Author Topic: Real estate may not be better than stocks - diversification worth it though?  (Read 1853 times)

pnw_guy

  • 5 O'Clock Shadow
  • *
  • Posts: 28
Would be real estate investor here. Have read a couple of awesome threads recently that have provided some convincing arguments as to why real estate might not be a superior investment to plain index funds:

https://forum.mrmoneymustache.com/real-estate-and-landlording/examining-the-1-rule/
https://forum.mrmoneymustache.com/real-estate-and-landlording/this-is-why-i-do-not-like-the-1-rule/

Here's some background for my question: We are in our early 30's have about $350K saved in retirement accounts and are looking to become financially independent. Recently, our financial situation drastically changed where we now have about $100K to invest every year. A good chunk of this goes to maxing our 401K's, IRA's, and HSA's. We really take a simple approach and just stick with the total stock market index.

Here's my question: We're thinking of taking the extra money we make and using it to invest in real estate. While I'm becoming increasingly convinced that real estate isn't going to provide better returns than the stock market, is it worth it purely from a diversification perspective? That is, stock prices rise and fall but hopefully including an asset class with a relatively low correlation with stocks could smooth out the ride. Thinking that this could be especially helpful since we don't like bonds.

Two other random thoughts: First, stocks seem like a more conservative and easier approach than real estate. Since we have so much money to invest each year, part of me thinks we should just dump it all in stocks since we know we can "win the game" and become financially independent in a relatively short amount of time. Second, our goal is to become financially independent ASAP and are willing to put in some extra time and work to make this happen - thus, our interest in real estate. However, I'm a bit worried about going all stocks because while I'm confident about the long term trajectory of stocks (say, over the course of 30 years), the trajectory of stocks across the shorter timeframe until we reach financial independence could be much bumpier (e.g., 10 years).

the_gastropod

  • Bristles
  • ***
  • Posts: 260
  • Age: 34
  • Location: Brooklyn, NY
Know that VTSAX already includes exposure to real estate via REITs. Buying real estate in addition to holding VTSAX is not really diversifying—it’s overweighting RE. Considering that a real estate purchase would be a substantial percentage of any non-millionaire’s net worth, you’d be undiversifying quite a bit with this strategy 

pnw_guy

  • 5 O'Clock Shadow
  • *
  • Posts: 28
Know that VTSAX already includes exposure to real estate via REITs. Buying real estate in addition to holding VTSAX is not really diversifying—it’s overweighting RE. Considering that a real estate purchase would be a substantial percentage of any non-millionaire’s net worth, you’d be undiversifying quite a bit with this strategy

This is a good reminder. Slipped my mind about the real estate exposure in VTSAX. Thanks for checking me on this.

Still would be interested on our situation and the proposition of buying some rentals to add to our portfolio.
« Last Edit: January 02, 2021, 01:58:21 PM by pnw_guy »

leighb

  • Stubble
  • **
  • Posts: 160
In my experience, real estate has been a good investment. Currently, 30% of my investments are in rentals. But unlike stocks they are not a passive experience. Some years they take more money than they give and are a headache. It's also heavy. You're investing in someone else's home and that (at least for me) is complicated.
Other years they done just fine. I bought throughout the housing crisis properties between 10,000-25,000. Most of them have made money over the years a few haven't. So for me it was important to be diversified within real estate as well. Because as a whole they've done well, but there are a few that have not preformed. If I were only invested in those few, I would have had a hard time staying the course.
For what it's worth, I'm in the process of slowly selling them now that the market has recovered.

pnw_guy

  • 5 O'Clock Shadow
  • *
  • Posts: 28
In my experience, real estate has been a good investment. Currently, 30% of my investments are in rentals. But unlike stocks they are not a passive experience. Some years they take more money than they give and are a headache. It's also heavy. You're investing in someone else's home and that (at least for me) is complicated.
Other years they done just fine. I bought throughout the housing crisis properties between 10,000-25,000. Most of them have made money over the years a few haven't. So for me it was important to be diversified within real estate as well. Because as a whole they've done well, but there are a few that have not preformed. If I were only invested in those few, I would have had a hard time staying the course.
For what it's worth, I'm in the process of slowly selling them now that the market has recovered.

