Author Topic: Real Estate Returns vs. Stock Returns: The Maths  (Read 27809 times)

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Real Estate Returns vs. Stock Returns: The Maths
« on: November 08, 2015, 05:44:55 PM »
This sounded like a fun math problem, and there was so much bad math and rationale in this thread that inspired this post, I figured I might as well work something out.

I pictured an investor, mid-20s, with enough for a rental down payment, who is wondering if they should buy a single rental property to hold for 30-50 years, or if they should invest that down payment in stocks.

Here's my baseline assumptions:
  • You are 25 years old.  You have saved up after college, and you have 22k to invest.
  • You don't want to start a whole real estate business or empire, but are considering getting a single rental.  You don't want to do any work on it yourself, so you will hire out all labor, property management, etc.
  • You will pay market price for a 100k home, get 1% of the purchase price in monthly rent ($1000), and expenses will run 50% of your gross rents (500).
  • Your interest rate is 4.5%, so your P&I payment on 80k for 30 years is 405.35 monthly.
  • You will put down 20% (20k), and finance 80% (80k), and pay 2k closing costs.  No PMI.
  • Inflation runs 3%, and the house appreciates at the rate of inflation.
  • Stocks return 7% real, so 10% including the 3% inflation.
  • After getting the one house, you will reinvest all net rents received into the stock market for the same returns as the stock returns, because you just wanted this one home, so once per year you take your annual profits of $1,135.80 and invest them in the stock markets.
  • I'm ignoring taxes for simplicity's sake, but the real estate should come out ahead, because depreciation on a 100k home is much more than the $1,135 annual profits.

We want to compare the returns of the two after 30 years, and after 50 years.

22k invested in stocks, at a 10% nominal return, is worth $383,886.85 after 30 years.
22k invested in stocks, at a 10% nominal return, is worth $2,582,598.76 after 50 years.

The 100k house at 3% return is worth $242,726.25 after 30 years.
The 100k house at 3% return is worth $438,390.60 after 50 years.

That's just a straightforward time value of money calculation.  So just on appreciation, the stocks win.  However, now we add in the rents:
$1,135.80 invested annually in stocks, at a 10% nominal return, is worth $186,832.31 after 30 years.
$1,135.80 invested annually in stocks, at a 10% nominal return, is worth $1,321,967.31 after 30 years.

After 30 years, RE total: $429,558.56   Stock total: $383,886.85  Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.
 
During the years you have leverage (those 30 years), real estate comes out ahead.  Stocks start to pull ahead after that, because the bulk of your investment in RE is in an asset earning 3% (the inflation rate) versus stock's 10%.

Now, if we keep all other assumptions the same (cost of house, expenses, etc.) and just tweak how much rent we're getting (i.e. buy at a better price-to-rent ratio than the 1% rule), we find that real estate equals stocks after 50 years at a ratio of 1.12% monthly rent to purchase price (in our example that would be monthly rent of $1120).  At that price, you'd net $1,842.25 annually which, when invested for 50 years, along with the ~438k of real estate, would equal stock's 2.58MM.  And it would be well ahead of stocks at the 30 year mark, it takes stocks til year 50 to catch up in that scenario.

If you can get a much better price to rent ratio, you'll do even better.  For example a 1.5% price-to-rent ratio ($1500 monthly rent, in this example) leaves real estate with over 5.25 million after 50 years, more than double stocks.

Let me know if I missed anything, but I think all my assumptions were very reasonable.  No big advantages to real estate that one can get (buying much better than the 1% rule, managing it yourself or doing any "sweat equity" to save on the expenses, buying a deal at below market, etc.).  I included closing costs and used a reasonable interest rate.  I did ignore taxes, but that should help the real estate case due to depreciation.

tl;dr The question was "What wins in the long run?"  The answer is: it depends on how good the real estate investment is.  At a 1% rule, it's pretty even between the two scenarios: Real estate wins over a 30 year timeframe, stocks win over a 50 year timeframe.  At a much better ratio, like 1.5%, real estate wins hands down, with over double the money of stocks.  At a worse ratio, naturally stocks would win.

Thoughts?  Math I screwed up?  Quibbles with assumptions?
« Last Edit: November 08, 2015, 05:55:54 PM by arebelspy »
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #1 on: November 08, 2015, 05:48:12 PM »
After 30 years one could simply releverage the real estate and buy another property.  Thus the nominal yield difference would not be 7%.  One could also do this long before 30 years and the whole analysis would change.  The major advantage for the real estate is the ability to leverage it cheaply. 

One could also buy multifamily properties with higher capitalization rates than residential real estate and the whole analysis would change.
« Last Edit: November 08, 2015, 05:50:17 PM by mr_orange »
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #2 on: November 08, 2015, 05:54:45 PM »
After 30 years one could simply releverage the real estate and buy another property.  Thus the nominal yield difference would not be 7%.

Yup.  RE beats stocks over 30 years (as it does even in the 1% rule scenario) due to leverage.  If you keep releveraging, buy more properties, etc., you can continually beat it.  However, one of my stipulations is that the individual didn't want to buy more and more real estate, continually leveraging, building a whole business.  They were willing to buy just a single house, and were just curious if their 22k should go into stocks, or real estate.

But as you point out, if they were willing to continue buying more real estate, if one beats it via leverage, continually leveraging (assuming favorable rates) will continue to beat it.

One could also buy multifamily properties with higher capitalization rates than residential real estate and the whole analysis would change.

