath the building. If for any reason, an investor loses a little money one year in managing his buildings, he or she will make up for it the following year; an investor will not get crushed as he or she might when owning a stock that can’t be managed and controlled.

Taxes:

The taxation code for real estate investments beats stock investments at all times. It doesn’t even come close. In real estate the first $500,000 gain is free of any kind of taxes ($250,000 for a single person). Mortgage interest payments and property taxes are fully deductible. With Residential Income Property all management costs and other expenses are deductible too, in addition to the ability to take depreciation loss on the property. Selling, and buying a new property by utilizing the 1031 Tax-Deferred Exchange, defers all taxable gains into the new property and this can be done over and over, property after property. A stock owner, on the other hand, must pay taxes on any capital gains in the year the assets are sold — there is no deferring taxes or deductions of any kind. This is in addition to paying taxes on all dividends one receives at the personal tax rate.

As an example, consider an investor who is buying a property worth $400,000 with 30% down payment at 6.50% interest for 25 years, at an annual appreciation rate of 5%. But the investor instead decides to invest the down payment in the stock market, hoping for an appreciating rate of 7% per year. He is assuming the stock market return would be 40% higher than an income-producing property. Here is how the investment will grow:

Stock returning 7% annual rate of appreciation in each year:

Investment 5 Years 10 Years 15 Years 25 Years
$120,000 $168,306 $236,058 $331,084 $651,292

Income property return on $400,000 property with 30% down & 5% annual appreciation:

Investment 5 Years 10 Years 15 Years 25 Years
$120,000 $230,513 $371,558 $551,571 $1,074,542

As anyone can see, the divergence in equity growth is significant. It demonstrates in real time the enormous power of leverage in real estate. Even when assuming that the stock market will retain 40% more favorable annual returns than a Residential Income Property, the income property wins by a long shot.

However, again, that is not to say that investing in the stock market is right or wrong. It is simply a different investment vehicle with different risk/reward ratios. This is where a financial advisor can be very helpful in determining what is best for the investor’s individual situation.

Photo Credit: rednuht

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