Thank you for sharing your story!

I think the sentiment that RE was a good option in the past but no longer is anymore is pretty common on this board. That's why I'm just going to plow money into index funds for the foreseeable future. If RE prices tank, I'll be happy to pick up some rentals. If they don't, I'll just stick to my truly passive index funds...

clarkfan1979

  • Handlebar Stache
  • *****
  • Posts: 2238
  • Age: 41
  • Location: Pueblo West, CO
When comparing rentals vs. stocks, I think the better question is what is a better fit based on your lifestyle. If you are working 50 hours/week at a high paying corporate job, stocks are probably the answer. If you work 40 hours/week at a non-profit or are a teacher with summer off, you might do better with rentals.

Repairs can vary greatly depending on the local cost of labor and your DIY skills. For one of my rentals, the p-trap under the bathroom sink rusted out and was leaking. I asked the tenants to put a bucket under the sink until my next visit in which I was scheduled to lay flooring. I replaced the metal p-trap with a plastic p-trap and it cost about $3.50 from Home Depot and 30 minutes of my time. If I was to hire it out to a professional plumber, the repair would be $200-$250.

I personally like rentals because you have 4 levels of wealth creation with a rental. Comparing rentals to stocks has been covered many times and people have provided different analysis. However, I do not think I have seen an analysis in which someone argues for rentals and provided all 4 levels. It is usually limited to cash flow and appreciation. However, with low interest rates, principle pay down is becoming more important, but it doesn't seem to grab much attention.

1) Cash flow above rent
2) Appreciation
3) Principle pay down
4) Tax advantages (Depreciation)


pnw_guy

  • 5 O'Clock Shadow
  • *
  • Posts: 28
When comparing rentals vs. stocks, I think the better question is what is a better fit based on your lifestyle. If you are working 50 hours/week at a high paying corporate job, stocks are probably the answer. If you work 40 hours/week at a non-profit or are a teacher with summer off, you might do better with rentals.

Repairs can vary greatly depending on the local cost of labor and your DIY skills. For one of my rentals, the p-trap under the bathroom sink rusted out and was leaking. I asked the tenants to put a bucket under the sink until my next visit in which I was scheduled to lay flooring. I replaced the metal p-trap with a plastic p-trap and it cost about $3.50 from Home Depot and 30 minutes of my time. If I was to hire it out to a professional plumber, the repair would be $200-$250.

I personally like rentals because you have 4 levels of wealth creation with a rental. Comparing rentals to stocks has been covered many times and people have provided different analysis. However, I do not think I have seen an analysis in which someone argues for rentals and provided all 4 levels. It is usually limited to cash flow and appreciation. However, with low interest rates, principle pay down is becoming more important, but it doesn't seem to grab much attention.

1) Cash flow above rent
2) Appreciation
3) Principle pay down
4) Tax advantages (Depreciation)

Thanks, this is also helpful. I especially appreciate the distinction between whether someone is busting their ass off at a high paying corporate job or working at a job that affords more time flexibility (with lower pay).

The former situation really describes my situation. As I mentioned in the initial post in this thread, we invest about $100K a year - all in total stock market index funds held in various accounts (HSA, 401K, IRA, taxable brokerage). My primary interest in starting this thread was whether it might be worth throwing $30K or $40K into rentals to diversify a bit. Though one poster helpfully pointed out that the total stock market index already does provide some real estate exposure.

« Last Edit: January 10, 2021, 09:13:55 AM by pnw_guy »

franklin4

  • 5 O'Clock Shadow
  • *
  • Posts: 7

I personally like rentals because you have 4 levels of wealth creation with a rental. Comparing rentals to stocks has been covered many times and people have provided different analysis. However, I do not think I have seen an analysis in which someone argues for rentals and provided all 4 levels. It is usually limited to cash flow and appreciation. However, with low interest rates, principle pay down is becoming more important, but it doesn't seem to grab much attention.