Yup.  RE beats stocks at a 1.12%  price-to-rent ratio or higher over 50 years.  Any better than that and it starts to crush stocks (earning over double after 50 years at a 1.5% ratio).  If you change assumptions to be even higher returns (via multifamily, commerical, whatever), then naturally it will do even better.  But this scenario was buying a single house, and seeing how it would do.  Multifamily is more work, and this hypothetical investor didn't want any more work.  But your point is correct: higher returns in the assumptions for RE will lead to even better numbers for RE by the end.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #3 on: November 08, 2015, 06:37:01 PM »
Enclosed is a spreadsheet from BiggerPockets that a CFA in Minnesota modified from my original model posted over there.  If you wish to do a more detailed analysis this would be a great tool to start with.  I know this says it is for small apartment complexes, but it will work just fine if tuned properly for one property. 

Real capitalization rates on residential real estate are generally around the 5% or so range (in many markets....some lower) because you're bidding with owner-occupants.  For those interested these articles are what I consider some of the better ones on the internet for a quick education on real estate yield calculations:

http://www.johntreed.net/positive.html
http://www.creonline.com/cap-rate-formula.html

So it is very easy to state that 5% real capitalization rates will under-perform stock index yields in the absence of leverage in the long run.  This will be the case in the long run even if you buy at a discount.  This, however, ignores leverage and many other pieces of the analysis.  The enclosed spreadsheet would give you a more detailed analysis if you want to take the time to see for yourself. 
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #4 on: November 08, 2015, 06:55:24 PM »
Methinks you missed the point of this thread.  Yes, believe it or not, I know how to calculate real estate returns.  :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #5 on: November 08, 2015, 07:01:31 PM »
However, one of my stipulations is that the individual didn't want to buy more and more real estate, continually leveraging, building a whole business.  They were willing to buy just a single house, and were just curious if their 22k should go into stocks, or real estate.

Okay....fine.  Just releverage at year 30 and place the capital into index funds instead.  Problem solved....and the conclusion is the same ;-)
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

sol

  • Walrus Stache
  • *******
  • Posts: 5417
  • Age: 40
  • Location: Pacific Northwest
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #6 on: November 08, 2015, 07:07:19 PM »
After 30 years, RE total: $429,558.56   Stock total: $383,886.85  Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.

This is basically what I came up when I ran my own independent analysis about a year ago.  Real estate was clearly better in the short term, but over lifetime-length time scales stocks always came out ahead.

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #7 on: November 08, 2015, 07:10:03 PM »
Methinks you missed the point of this thread.  Yes, believe it or not, I know how to calculate real estate returns.  :)

I wasn't challenging your analysis.  I was attempting to provide a tool to make the analysis more precise.  There are about 10 (or more) variables to control for to really do it correctly.  Tax shields, tax rates, loan types, leveraging assumptions, inflation rates, what you invest cash flows in, etc. all matter in the real world analysis. 
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #8 on: November 08, 2015, 07:11:40 PM »
After 30 years, RE total: $429,558.56   Stock total: $383,886.85  Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.

This is basically what I came up when I ran my own independent analysis about a year ago.  Real estate was clearly better in the short term, but over lifetime-length time scales stocks always came out ahead.

Only for a mediocre real estate investment.  For a good one, RE should come out ahead on any length time frame, whether you invest the proceeds in more RE, or in stocks after you have your fill of RE.

Even if it's just a mediocre one, RE beating stocks via leverage over the short term seems like a good reason for someone about to FIRE at age 50-55 or so to take out a mortgage and get a rental--besides giving them something to do in ER (could be a pro or con), it likely leaves them with more money over their expected lifetime, and provides a better inflation hedge in case we see some big inflation.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #9 on: November 08, 2015, 07:13:56 PM »
Methinks you missed the point of this thread.  Yes, believe it or not, I know how to calculate real estate returns.  :)

I wasn't challenging your analysis.  I was attempting to provide a tool to make the analysis more precise.  There are about 10 (or more) variables to control for to really do it correctly.  Tax shields, tax rates, loan types, leveraging assumptions, inflation rates, what you invest cash flows in, etc. all matter in the real world analysis.

Gotcha.  I absolutely agree, and I have my own spreadsheets that model all of that.

I was attempting to provide a simple analysis though, where we can show the math in the post without needing a spreadsheet.  I'd absolutely recommend anyone actually investing in RE to do a very thorough analysis before they buy, specific to the property their looking at.  This is for those wondering about the rough general numbers.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #10 on: November 08, 2015, 07:24:06 PM »
Okay...well to piggyback on that here is more evidence that real estate wins:

-Tax shields over 27.5 years will yield $3k+ in tax shields annually (assuming a normal property basis in many cities), which will translate to at least 25% of that number in real world tax savings annually for most posters on this board during the accumulation phase.  So let's call this $750 that we can now save in taxes and place into service in index funds annually

-You could, in theory, use interest-only loans with long bullets and increase your cash flow.  You'd lose the loan amortization, but the money would be more effectively used in index funds from the increased cash flows.  You'd of course need to account for the transaction costs during a refinance and see if it helps over your hold period

-Inflation will erode the real value of your loan and rents will, in theory, keep pace with inflation

Those three factors alone will be a big deal in the real world and will make the real estate outpace index fund investing by a wider margin. 
« Last Edit: November 08, 2015, 07:26:01 PM by mr_orange »
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

candymaldy

  • 5 O'Clock Shadow
  • *
  • Posts: 15
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #11 on: November 08, 2015, 09:39:28 PM »
The thing I really dislike about real estate is that it is an inherently riskier investment.

The risk of total loss is far more real for a single home than for a diversified portfolio of stocks.

The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.

And leverage only increases your downside exposure.

You can insure against some of this of course, but if you insure against all of it, your returns will be severely effected.

