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Is the Smarter Choice Market or Mortar?
As the economy wishfully bustles upward, the more sophisticated investor faces an unprecedented and unique amount of choices. Does my money belong in the stock market or in real estate investments? There are so many diverse investment choices these days, and given our current economic fundamentals, it's a tough call. With the 100 year average stock market return around 8%, historically low interest rates, and a relatively depressed real estate market, one can virtually flip a coin as to which vehicle will put them on top in the future.
There are many factors to consider when deciphering financial strategy. Some factors are based on age and lifestyle, and others based on risk tolerance. There will always be positives and negatives associated with investing in both the stock market and the real estate market in the United States. These upside and downside risks will be disputed and analyzed by experts for centuries to come. Truth be told, there is no crystal ball showing the better investment choice going forward. This raises the following question: Is there a side by side way for an investor to compare the upsides and downsides of the stock market and the real estate market in order to make an educated decision? Luckily for you, the answer is, “yes.”
Let’s touch on the main reason why an investor would consider a real estate investment or a mutual fund index over a fixed rate investment. Obviously, a better rate of return is the correct answer. Most aggressive investors will forego a safe fixed yearly return on investment (“ROI”) in the 2-5% range, for a chance of an enticing 6-15 % ROI in a more aggressive investment vehicle. An investor has a chance to get bigger and better returns in a higher risk situation, but we all know that the higher the upside potential, the lower the stability and safety of the investment. Is there a way to harness upside potentials while eliminating downside risks? Can we get the best of both worlds? Yes!! The solution is with the correct commercial real estate vehicle. However, you must put your trust and faith into a franchise realty expert that can help guide you through the real estate investment maze.
Real estate has had an impressive performance blast; appreciating 12.4% annually between 2001 and 2006 according to a U.S. Price index. That kind of a performance blows stocks out of the water; as the rate of return in the stock market has been relatively zero between 2001 and 2011. It's not hard to find an older investor out there that had more money in his 401K plan or mutual fund ten years ago than he does today. These performances are strange within these time frames; however these statistics historically are very unusual.
I am a real estate broker by trade. I make a living in the world of franchise negotiations and transactional real estate. Others in the investment real estate businesses are not going to appreciate what I am about to say, but professionals in my industry are not always known for their “hit you between the eyes” approach and brutal honesty. So, I am going to give it to you straight in regard to stock market investment vs. real estate investments.
In the long run, the stock market wins easily over the real estate market. The annual returns of real estate compared to paper vehicles offered by Wall Street and financial planners such as stocks, bonds, futures, commodities, etc., make the stock market a hands down winner by ROI comparison. By national yearly average, from 1977-2006, the residential real estate market ROI was 8.5%, and the commercial property market scored a solid 9.5%. However, the most impressive ROI lies within the stock market at an astonishing 13.4%. It's not even close.
Some may argue that the Tech and .COM boom of the 90's was responsible for such an enormously inflated ROI in the stock market, but that is completely unfounded. Why? Would anyone argue that the real estate market from 1998-2005 was not an inflated bubble as well? The only other time that real estate appreciation was ever that high in the last 100 years dates back to the end of World War II when families were setting themselves up at the end of the war. In fact if you believe that eventually we have to trend back to the average real estate ROI of about 3% a year, (same as inflation) the past four years have been steady declines from inflated bubble values, and if that is any indication that the average will work itself back into play, we very well could be in for many years of losses.
Transaction costs associated with buying property are as equally depressing. When you buy a house or an investment property you get the pleasure of hiring a high priced attorney, someone charges you to run credit reports, you pay for application fees, mortgage processing, loan origination fees, and an appraisal. Then you get to pay for a new survey and a title insurance policy. Just when you think it is all over you get to pay a percentage point to lower your interest rate and pay local transfer taxes. The cherry on the sundae is the bill from your bank's attorney, alongside your own attorney, and you get to pay both bills simultaneously!! Sounds fun right?
At the end of the day, closing costs can run anywhere from 2% to 4% of your purchase price. Once you own an investment property, in most cases you will incur the costs of maintenance, renovation, taxes, insurance, signage, and mortgage interest. You also have to deal with the day to day corrections from wear and tear, damage caused by natural disasters, landscaping, snow removal and utility issues such as heating, cooling, and electrical systems. In the likely event that you have to evict someone if you own multiple unit residential apartments, do not forget to add those court cost in, as well as a vacancy factor. Unfortunately, these cost issues are often overlooked by investors and should be considered as, “built in,” when configuring a rate of return.
On the other hand, stocks are incredibly cheap by comparison. One can open an account with their favorite online brokerage and trade away for under $10 per trade. A mutual fund or an exchange traded fund (“ETF”) vehicle can give you instant diversity in owning a bread basket of stocks with the click of a mouse. Broker assisted trades are also available, as well as a whole TV channel dedicated to tracking your investments on a day to day basis, and a series of experts to advise you on what stocks to buy. What could be better?
The moral of the story is, if you live in the beautiful suburbs of our beloved country, with your average streets and highways, chances are 98% of all of the real estate you see on the side of the road will never outperform the stock market ROI in the long run. With tenants moving in and out, property taxes rising, insurance, maintenance, refurbishing, and vacancy, the near zero entrance cost into the stock market seems like a no brainer. The average real estate appreciation based on the last one hundred years of 3.5% annually is nowhere near the average annual stock market return of 8%. Straight math right?