1) Cash flow above rent
2) Appreciation
3) Principle pay down
4) Tax advantages (Depreciation)

Stated a slightly different way that is easy to remember, rentals can be the IDEAL investment:
I - ncome
D - epreciation
E - quity
A - ppreciation
L - everage

Mustache ride

  • Stubble
  • **
  • Posts: 144
REITs make up only 3.49% of VTSAX. You are diversified, the question is do you want to increase your allocation.

PMJL34

  • Stubble
  • **
  • Posts: 167
Buying real estate in addition to holding VTSAX is not really diversifying—it’s overweighting RE. Considering that a real estate purchase would be a substantial percentage of any non-millionaire’s net worth, you’d be undiversifying quite a bit with this strategy 

I agree with gastropod that most folks are actually doing the opposite of diversifying by purchasing a rental.

FatFI2025

  • Bristles
  • ***
  • Posts: 352
  • Location: California
Buying real estate in addition to holding VTSAX is not really diversifying—it’s overweighting RE. Considering that a real estate purchase would be a substantial percentage of any non-millionaire’s net worth, you’d be undiversifying quite a bit with this strategy 

Really, quite a bit? How much single family residential real estate does VTSAX hold? 0%? 1%?

As a separate issue from VSTAX allocation, REITs are not comparable to other ways of holding RE -- for this discussion, the key differences are volatility and correlation. The prices of publicly traded REITs are 1) more volatile than privately held investments and 2) are correlated with stocks.

I have a target 25% allocation to residential real estate. It is a distinct asset class. In my opinion it has higher risk than other classes owing to tenant lawsuits and regulatory risk. And it's definitely more work. But in exchange you get tax-advantaged, leveraged returns -- some combo of appreciation and yield -- that are higher than most other classes.

If you believe in efficient market hypothesis, every asset class has its advantages and disadvantages, with overall risk corresponding to return. Although I don't believe markets are perfectly efficient, I do believe that theory in general, and I build a portfolio that has some of everything with a weighting that fits my risk-reward values. I think it's rash to exclude an asset class that's been performing for thousands of years.

PMJL34

  • Stubble
  • **
  • Posts: 167
Fatfire,

I never said real estate wasn't a great asset class. I love real estate.

Here's the issue: for example, if you live in your primary home that is worth 300k (national median average) and you want to buy a 100k rental (1/3 of national median average) to "diversify." Now, you are 400k into real estate. And even if you put down 20% for your primary and 25% of for your rental, you have a debt of 315k in mortgages, plus all the carrying costs that homes have. Assuming the above individual has another 200k in assets, this person is 75% real estate. This person would need $1.2 million in other assets for your target of 25% real estate allocation. Most folks don't have another 1.2 million in their brokerage/401k/gold/or whatever.

If the housing sector/asset class doesn't perform well for a decade, this person's 75% of assets don't perform well. Therefore, you can see how easy it is to be overly tilted into real estate, even with just one primary + rental (at very reasonable costs btw).

Mustache ride

  • Stubble
  • **
  • Posts: 144
Fatfire,

I never said real estate wasn't a great asset class. I love real estate.

Here's the issue: for example, if you live in your primary home that is worth 300k (national median average) and you want to buy a 100k rental (1/3 of national median average) to "diversify." Now, you are 400k into real estate. And even if you put down 20% for your primary and 25% of for your rental, you have a debt of 315k in mortgages, plus all the carrying costs that homes have. Assuming the above individual has another 200k in assets, this person is 75% real estate. This person would need $1.2 million in other assets for your target of 25% real estate allocation. Most folks don't have another 1.2 million in their brokerage/401k/gold/or whatever.

If the housing sector/asset class doesn't perform well for a decade, this person's 75% of assets don't perform well. Therefore, you can see how easy it is to be overly tilted into real estate, even with just one primary + rental (at very reasonable costs btw).

A primary home isn't an investment and shouldn't be included in your asset allocation.

theoverlook

  • Bristles
  • ***
  • Posts: 346

A primary home isn't an investment and shouldn't be included in your asset allocation.