Add on to that poor liquidity, the hassle of having to deal with tenants, finding competent managers, vacancies, etc, and I would take on a well diversified investment portfolio any day of the week.

It's just so much less work for a better return long term.

SwordGuy

  • Magnum Stache
  • ******
  • Posts: 3286
  • Location: Fayetteville, NC
    • Flipping Fayetteville
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #12 on: November 08, 2015, 10:33:47 PM »
The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.

The house could also burn down.

Of course, my rental property insurance includes a rebuilding cost payment for a total cost of less than $1k.

Crazy as it sounds, my $80,000 rental properties that cost me $45,000 would cost about $140,000 to rebuild.

Let's assume the house burns down in the first year.

I would collect the $140,000, pay $10,000 to have the lot cleared off, and sell the lot to a builder for $30,000, which would be a profit of (drum roll please):

140,000 - 10,000 + 30,000 - 45,000 - 1,000 equals $114,000 in profits, for a 250+% return on investment.

It would be an even better return on investment if I had leveraged 80% of the purchase and repair price, giving me a 1000+% return on investment.  If it burned down empty and no one was killed or injured, how much better could it get?

If I had owned a block or two of Chicago when Mrs. O'Leary's cow kicked over the lantern and burned the town down, my family would still be stinking rich from the event...

 



candymaldy

  • 5 O'Clock Shadow
  • *
  • Posts: 15
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #13 on: November 08, 2015, 10:39:10 PM »
Yeah. Everyone has fire insurance.

But do you have flood/earthquake/tornado/hurricane insurance?

This are all low probability events, but they would be devastating to a levered landlord with no house and no income stream.

I just detest taking risks for which I don't get paid.

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #14 on: November 09, 2015, 03:12:27 AM »
rents will, in theory, keep pace with inflation

That's a good point, I used flat, fixed rents for the full 30-50 years, which won't be the case.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

Left

  • Handlebar Stache
  • *****
  • Posts: 1156
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #15 on: November 09, 2015, 03:32:17 AM »
um... since im assuming you are picking real estate and not buying the entire listing book... why isnt your stock investor picking sectors or even individual companies?

it would be like comparing donald trump to warren buffett...

sure i get index makes it safer for most people, but if you are saying to be selective in real estate, why cant the investor be as selective?

and in the end, the total amount isnt really important once you have enough for your needs... do the math on which is quicker to fi instead.

i get tempted one by real estate, but it just isnt for me... i could see getting into it after fi but not before. im on a 15 year plan with stocks for fi, real estate may or may not speed it up, but such a short time span, my own savings rate would add more than the investment would unless i leverage at a rate more than i am comfortable with
« Last Edit: November 09, 2015, 03:37:21 AM by eyem »

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #16 on: November 09, 2015, 03:36:21 AM »
um... since im assuming you are picking real estate and not buying the entire listing book... why isnt your stock investor picking sectors or even individual companies?

it would be like comparing donald trump to warren buffett...

sure i get index makes it safer for most people, but if you are saying to be selective in real estate, why cant the investor be as selective?

Aside from getting into a debate about picking individual stocks and it being better/worse than an index, I'll just point out that I didn't have the person pick a particularly good deal, I had them buy at market prices.  Picking a good deal would have had them them paying 70k or less for a 100k property.  Instead they paid the full market value.

One can get 1%, 1.12%, or 1.5% in good markets, even paying retail prices.

If I cherrypicked good investments (note that every single one of my investments are above the 1% rule), it would be even more lopsided.  I was trying to pick an "average" scenario where we compare the index to a property bought not at a discount, but market prices.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

Left

  • Handlebar Stache
  • *****
  • Posts: 1156
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #17 on: November 09, 2015, 03:39:36 AM »
oh, i thought the 1% was being selective... didnt know it was fairly common...

i meant that you select safe area so house isnt burned down too. and other factors like selecting tenants. to me, real estate has a lot of selection involved vs dumping into an index. or is renting to drug dealers who pay rent in cash a thing now?

even your post on buying non local, you select the people you trust to work with...

i dont have to trust any of the companies with an index
« Last Edit: November 09, 2015, 03:43:34 AM by eyem »

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #18 on: November 09, 2015, 03:54:25 AM »
oh, i thought the 1% was being selective... didnt know it was fairly common...

It's a rough rule of thumb, but one many of us follow, and has been around a LONG time.  It's not being selective on a particular property necessarily, no.

i meant that you select safe area so house isnt burned down too.

It sounds like you're just making up objections. I mean.. are there areas where it's common for houses to burn down all the time? If no, what are you talking about?  If yes... don't buy in that area?

and other factors like selecting tenants. to me, real estate has a lot of selection involved vs dumping into an index. or is renting to drug dealers who pay rent in cash a thing now?

Yes, you'll need to vet your property manager, but no, a good one isn't renting to drug dealers.  All the work was outsourced in this scenario, and we're just assuming an average property bought from an average real estate agent off the MLS, with average tenants.  Nothing special.  It would be easy to rig it if our investor in question had any sort of real estate knowledge, but we were presuming they didn't.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

Left

  • Handlebar Stache
  • *****
  • Posts: 1156
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #19 on: November 09, 2015, 04:22:49 AM »
hm then I guess it is pretty average? I'm not in real estate, thought it would be more picking and choosing than that

to me, being a landlord is more akin to being a business owner than just an investor. which is why I suggested comparing the investor with someone who does investments as a business, like or someone who did it full time buffet

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #20 on: November 09, 2015, 04:32:59 AM »
to me, being a landlord is more akin to being a business owner than just an investor. which is why I suggested comparing the investor with someone who does investments as a business, like or someone who did it full time buffet

Yes, if you get multiple real estate investments, it absolutely is more akin to a business.  A single rental one does no work on?  Not so much.  That'd be like owning a "business" of having a yard sale twice a year with the junk you clean out from your garage.  Technically you can call it that, but it's barely so.  :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

ShoulderThingThatGoesUp

  • Magnum Stache
  • ******
  • Posts: 2761
  • Location: Emmaus, PA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #21 on: November 09, 2015, 07:40:25 AM »
It sounds like you're just making up objections. I mean.. are there areas where it's common for houses to burn down all the time? If no, what are you talking about?  If yes... don't buy in that area?

