We make a detailed comparison between real estate and stocks, probably the two most popular asset classes for those interested in investing and growing their wealth.
Content
Introduction
Stocks and real estate, especially housing, are the most popular asset classes when it comes to investing. It is relatively easy to invest in them, as they feel accessible. Therefore, they tend to be the preferred choices for many investors.
However, even though we all know what both assets represent, few people stop to think about the main differences that exist between them.
First, real estate can have multiple uses. We will focus on housing in this post. Residential real estate offers society shelter and a place to live. Whether we buy real estate for us to live in or to rent out to someone else, it will provide an essential service.
Furthermore, real estate is a real asset. It exists in the physical world and is composed of two sub-assets at the same time: the land and the building.
The land, either it is exclusively ours if we buy a house, or we co-own it if we buy an apartment, is eternal and will never change. Consequently, it will always represent an asset to the economy and society of that region. As such, its value will mainly be driven by the level of economic development.
When it comes to the building, its value will gradually decrease over time. This is because the passage of time will cause materials to deteriorate. As a result, we will have to invest additional money in repairs and rehabilitations to extend its useful life. Similarly, a house or flat will not suddenly become bigger or nice if we do not put money into it.
At any given time, the value of the building will be determined by the state of the economy, its own characteristics, availability of other properties in the market, etc.
By contrast, stocks represent fractional ownership in a company. Companies are responsible for producing goods and services that meet society’s needs, through the coordination of labor and capital, with the goal to produce a profit.
Companies’ profits are the incentive that the marketplace offers in order to incentivize production. Corporate profits tend to be more volatile than the profits generated by real estate investments. This is because sales can fluctuate a lot, and this will have a major impact on net profits, in either direction.
Profits are used to finance the payment of dividends to investors, who have in turn had previously financed the company’s activities with their capital. This capital made it possible for the company to carry out an economic activity, grow the business, expand operations, and generate profits.
In this sense, companies can grow organically, unlike housing. A three-bedroom house will always be a three-bedroom house, unless we put in the money to build it out. But a recently founded company may become an Amazon a couple of decades later.
This analogy can also be applied to the entire stock market. The stock market is a good proxy for the corporate sector in a given country. If the economy grows, we can expect companies’ businesses and profits to increase.
Therefore, companies can benefit more from economic growth. This is because they benefit directly from it, unlike real estate, which benefits indirectly. The same applies if the economy is weak.
Next in our comparison, we will talk about the main differences between investing in real estate and stocks:
Dividends and Cash Flow
Apartments and houses can be used as shelter. If we invest in a piece of property, we can live in it rent-free. In a way, the dividends will be fully guaranteed. The dividends will be in the form of free rent less all the costs associated with the ownership of that property.
We can also live somewhere and be renting out our real estate properties. The rental income will be the equivalent to a company’s sales. And the net cash flow will be what is left after we have paid for the expenses that come with owning that asset. The net cash flow is the equivalent to a company’s profits.
Rents are much more stable than corporate sales, profits and dividends. This means they will not fall much in the event of a recession, nor will they grow spectacularly in the event of an economic boom. In the long run, rents will tend to rise with real inflation.
Whether we decide to live in one of our properties or rent it out, the ownership of real estate goes hand in hand with expenses: mortgage payments, property taxes, service charges, repairs, etc. These vary by country and need to always be taken into account.
Gross rental income, calculated as annual rent divided by the price of the asset, will be determined by the country, area, and type of property we own and usually hover around 3-6% per year. Expenses associated with the piece of real estate, excluding mortgage payments, will tend to be around 1-2% per year. Both rents and expenses are expected to increase in line with inflation in the long term.
Even though not all properties or property markets are the same, stocks are way more heterogeneous as an asset class. We will focus on the general stock market to draw our conclusions. But bear in mind, of course, that the differences between technology and utility stocks are massive.
While owning stocks does not create additional expenses for the investor, companies must continue to reinvest for the company to continue to operate and grow. If we generalize, approximately half of all corporate profits can be paid out to investors in the form of dividends and share buybacks.
The dividend yield we can expect from stocks is around 3-4% per year. In the long run, dividends should grow in line with inflation and real economic growth. In the short term, however, they can fluctuate heavily. And remember that, because stocks are very heterogeneous, the expected dividend yield will vary by country.
Long-Term Appreciation
Let us now make a comparison about how stocks and real estate appreciate in the long term.
Because real estate does not grow or change much over time, housing prices tend to be correlated with the real rate of inflation in the economy. In real terms, its value remains stable over time.
This is because the value of housing is closely linked to the income level of the country. And wages are largely driven by inflation and real economic growth. How much real estate can generate depends on how much the individual benefitting from it is able and willing to pay.
In the very short term, the price of housing is quite stable. However, in the medium term, the price of homes is influenced by other variables.