This is very true - you aren't going to be getting a return on your primary home, it will mostly be an expense. Unless you plan to sell the house and rent something, even large increases in value don't help you in retirement. I include mine in my overall "net worth" tracking, but not in my asset allocation or investment value numbers.

PMJL34

  • Stubble
  • **
  • Posts: 167
Whether you include your home equity/value in your networth/asset is up to the individual and their FIRE plans/circumstances. 

The point remains: a person who owns a 300k home and a 100k rental is exposed to 400k worth of real estate whether they like it or not. If they have another 200k in stocks, real estate's performance (positive or negative) will have a bigger impact on this individual's networth/asset than the stocks due to math.

I personally lean towards including personal residence in my asset just because it's something I can sell if needed. My home is worth more than a million dollars so if my FIRE plans ever fail, I can always sell and relocate to a lower COL area if needed. It's an asset for me.

I also think this is regional. If you are in a HCOL area, people tend to include their home equity/value in their networth because it's such a significant number. I agree if I was elsewhere, I may not.

   

aasdfadsf

  • Stubble
  • **
  • Posts: 117
FWIW, I agree with gastropod and the others. I wouldn't buy an investment property purely for the sake of diversification. If you think you need more real estate exposure in your portfolio, you can always buy more REITs like VNQ.

Mom 'n pop real estate investing can get you outsized gains in large part because it in effect opens up a bunch of highly remunerative side gigs. You can become a part-time market analyst, rental manager, maintenance guy, landscape architect, renovator, broker, etc. Any of those things you take on yourself, if you do them well, will earn you more money than bottom-line market returns. If you have no interest or time for that stuff, then there's probably no sense in it.

aasdfadsf

  • Stubble
  • **
  • Posts: 117
A primary home isn't an investment and shouldn't be included in your asset allocation.

Your primary home is definitely an investment, and if you aren't coming out ahead when the imputed rent and capital appreciation are accounted for, then you have made a bad investment, not a non-investment. It's a major capital asset, and for most people, the bulk of their asset allocation.

A home you live in can always be rented out and you can always rent another home, so it's all symmetrical. You can just think of your own house as a rental that you choose to rent to yourself if it clarifies things.

SeattleCPA

  • Handlebar Stache
  • *****
  • Posts: 1656
  • Age: 61
  • Location: Redmond, WA
    • Evergreen Small Business
@pnw_guy you would probably find this set of charts I did, based on the "rate of return of everything" paper useful to further develop your thinking:

https://evergreensmallbusiness.com/rate-of-return-of-everything-study-in-line-charts/

The data suggests that housing is a better investment than stocks. Here's the graph of returns for Belgium which highlights what often seems to occur:



The actual paper--which is well worth reading given your research interests--appears here:

https://www.frbsf.org/economic-research/files/wp2017-25.pdf

Full disclosure to add context: I am not really a real estate investor. I accumulated my nest egg using stocks and, as I've noted numerous times over the years, employ David Swensen's asset allocation formula.

Boll weevil

  • Stubble
  • **
  • Posts: 119
I seem to recall a thread saying real estate was better as long as it was leveraged. Once it was paid off, the appreciation slowed and stocks soon caught up and kept going. I don’t remember all the assumptions that went into those calculations though.

Fishindude

  • Magnum Stache
  • ******
  • Posts: 2686
In my experience, real estate has been a good investment. Currently, 30% of my investments are in rentals. But unlike stocks they are not a passive experience. Some years they take more money than they give and are a headache. It's also heavy. You're investing in someone else's home and that (at least for me) is complicated.
Other years they done just fine. I bought throughout the housing crisis properties between 10,000-25,000. Most of them have made money over the years a few haven't. So for me it was important to be diversified within real estate as well. Because as a whole they've done well, but there are a few that have not preformed.

We've done well in real estate also, but have never owned any residential rentals.  Farm ground rented out for row crops and a commercial building, neither of which require very much headache or work as noted above.   Farm ground requires little to no work, and the commercial building was a triple net ten year lease where tenant paid and maintained everything.   Leased that building for 17 years before they elected to take the purchase option.