I bet you can CRUSH the 1% rule in Aleppo right now!

Bearded Man

  • Handlebar Stache
  • *****
  • Posts: 1142
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #22 on: November 09, 2015, 08:40:13 AM »
I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.

Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.

Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.

Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.

Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.

There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.

But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.

Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.

But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...

http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2
« Last Edit: November 09, 2015, 08:53:05 AM by Bearded Man »

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #23 on: November 09, 2015, 09:23:59 AM »
Instead of claiming that study after study proves something why not post the study so people can examine it?  I agree that the OP did not account for all variables, but you can't just snipe and avoid serving up alternative math instead. 

The 50% rule already accounts for repairs, etc. so I am not sure how that criticism is valid. 

Stock returns can be cherry-picked, but 12% or so nominal returns probably already factor in dividend reinvestment.  How is this data cherry-picked?  I'm not saying it isn't.  I am saying that you have failed to provide evidence that it is cherry-picked. 

How about we try to be constructive with our posts and dialog instead of complaining? 

Edit:  I see that he used 10% in the OP instead of 12% including dividends.  Carry on with the complaining. 
« Last Edit: November 09, 2015, 09:26:42 AM by mr_orange »
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

Reynold

  • Stubble
  • **
  • Posts: 226
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #24 on: November 09, 2015, 09:53:12 AM »
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.

Yeah, I have to say, of the half dozen houses I know something about regarding values over time (father, father-in-law, 2 rentals by sister-in-law, friend's house, our own house), in three different states, the only one that went up by more than enough to pay a 5% sales commission over 10-20 years was ours, which went up by a grand total of 30% over 18 years.  Those don't seem like good odds for a 3%/year compounding value of a house. 

Of course, if you get lucky and live in an area with a hot real estate market, like California, or Seattle, or Denver, I'm sure you could do better.  As you could if you get lucky and invest in developing country stocks, or tech stocks, or medical stocks at the right time.  The difference being that I don't have to live in a developing country to invest in their stocks, but I'd be pretty hesitant to invest in Denver real estate if I live in Alabama, for example. :) 

I suspect the big advantage real estate has over stocks is not so much the leverage, but rather an inefficient market.  If you really know your area and rent and purchase prices, and keep track of what comes on the market, you can buy that "half off" house, a short sale or fixer-upper.  Buying a stock that you know is only selling for half of what it should be is pretty hard without insider trading. . .

candymaldy

  • 5 O'Clock Shadow
  • *
  • Posts: 15
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #25 on: November 09, 2015, 10:04:36 AM »

I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.

Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.

Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.

Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.

Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.

There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.

But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.

Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.

But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...

http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2

This is a fair criticism.

In all of these projections, the conclusions are only as good as the assumptions used to project into the future.

Real estate ends up being a different flavor of investment, but it's pretty clear that indexing is easier and has been more profitable in the past.

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #26 on: November 09, 2015, 10:05:29 AM »
I suspect the big advantage real estate has over stocks is not so much the leverage, but rather an inefficient market.  If you really know your area and rent and purchase prices, and keep track of what comes on the market, you can buy that "half off" house, a short sale or fixer-upper.  Buying a stock that you know is only selling for half of what it should be is pretty hard without insider trading. . .

It depends. 

If you are planning to optimize your ROE then buying the house at a discount and selling quickly will be optimal.  If, however, you plan to hold the property long-term the leverage will dominate purchasing it at a discount.  You're not really getting leverage very easily on purchasing at a discount because the lender will generally use the lower of the purchase price or the appraised value for lending.  So the LTC and not the LTV will drive your financing setup.  You could get high-priced debt on the appraised value in situations where the appraised value exceeds the purchase price, but that would defeat the purpose of doing so.  You could also make the assumption that you'll refinance the discount portion later on after the note has seasoned for a year or two. 

Real capitalization rates for SFRs are probably in the 3-6% range absent a great purchase which can drive the yield well north of this.  With good positive operating leverage you'll be able to lever this well north of 12%.  The advantage of this leverage is that you don't have margin calls and it is long-term, fixed-rate FNMA (gov-mint coked) debt.  If you want to get really fancy you can purchased properties subject-to and eliminate personal liability too.

The reason people are going to talk past each other in this thread is because the model is inherently unstable because there are more variables than there are fixed items.  Hold period is a big one that you have to make an assumption on.  When you sell quickly people will claim "real estate is a job" and the whole conversation will go round and round arguing about what it means to have a job. 
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

clarkfan1979

  • Handlebar Stache
  • *****
  • Posts: 1509
  • Age: 38
  • Location: Kauai & Denver
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #27 on: November 09, 2015, 10:11:42 AM »
I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.

I think the math looks pretty good. He is usually industry standards. I don't agree with all industry standards because my property taxes, insurance and vacancy are lower than normal. I don't 100% agree with the 50% rule because I think there are ways to beat it. However, it is an industry standard.

Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.

This assumption looks good to me and is another industry standard. If anything, I would argue appreciation higher than inflation especially if you bought at the bottom in Las Vegas or Florida at the bottom of the market.

Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.

If you claim higher stock returns you need to understand that rental cash flow is also going into the stock market so it's not going to be that much different

Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.

He doesn't mention anything about 15 rental properties. The post is for people considering one rental property.

Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.

I don't understand this argument. This seems more like a personal attack.

There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.

You are both in agreement that houses win with leverage. If you don't have leverage then stocks win. I don't see a disagreement here. I think you are both in agreement.


But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.

This seems to be repeating an earlier point about dividends

Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.

This seems to be the same point about dividends again

But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...

His post doesn't say anything about Las Vegas and his numbers do not represent Las Vegas. He picked generic numbers that would work for many places across the United States


http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2

THank you for providing the article. I look forward to reading it.

I really like the simplified argument. If you have leverage, real estate typically wins. If you do not have leverage, then stocks win. It makes a lot of sense. Not because of the numbers posted in this thread, but because I also have similar spread sheets and have come to similar conclusions. It is supposed to be theoretical. The numbers are going to be very different if you apply it to a specific situation that we have all gone through.

I have never tried to respond to specific comments before. Hopefully people are able to read it.

[Mod Edit: Quote Tags fixed.]
« Last Edit: November 09, 2015, 10:55:32 AM by arebelspy »

BBub

  • Pencil Stache
  • ****
  • Posts: 865
  • Age: 32
  • Location: Deep South
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #28 on: November 09, 2015, 10:15:17 AM »
Interesting & fun scenario ARS.  1 beef & 1 question re: the methodology...

1. Beef.  Your example does not compare stocks to Real Estate.  It compares Stocks to a combination of Real Estate & Stocks... Perhaps a better methodology for the real estate scenario is to reinvest accumulated cash flow back into another house w/ the same parameters of 20% down, 2% closing fees, 50% costs, etc.  In the meantime while the cash accumulates, the money would grow risk free at the 3% inflation rate (a generous claim in today's environment, but one that could play out over the decades).  That way, you can purely compare a compounding stock portfolio to a compounding, leveraged real estate portfolio.

2. Question. Does the $1k annual gross income in the real estate scenario also inflate at 3%?  I didn't dive into the maths to check for myself.  It should IMO.


WerKater

  • Bristles
  • ***
  • Posts: 324
  • Location: Germany
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #29 on: November 09, 2015, 10:27:21 AM »
tl;dr The question was "What wins in the long run?"  The answer is: it depends on how good the real estate investment is.  At a 1% rule, it's pretty even between the two scenarios: Real estate wins over a 30 year timeframe, stocks win over a 50 year timeframe.  At a much better ratio, like 1.5%, real estate wins hands down, with over double the money of stocks.  At a worse ratio, naturally stocks would win.

Thoughts?  Math I screwed up?  Quibbles with assumptions?

I think your math is correct and it does make sense. It comes down to the exact numbers, however. All of the current has really been mentioned already, but I'd like to spell it our, mostly as an excercise for myself:

Your assumed real rate of return of the rental is 6% (12*500/100000).
Your assumed real rate of return of stocks is 7%.
If the real estate in the example were not leveraged, stocks would win over any timeframe.

If we take the leverage into account:
Getting 6% return on 100% of the price is 0.06; you are paying 4.5%*80%=0.036; so your actual rate of return on your 20% you invested from your own money (I think that is what fancy business types call "return on equity") is
  (0.06-0.036)/20% = 12%

So this the actual rate of return on your money in the rental case before you start paying it off. As you are paying off the loan, you are deleveraging and the rate of return goes down, converging against 6%. That's why the rental wins short-term and the stock win long-term.

As to the closing costs: In the very very short term, stocks would again win, but then none of us care about the very short term.

Telecaster

  • Pencil Stache
  • ****
  • Posts: 892
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #30 on: November 09, 2015, 10:28:28 AM »

Edit:  I see that he used 10% in the OP instead of 12% including dividends.  Carry on with the complaining.

 10% is fine for a back of the envelope calculation like this one.  Since 1929, the S&P including dividends has nominally returned 10% on average.  There have been fairly long periods of time when that number was higher or lower, but 10% is fine if we are taking a SWAG.   

The only problem I see with the calculation that one you pointed out:  The stock market and house appreciation returns assume inflation, but the rents don't. 

Not sure what  Bearded Man is going on about.   

Jack

  • Magnum Stache
  • ******
  • Posts: 4745
  • Location: Atlanta, GA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #31 on: November 09, 2015, 10:37:45 AM »
I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).

For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #32 on: November 09, 2015, 11:02:00 AM »
I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous.

Oh boy, I thought the math was straightforward..guess not.

I see 3 math criticisms in your post.

1:
Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.

Wrong.  You did not read closely/correctly.

I included both expenses and debt service.  The house rented for 1000/month. I put 50% towards expenses ($500), and used an amortization calculator to calculate $405.35 of debt service per month on an 80k loan at 4.5%.  That leaves $94.65 per month profit, or $1,135.80 annually.

2:
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.

Wrong. I used 3% nominal appreciation, which is 0% real for our assumed 3% inflation.  I used lower than that 0.08% you quoted.

3:
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.

This is the only potential criticism that's valid.  If you think 12% returns are what will happen going forward in the stock market, feel free to use those in the analysis, and tweak what variables in real estate you'd like as well.  I think 10% is reasonable, as Telecaster pointed out:
10% is fine for a back of the envelope calculation like this one.  Since 1929, the S&P including dividends has nominally returned 10% on average.  There have been fairly long periods of time when that number was higher or lower, but 10% is fine if we are taking a SWAG.
   