Interest rates, because most purchases are made with a mortgage, significantly affect the price of homes. The lower the interest rates, the more expensive housing will become, and vice versa. If housing has become so expensive over the last few decades, it is because interest rates have been steadily going down.
Other important variables affecting real estate are demographics, housing policy and internal migration trends. Demographics determine whether there is more or less demand for housing. If a country’s population is increasing, prices tend to rise.
Housing policy is important because, in a normal environment, the number of existing dwellings should increase in line with the size of the population. But if governments make it harder to build new homes, or riskier to renovate old ones, prices will go up.
Finally, internal migration trends, although they have a net result of 0 for the country as a whole, determine the value of real estate in one region relative to another. If people move from region A to region B, housing in region B will become more expensive relative to region A.
When it comes to the general stock market, its price represents the value of an economy’s business sector. The ratio of enterprise value to the size of the economy is very stable over the long term, though it can fluctuate wildly in the short and medium terms. As a consequence of that, and over the long run, stocks will be valued based on the size of the economy.
Taxation
In this section, we will talk about taxes that are relevant to investors in real estate and stocks:
The purchase of a property can be quite expensive, though that depends on the country and region. Some countries, especially in Europe, charge hefty property transfer taxes. There are also legal fees, financing costs, etc.
Once we own the property, net rental income will be taxed. In many countries, rental income is more lightly taxed than dividends, with the goal to encourage housing construction. However, this is not true everywhere.
Regarding appreciation and capital gains, we will only have to pay taxes when we sell our properties, which will be very rare, since real estate is not traded very often.
In many countries, when calculating the taxable capital gain, the original price paid for the property is adjusted for inflation, so we will only have to pay taxes on the profit that exceeds the increase due to inflation.
As for stocks, the dividends we receive will be taxed in most cases. In fact, they may also be subject to triple taxation sometimes: corporate tax, withholding tax and dividend income tax. On the other hand, some jurisdictions such as Singapore, Hong Kong or Dubai, are very favorable to dividend income from a tax perspective.
Similar to real estate, stocks will generally also be subject to capital gains tax if we sell them at a profit. And most countries will not adjust the price we paid originally for them to account for inflation, though some South American countries do, while some jurisdictions in Asia do not have any capital gains tax at all.
Liquidity
Liquidity addresses the ability to convert an asset into money or money into an asset. This is measured in several ways: how long it takes to buy or sell an asset, costs associated with the transaction, and at what price we execute the transaction relative to the asset’s intrinsic value.
Selling a property is usually slow and expensive. The sale of an apartment or a house means we have to find a buyer and go through some legal and bureaucratic procedures. In addition, in almost all cases, we will have to pay expenses associated with real estate agents, lawyers, and municipal taxes.
Furthermore, if we want to sell our asset fast, the price we will get will probably be lower than its intrinsic value.
Conversely, stocks can be bought sold at almost any time, and the costs associated with that are totally negligible. Additionally, the price we receive when selling is basically the same as the value of our shares since, by definition, the value of a share is the price at which transactions are being made on the stock market.
Therefore, from a liquidity standpoint, stocks are by far much better than real estate.
Legal Risk
Legal risk is often thought as the risk that the government will carry out a mass nationalization program and take our assets from us. But that is only an extreme form of legal risk. In most cases, legal risk is present in much subtler ways. It is a key aspect in our comparison between real estate and stocks.
In actuality, any change in laws, regulations, or the application thereof may negatively affect us as asset owners.
In the case of real estate, because it is immovable, there are many legal risks to consider.
First is taxes. The government can raise property taxes, making owning property more expensive and lowering the profitability of our investments. Additionally, capital gains taxes or their methodology can change, increasing the tax burden if we want to sell in the future.
Other aspects to consider are rent controls, which are particularly harmful in cases of high inflation, and the risk that our property is occupied illegally and the government refuses to take action.
For investors in stocks, legal risk is often associated with tax increases, increased regulation, price controls, and the direct or indirect nationalization of assets.
An example of indirect or partial nationalization can occur with a goal or copper mine if the government decides that, in order for the company to continue to operate that asset, higher fees will have to be paid to the tax authorities or the politicians.
Because real estate is immovable and less liquid, and its risks are more difficult to diversify than the stock market, real estate investors are more exposed to legal risks and uncertainty than stock investors. Additionally, because the sense of ownership is greater with real estate than with stocks, property investors should pay attention to the evolving legal and fiscal landscape.
Conclusion
As we have discussed, both stocks and real estate are investments with multiple aspects to consider. While they share some similarities and their returns can often be correlated, there are multiple differences between them.
Both assets have strengths and weaknesses, so it is up to you to decide which option best suits your preferences, goals, motivation, and even lifestyle. It is very likely that, if you have enough capital, you will realize that a combination of real estate and stocks can be more powerful than just focusing on either of them.
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