So investors, you must be reading this saying to yourself, why would a guy who makes his living buying and selling real estate highlight how the stock market is a better surface investment choice over a real estate asset? Because surface is the key word, and despite all of the negatives in this match up comparison, real estate brings home the winning trophy every day of the week. Real estate packs some crucial winning knockout punches that the stock market has to bow down to. Real estate has three golden tickets that stock investors will be jealous of forever: (1) leverage; (2) tax advantages; and (3) appreciation.
Leverage is the use of a mortgage to maximize return on your cash.
The math is easy: You make a 20% down payment on a $1,000,000 investment property. Two years later the property increases in value to $1,100,000, or 10%. The return on your initial down payment is a remarkable 50% (i.e., your true financial output). Assuming your rental income covers expenses that kind of investment power is unparalleled and always will be. One may argue that they could buy stock on margin or trade options, but that is not true leverage, especially when you have the risk of losing your entire investment. Most real estate assets are insured to full value with an insurance policy, so if your house or building burns to the ground, chances are you will be compensated fully to replace it. Anyone out there have a stock portfolio reimbursement policy that is fully insured if the stock market crashes? Not likely.
Tax advantages also make real estate a very attractive investment vehicle. Depreciation of property is a write off, as an owner can also defer payments of income taxes while they keep on owning their property. Even better, when an investment property is sold the capital gains tax rate of 15% is usually applied, but an owner may opt to do a 1031 exchange to defer the capital gains and roll into another real estate investment.
Appreciation is just simple math but extremely powerful when coupled with leverage. Just figure a conservative LTV ratio (i.e., the amount of down payment vs. the loan amount) of 20/80. An example of this would be $50,000 dollars down to purchase a $250,000 rental unit. With 7% appreciation in one year, the asset is now worth $267,500, a return of $17,500.00. Now let's say that same $50,000 was invested in a mutual fund and got the same yearly return of 7%. The value of the mutual fund would be $53,500.00, a gain of $3,500.00. As you can see the application of leverage creates a considerably more lucrative situation. Assuming your rental income covers your expenses, a 20/80 LTV applied through leverage, every 2% of appreciation in the real estate market is equal to 10% of return in the stock market. Where else can you buy an asset and only put 20% down, someone else puts up the other 80 %, someone else pays off the mortgage for you via rental income, and at the end of 25 years you own an extremely appreciated income producing asset? What a concept right? The only factor missing from this scale is the operating expenses of the real estate asset vs. the near zero entrance cost of stock market investing. This is why our real estate investment choices are an important and crucial decision. Can one invest in a real estate vehicle and receive aggressive returns without the operating costs and maintenance headaches? The answer is yes; within a type of real estate investment known to the savvy real estate investor as a triple net investment.
A triple net investment is defined as a lease agreement on a property where the tenant or lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property, in addition to the costs of repair and maintenance of any common area. Sounds too good to be true? Not really, triple net investments are out there, they are not easy to come by, but are obtainable by someone who has a working intimacy with franchise companies, or what we call in the investment world, credit tenants.
Credit tenants are those who already have a commercially successful track record, operate a multitude of locations, and have highly trained business operators, mostly franchisees. These tenants always execute 10-30 year lease agreements with various options and rewarding rent escalations. The periodic bump-ups in rent, long term rent extensions and options combat inflation and increase return. Credit tenants often insure their payment stream to an owner through corporate guarantees, and allow the owner of the asset to attain a no recourse mortgage loan. This means that at no time in the deal, will the purchaser/borrower ever have any personal liability to the loan. These are just some of the perks to investing in triple net tenants, as they are usually publicly traded Fortune 500 companies. An example would be renting your building to Dunkin Donuts or Starbucks, rather than the guy who says he makes good coffee and wants to start up a coffee shop.
It is mind boggling to me that successful people with hard earned money looking to invest in real estate find themselves buying various retail strips or mixed use buildings in need of refurbishment with vacancies, and have hopes and dreams of finding solid tenants. Remember that fixed returns such as bonds, CD's, annuities, and treasury returns almost always have average returns of up to 5%, historically. One or two months of vacancy in a rental property usually causes a higher anticipated ROI to drop significantly below 5% on investment properties. So be careful, this can easily happen to an owner just bridging two tenancy terms together and missing one month's rent. Yet, I find that many investors do not see the fragility in their investment choices. I have actually told investors traveling down this dangerous road that I think their money would perform better in the stock market rather than in a lousy real estate investment. Have you ever heard of a real estate broker doing that, recommending the stock market over a real estate investment? I am sure not often, I may even be the first! But I am a believer that brutal honesty in business is always going to save a lot of time, heartache, and expense for people, no matter what the industry. Investment honesty always serves everyone best, even if it means foregoing compensation.
Investment brokers out there, read the following statement carefully: the largest real estate commission is not worth watching an investor roll the dice against themselves! Take pride in not only your clients but what your clients are buying. Wouldn't it be good for your brokerage business to have a client brag to their wealthy friends about the outstanding financial performance of their investment property that they just bought, and what company procured the lucrative purchase, or have an investor's CPA at tax time notice a great spike in cash flow from a solid investment property and recommend your real estate outfit to other investor clients? You just may find your phone ringing more and more at your real estate office.
The true investment advice that every economist and financial planner has to give is a balance of both stock market investments and real estate investments. No one can argue the soundness of someone trying to achieve balance and diversity between two historically rewarding investment products. As a side note, most people do diversify; although sometimes unintentionally. Do you own a home? Yes. Do you have a 401k or IRA plan? Yes. Ok, you just diversified. You are balanced in both markets without realizing it.
HSR Investments LLC prides itself on interactive client support and successful high stakes negotiations. The best route to prosperity in investment real estate is with someone who has been there before and can help lead the way. Never hesitate to contact me for any real estate investment questions or advice.