Further, since both are investing in stocks, it hurts both cases (though pure stocks more, obviously), plus not accounting for rent inflation should help cancel most of this out.

Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.

If I wanted to skew the numbers, I would have started with much better, not neutral assumptions.  Hell, if I wanted to skew the numbers, I wouldn't have to cherry pick them, but could just use my own.

I was trying to come up with a fairly neutral analysis. The point of my analysis wasn't to argue for one over the other.  I wrote my assumptions without knowing the outcome, just trying to make a neutral scenario to find out if someone in their mid-20s with a down payment would be better buying a single rental (assuming it was a reasonable deal, but nothing special), and then all stocks, or just going for stocks right away.  If the leverage alone made it worth it.

The only problem I see with the calculation that one you pointed out:  The stock market and house appreciation returns assume inflation, but the rents don't. 

Not sure what  Bearded Man is going on about.   

Yes, and the rent appreciation would only tilt it more towards RE.  Having realized I missed that after posting, and based on the conclusions that were drawn, it didn't seem worth redoing.

I think Bearded Man took offense at my first sentence, which wasn't even directed at him, and went on tilt.  Unfortunately he severely misread things, and his main two criticisms were both incorrect.

Bearded Man, I hope you can calm down, try not to take offense like someone is personally attacking you when trying to analyze real estate versus stocks, and actually read the analysis.  If you have any legitimate criticisms, great!  Feel free to post.  But vitriol won't help anyone.

Interesting & fun scenario ARS.  1 beef & 1 question re: the methodology...

1. Beef.  Your example does not compare stocks to Real Estate.  It compares Stocks to a combination of Real Estate & Stocks... Perhaps a better methodology for the real estate scenario is to reinvest accumulated cash flow back into another house w/ the same parameters of 20% down, 2% closing fees, 50% costs, etc.  In the meantime while the cash accumulates, the money would grow risk free at the 3% inflation rate (a generous claim in today's environment, but one that could play out over the decades).  That way, you can purely compare a compounding stock portfolio to a compounding, leveraged real estate portfolio.

Right.  I specifically didn't want to do that.  Most people aren't going to buy a home, then another, then another, and end up with a dozen.  It's just not something they desire to do.  But many would be willing to buy a single rental home, if it was worth it.  I attempted to look at if it was, or not.

Quote
2. Question. Does the $1k annual gross income in the real estate scenario also inflate at 3%?  I didn't dive into the maths to check for myself.  It should IMO.

No, that was the one math mistake, realized above:
http://forum.mrmoneymustache.com/real-estate-and-landlording/real-estate-returns-vs-stock-returns-the-maths/msg863755/#msg863755

That should tilt the analysis much more in favor of real estate.  I'm open to any other math criticisms, but that's the only valid one so far, and not a product of someone misreading something.

Your assumed real rate of return of the rental is 6% (12*500/100000).
Your assumed real rate of return of stocks is 7%.
If the real estate in the example were not leveraged, stocks would win over any timeframe.

Absolutely.  But since RE does have leverage, it was interesting to compare them.

I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).

For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

iamlindoro

  • Handlebar Stache
  • *****
  • Posts: 1522
    • The Earth Awaits
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #33 on: November 09, 2015, 11:15:42 AM »
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.

http://dqydj.net/sp-500-return-calculator/

The S&P index return since inception, including reinvested dividends, is 9.012%. If you only count the modern S&P 500 index (since 1957), you get 9.98%.  The numbers for the total market (dividends included) roughly match those S&P returns.

http://www.investopedia.com/walkthrough/corporate-finance/4/capital-markets/history-stocks-bonds.aspx?header_alt=false

Quote
Siegel also gives an average compound inflation-adjusted rate of return of 6.8% for the stock market from 1802 to 2002. He further notes, "A 6.8% annual rate of return means that if all dividends are reinvested, the purchasing power of stocks has doubled, on average, every ten years over the past two centuries."

Backing out the inflation adjustment, you get about 9.8% for the entire market.
Life is short. Save hard. Travel far.
http://frugalvagabond.com/
---------------------------------------
The Earth Awaits: The Custom Budget-building and Travel-Hacking Search Engine for World Travelers
https://www.theearthawaits.com/

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #34 on: November 09, 2015, 11:19:53 AM »
Cool.  I just picked 10%, mostly cause it was in the ballpark and a round number.  There's no reason one couldn't use 9%, or 12%.  Obviously these assumptions will way skew your results, so I was just trying to pick something "reasonable."  Glad to see history is pretty close to 10%, close enough that it shouldn't even really be a nitpick.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

Left

  • Handlebar Stache
  • *****
  • Posts: 1156
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #35 on: November 09, 2015, 12:01:13 PM »
I got another question
Quote
Right.  I specifically didn't want to do that.  Most people aren't going to buy a home, then another, then another, and end up with a dozen.  It's just not something they desire to do.  But many would be willing to buy a single rental home, if it was worth it.  I attempted to look at if it was, or not.
Where's the person living while they do this?

Sure I am investing in stocks now and living in my house... I'm not entirely sure I could "afford" to leverage another house, or are you saying that I could? And what bank is going to give 2 mortgages to someone with an average salary?

So if I am investing $500/month into stocks, I would transfer all of that into the rental payments for the duration of the mortgage? Then use the rents to buy stocks? It's a round about way, but the only way I could think of if I had to cover vacancies... and in the end $500 or so/month would be invested in stocks as long as there is a tenant. And if I lose job for some reason, I end up losing both houses? At least with stocks, I don't lose that portion if I am out of work...