Seems like when real estate gets mentioned on these forums as an investment, everyone immediately thinks housing.  There are numerous ways to get involved in real estate investing and not all of them require a ton of work.

rothwem

  • Pencil Stache
  • ****
  • Posts: 772
  • Location: WNC
In my experience, real estate has been a good investment. Currently, 30% of my investments are in rentals. But unlike stocks they are not a passive experience. Some years they take more money than they give and are a headache. It's also heavy. You're investing in someone else's home and that (at least for me) is complicated.
Other years they done just fine. I bought throughout the housing crisis properties between 10,000-25,000. Most of them have made money over the years a few haven't. So for me it was important to be diversified within real estate as well. Because as a whole they've done well, but there are a few that have not preformed.

We've done well in real estate also, but have never owned any residential rentals.  Farm ground rented out for row crops and a commercial building, neither of which require very much headache or work as noted above.   Farm ground requires little to no work, and the commercial building was a triple net ten year lease where tenant paid and maintained everything.   Leased that building for 17 years before they elected to take the purchase option.

Seems like when real estate gets mentioned on these forums as an investment, everyone immediately thinks housing.  There are numerous ways to get involved in real estate investing and not all of them require a ton of work.

Very good point, residential real estate is drastically more common. I think it’s seem by many as a safer investment—banks don’t want to hold houses in their portfolios, that’s way too far out of their core competence. Also, the govt wants to avoid 2008 again, so they’ll go to pretty long lengths to keep houses from devaluing again IMO.  So safer, but probably less return than other sectors.

I don’t know much about farm land real estate investing, though I do have some acquaintances that own significant amounts of land. It’s all family land though, so the acquisition process is a bit of a mystery to me.

What kind of leverage is possible? If you can get a loan, what kind of interest rates are normal and what LTVs do they usually require? 

When you’re doing your due diligence, how do you know if the land is good or not? I can just imagine buying 500 acres in Mississippi and finding out it’s complete garbage and nothing will grow there.

Fishindude

  • Magnum Stache
  • ******
  • Posts: 2686

I don’t know much about farm land real estate investing, though I do have some acquaintances that own significant amounts of land. It’s all family land though, so the acquisition process is a bit of a mystery to me.
Farms change hands every day; auctions, realtors, estate sales, private sales, etc.   Easiest way to find something is start browsing real estate listings.

What kind of leverage is possible? If you can get a loan, what kind of interest rates are normal and what LTVs do they usually require? 
Depends on your banking relationship, collateral, etc.   It's pretty typical to require at least 20% down and since it's not a primary residence, you'll probably pay at least 1% more than a residential rate.
Any decent AG banker can evaluate a deal and decide if it makes sense for their bank pretty quickly.   Farms are a good safe place to invest cash for a non-farmer.  Borrowing and paying a mortgage will suck up most of the returns.

When you’re doing your due diligence, how do you know if the land is good or not? I can just imagine buying 500 acres in Mississippi and finding out it’s complete garbage and nothing will grow there.
If they are growing row crops there now, it's a safe bet you can grow row crops there next season.   It's easy enough to ask around at the local CO-OP's, fertilizer dealers, farm neighbors, etc. to determine what average yields are for an area and what average cash rental rates are.   Your local USDA soils office or a nearby AG focused university can also be a wealth of information.

Le Poisson

  • Senior Mustachian
  • ********
  • Posts: 13960
I think a lot of this depends on local market. Here (southern Ontario) we are seeing gains of 20 -30% year over year in real estate value. Outside Toronto, COVID has boosted values in a big way. Inside the city, condos are struggling. Even with a 50% capital gains tax, our numbers are tough to beat. Our tenants do provide some challenges, but the properties are cash flowing at least revenue neutral (our challenging tenants) to positive $3K/mo (our duplex) - currently one property is offsetting the other.

The great lie about RE (in my experience) is that it is passive income. We are kept busy managing, maintaining, and administrating this business.