Or are you referring to duplexes where the land lord is living in half of the house? It almost sounds like your real estate is a "free" meal, all the expenses is covered by the rent and you are only fronting the down payment/closing costs? But I'm fairly certain it isn't as risk free as you make it sound but I just don't know enough about it to put it to words.

if it is that risk free, want to mentor me in finding a local rental? :D
« Last Edit: November 09, 2015, 12:07:17 PM by eyem »

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #36 on: November 09, 2015, 12:15:52 PM »
I got another question
Quote
Right.  I specifically didn't want to do that.  Most people aren't going to buy a home, then another, then another, and end up with a dozen.  It's just not something they desire to do.  But many would be willing to buy a single rental home, if it was worth it.  I attempted to look at if it was, or not.
Where's the person living while they do this?

Wherever they were living before this.

I was presuming they have their living situation figured out.  I'm not going to decide buy versus rent for them.  But a Mustachian who comes out of college at 22, gets a job, decides to buy, or rent, and then after a few years they're 25 and wondering "Should I buy a rental, or not?" may find an analysis like this useful.

I'm not trying to decide their whole life--where they live, for example.  I don't know how they saved up the 22k for the down payment/closing costs.  My assumptions are much more simple than that.  :)

Sure I am investing in stocks now and living in my house... I'm not entirely sure I could "afford" to leverage another house, or are you saying that I could? And what bank is going to give 2 mortgages to someone with an average salary

Yes, probably.  It'll depend on your situation, check with a mortgage broker, but many people can qualify for a rental (or multiple) while owning a home.

So if I am investing $500/month into stocks, I would transfer all of that into the rental payments for the duration of the mortgage? Then use the rents to buy stocks? It's a round about way, but the only way I could think of if I had to cover vacancies... and in the end $500 or so/month would be invested in stocks as long as there is a tenant.

Not exactly.  The rental, being cash flow positive, should pay all of its expenses (via the assumed 50% rule), including setting aside reserves to cover the mortgage when there is vacancies.  So you'll get 1000/mo in rent.  $500 will go to expenses (insurance, repairs, property tax, property manager, setting aside money for capital expenses and vacancies, etc.), $405.35 will go to P&I, and $94.65 will be profit.  The $500/mo you're already investing in stocks is irrelevant--keep investing it!  It's not used to pay the mortgage, the rent is (and the reserves, when there's vacancies).

And if I lose job for some reason, I end up losing both houses? At least with stocks, I don't lose that portion if I am out of work...

No, the rental is cash flow positive, so if you lose your job it pays for itself and helps pay for your other expenses.

Or are you referring to duplexes where the land lord is living in half of the house? It almost sounds like your real estate is a "free" meal, all the expenses is covered by the rent and you are only fronting the down payment/closing costs? But I'm fairly certain it isn't as risk free as you make it sound but I just don't know enough about it to put it to words.

No, I didn't mean living in part of it. Hope the above cleared up some of your confusion.  :)

Quote
if it is that risk free, want to mentor me in finding a local rental? :D

I don't know if your local area is good or not.  You may want to look into the numbers, and if it's not, also consider investing outside your area.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

Jack

  • Magnum Stache
  • ******
  • Posts: 4745
  • Location: Atlanta, GA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #37 on: November 09, 2015, 12:45:37 PM »
I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).

For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.
[this space intentionally? left blank]
What happened? Did you start to respond but then changed your mind?

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 26153
  • Age: -999
  • Location: Traveling the World
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #38 on: November 09, 2015, 12:51:12 PM »
What happened? Did you start to respond but then changed your mind?

That is exactly what happened!  I was going to opine, but then realized I didn't have enough knowledge or data for that particular question (or rather, I might, but I'm not confident enough to be sure), so decided not to just guess.  :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with a kid.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #39 on: November 09, 2015, 01:19:29 PM »
The tax shelter impact of real estate investing is ridiculously complicated.  After $150k you lose out on many things unless you can structure your affairs properly to be able to play the tax maze game.   For instance, my wife is a 50% owner in our operations business and thus we can call these "passive gains" which can then be offset by passive losses.  Modeling this is necessarily going to be situation-specific and it would be very hard to model precisely in all scenarios. 

However, this is the tail wagging the dog.  Your goal should be maximal after-tax profits; not minimal taxes.  Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return. 

For those worried about down payments there are techniques to purchase distressed sales for very little (or no) money down.  It isn't easy to find good projects like this, but they do exist.  Since this thread is centered around non-exotic topics though I won't elaborate or sidetrack it. 
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

Jack

  • Magnum Stache
  • ******
  • Posts: 4745
  • Location: Atlanta, GA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #40 on: November 09, 2015, 01:38:02 PM »
However, this is the tail wagging the dog.  Your goal should be maximal after-tax profits; not minimal taxes.  Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return. 

That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #41 on: November 09, 2015, 01:43:56 PM »
However, this is the tail wagging the dog.  Your goal should be maximal after-tax profits; not minimal taxes.  Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return. 

That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The tax benefits are small from holding real estate because it has to be amortized straight-line over 27.5 years for residential projects unless you do a chattel appraisal or some such. 

Your question/point really has more to do with trading off contributions to tax-advantaged accounts with purchasing leveraged real estate though.  One thing I will point out is that you can set up a SoloK or other retirement construct (SEP, etc.) and purchase rentals with it.  There are tax considerations like UDFI to account for if you leverage the project with non-recourse loans. 

I'm too lazy to do a full analysis, but there is really no reason you can't do both if you invest effort in learning to purchase real estate with seller financing.  This is obviously more work, but if you do so you can use the AND operator instead of the OR operator when analyzing stock indexing and real estate investment. 
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

Telecaster

  • Pencil Stache
  • ****
  • Posts: 892
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #42 on: November 09, 2015, 02:37:04 PM »
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.

The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.   

There are any number of real estate investment calculators online.  Google one up and punch in your own set of numbers and compare it to your personal situation.   

beltim

  • Magnum Stache
  • ******
  • Posts: 2746
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #43 on: November 09, 2015, 02:49:02 PM »
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.

The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.   

There are any number of real estate investment calculators online.  Google one up and punch in your own set of numbers and compare it to your personal situation.

In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance.  Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor. 

The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.

Cheddar Stacker

  • Magnum Stache
  • ******
  • Posts: 3760
  • Age: 39
  • Location: USA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #44 on: November 09, 2015, 03:15:14 PM »
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.

The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.   

There are any number of real estate investment calculators online.  Google one up and punch in your own set of numbers and compare it to your personal situation.

In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance.  Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor. 

The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.

The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:

1) Sell the property for a loss.
2) Die.

Neither is a good tax planning mechanism.

The short answer to Jack's question is, much like comparing real estate returns to stock market returns, you are comparing apples to cell phones. They're very different. There are many variables making the comparison difficult, and situational. If you must choose one over the other strictly from a tax planning viewpoint for a mustachian, I see more benefit in the 401K tax deferral than I do the real estate investment tax benefits.

That's not intended to argue for Stocks rather than Real Estate. That's a separate issue and I align more with the Real Estate argument. I'm merely referring to the tax benefits of each. And this is a generic, 10,000 foot level view. Not one size fits all.
Indecision may or may not be my problem.

beltim

  • Magnum Stache
  • ******
  • Posts: 2746
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #45 on: November 09, 2015, 03:20:10 PM »
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.

The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.   

There are any number of real estate investment calculators online.  Google one up and punch in your own set of numbers and compare it to your personal situation.

In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance.  Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor. 

The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.

The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:

1) Sell the property for a loss.
2) Die.

Neither is a good tax planning mechanism.

Does dying actually avoid depreciation recapture?  I.e. does the basis get re-set as of date of death for heirs?

Cheddar Stacker

  • Magnum Stache
  • ******
  • Posts: 3760
  • Age: 39
  • Location: USA
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #46 on: November 09, 2015, 03:33:50 PM »
The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:

1) Sell the property for a loss.
2) Die.

Neither is a good tax planning mechanism.

Does dying actually avoid depreciation recapture?  I.e. does the basis get re-set as of date of death for heirs?

It can. Again, individual circumstances will dictate this. With proper estate tax planning, the answer is yes. When someone dies holding ownership in real estate, or a business, or whatever, the heirs can make a 754 election commonly referred to as a step-up in basis.

The Bush tax cuts created a strange anomaly. All the estate planning professionals starting telling people they should plan to die in 2010. There was no estate tax. This is when George Steinbrenner died. So his $1B inheritance from the NY Yankees was not hit with any estate tax. The flip side of that coin: his heirs were not eligible to make a 754 election, so his cost basis carries forward to them.

When you make a 754 election, you get the FMV at date of death as your basis. The difference between that and the cost basis held by the decedent is taxable income to the estate. As long as you remain under the $5.X million lifetime exemption, this completely avoid the depreciation recapture tax.

Some people continually utilize the 1031 exchange rules (like-kind) which is tax deferral. However, if you combine that with the 754 election upon death, it becomes a valid tax avoidance strategy.
Indecision may or may not be my problem.

beltim

  • Magnum Stache
  • ******
  • Posts: 2746
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #47 on: November 09, 2015, 03:44:02 PM »
The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:

1) Sell the property for a loss.
2) Die.

Neither is a good tax planning mechanism.

Does dying actually avoid depreciation recapture?  I.e. does the basis get re-set as of date of death for heirs?

It can. Again, individual circumstances will dictate this. With proper estate tax planning, the answer is yes. When someone dies holding ownership in real estate, or a business, or whatever, the heirs can make a 754 election commonly referred to as a step-up in basis.

Fun!  Thanks for the info.

mr_orange

  • Handlebar Stache
  • *****
  • Posts: 1115
  • Age: 38
  • Location: Round Rock, TX
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #48 on: November 09, 2015, 04:31:55 PM »
Well....if you continually defer taxes until you die and exchange for larger properties you never have to pay the recapture tax.  This situation really isn't deferral in that case.  It just necessitates that you keep your equity accumulated in like-kind investments which could generate levered returns in excess of what index funds will generate as this thread shows. 

Claiming that dying is the only way to avoid the tax is correct, but covers up the idea of continually exchanging combined with refinancing can give you access to the equity tax free. 

Edit:  Here is an article from BP on this for anyone interested in learning more about navigating this tax game:

https://www.biggerpockets.com/renewsblog/2014/08/21/strategy-take-cash-1031-exchange-tax-free/
« Last Edit: November 09, 2015, 04:50:00 PM by mr_orange »
12/30/16                                       06/30/17
Fire Totals:                                   Fire Projections:
-$7k/month - 68.1% Funded             86.1% Funded
-$8k/month - 59.6% Funded             75.4% Funded
-$9k/month - 53.0% Funded             67.0% Funded
-$10k/month - 47.7% Funded           60.3% Funded

-Calculus gives speculation the deceptive guise of investment ~Benjamin Graham
-The future ainít what it used to be ~Yogi Berra

Telecaster

  • Pencil Stache
  • ****
  • Posts: 892
Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #49 on: November 09, 2015, 04:47:07 PM »

Does dying actually avoid depreciation recapture?  I.e. does the basis get re-set as of date of death for heirs?

It does for you.  You're dead  :)