Author Topic: Real Estate Returns vs. Stock Returns: The Maths  (Read 31220 times)

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #50 on: November 09, 2015, 08:03:38 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/

So I agree with you, but just so we're all clear on what's going on here:

Every like kind exchange decreases cost basis of the next purchase. Every decrease in cost basis decreases depreciation. Every decrease in depreciation increases annual taxes at your marginal rate.

So you won't technically pay depreciation recapture, but it's very possible you will pay additional annual taxes if you do this a lot. If you make a lot of money, you could be paying well in excess of the 25% rate each year because of this.

Even if you 1031 until you die, then your heirs 754, you aren't avoiding all the taxes.
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #51 on: November 09, 2015, 08:33:29 PM »
Every like kind exchange decreases cost basis of the next purchase. Every decrease in cost basis decreases depreciation. Every decrease in depreciation increases annual taxes at your marginal rate.

So you won't technically pay depreciation recapture, but it's very possible you will pay additional annual taxes if you do this a lot. If you make a lot of money, you could be paying well in excess of the 25% rate each year because of this.

Even if you 1031 until you die, then your heirs 754, you aren't avoiding all the taxes.

I'm not sure that this is correct.  Perhaps you can use an example to illustrate what you're claiming. 

There are several things happening here.  Why could one not exchange for a property that is MUCH more valuable and still get plenty of adjusted basis for depreciation and thus an increase in tax shields?  Your claim above is that every like-kind exchange decreases cost basis on the next purchase.  Is this what you meant to claim? 

Another problem with the absolute assertions above is that your tax situation may change year to year.  As a business owner I know my income is lumpy and some years I have far more passive income to offset with passive losses and/or suspended losses.   

I wasn't claiming you'd avoid ALL taxes, but you certainly should be able to avoid the recapture tax if you do things properly.  Avoiding the marginal federal taxes year-to-year is a complicated game with many pieces, some of which are dependent on systemic things going on in the economy that drive banner years. 
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

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #52 on: November 09, 2015, 08:52:24 PM »
We're waaay off topic, but I don't think rebs will mind since he's an RE investor. I'm typing on a phone so this will be choppy/imperfect.

It's correct. At least what I'm attemting to write is correct. It might not be coming accross properly. Example:

Buy 100,000
8 yrs of depreciation (~3,600/yr) ~30,000
Sell 125,000
Gain 55,000
1031 exchange
Buy 160,000
Less rolled in gain 55,000
Cost basis 105,000
Annual Depreciation ~4,000

Depreciation is higher. So is cost basis. I wasn't trying to say your cost basis would be lower compared to the old property, I was trying to say it would be decreased by the deferred gain. Every year your depreciation will be lower with a 1031 exchange than it would be without it (if you'd paid the tax rather than rolling the gain). So you pay some tax at marginal rates as a result of decreased basis.

Yes you might not pay every year due to offsetting passive losses. But the effect still increases taxes at some point through current taxes, reduced passive loss carryovers, etc.
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #53 on: November 09, 2015, 09:57:07 PM »
I'm pretty tired so maybe I am missing something, but why not just buy another asset worth $500k instead of $160k?  Sure, your cost basis will be lower than it would be absent exchanging, but your depreciation will be much higher from buying a more expensive asset. 

I read your second paragraph several times, but I am not following the logic.  Sure, if you compare the cost basis with and without exchanging you can claim this is "extra" in marginal rates absent other variables.  However, you'll have more depreciation if you purchase a higher-priced asset and thus higher tax shields.  Thus you're better off than you would be absent the higher-priced asset. 

Your last paragraph is the one I am not following.  Higher tax shields equals less in taxes overall.  You may be paying more than you would absent the basis adjustment, but it is still less than you would without the asset you exchanged to.  I'm not sure how you get an increase out of this logic. 
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

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #54 on: November 09, 2015, 10:13:10 PM »
It comes down to this simple fact: you are buying something and reducing your cost basis by the deferred gain. Buy a new one for $10M, it really doesn't matter. Whatever the new cost, it will be reduced by the pior deferred gain. Therefore, the deferred gain reverses itself by 1/27.5 every year. It's deferral, not avoidance, and that's the point I'm trying to make.
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #55 on: November 09, 2015, 10:29:24 PM »
I get that you're trying to make the point that it is deferral, but it doesn't make sense.  If you defer it forever by exchanging to higher-priced assets you'll get more in tax shields and thus less in taxes as compared with either selling or not having the asset to begin with.  Thus by definition an indefinite deferral that gives you higher tax shields for your lifetime means you don't pay any taxes at all.  This is avoidance entirely; not deferral. 

You'll also pay less in taxes over the course of your lifetime by owning the assets and thus you'd need to count this "extra cash" as accretive to your overall wealth.  Each year you'd be able to contribute more to your investment vehicle of choice and this would need to be added to what you are gaining by selecting to invest in real estate instead of index funds. 
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

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #56 on: November 09, 2015, 11:38:01 PM »
Cheddar's point, as I understand it, is you're taking less depreciation on the new asset than you would be if you bought it outright, due o the decreased basis from the 1031, so you're in essence paying on that tax deferred.

Compare the amount of taxes paid (and depreciated) from someone who bought a 5MM property versus someone who rolled into one via 1031.  Since the person who rolled into it has a lower basis, their amount of depreciation taken is lower, meaning they pay more taxes overall on the new property.  Those extra taxes?  They're essentially undoing the taxes you saved, (this is the 1/27.5/yr CS mentioned), so you deferred them TO THAT POINT, but didn't totally eliminate them (by being able to 100% defer, then leave to heirs on a stepped up basis).

Does that make more sense?

CS, let me know if I got that right, cause your point was brand new to me, and pretty revolutionary--I had always thought what mr_orange is arguing, that you're totally deferring it, but it seems not, based on your point, which makes sense to me when I think about it as a comparison of two identical properties--the 1031 reducing the basis leads to less eligible depreciation on the next one, meaning you're paying more taxes on that, undoing the less taxes you paid earlier.
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Radagast

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #57 on: November 10, 2015, 12:49:50 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.
There are two general ways to forecast future returns for the broad stock market (add inflation for both if you don't want to calculate the real return, it would make the numbers look bigger) :
1) return = current dividend yield + growth
Right now it is about 2%+ 2% = 4%, or a little less.

2) return = 10-year averaged earnings / price
1 / 26 = 4%, or a little less

Both estimates show a little under 4%. Expecting anything more than 4% from US stocks right now is speculative.  Obviously the actual return will be completely different every year, but a 12% US stock return starting today is an optimistic assumption for the next 30 years. In the past dividends were higher, growth was higher, and prices were relatively lower, which is why 12% was true in the past. I think this makes real estate look attractive right now.

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #58 on: November 10, 2015, 05:19:59 AM »
Isn't the higher ROI in RE essentially compensation for the higher risk?  When you are leveraged, you are exposed to a higher risk since you have to repay the mortgage regardless of whether you have a tenant or a Detroit scenario reduces the rent you can get for your property.  If things go really south you could go bancrupt.

When you are long in stocks, assuming a standard investment portfolio without borrowing etc, your stocks will never be able to cause you to go bancrupt.  You have less exposure to risk and therefore lower ROI.

We learned in 2008 that real estate doesn't "always go up", and what overleveraged real estate can do to your net worth.  Your stock portfolio doesn't cost money to own, even if it is way down.  So you can simply sit on your portfolio until the market goes back up.  That proved to be an excellent strategy from 2008 until now.  Real estate costs money to own.  So cash flow is necessary just to keep owning it.  That is true whether the property is rented or not.  Or whether the tenant trashes the place or not.  You should be compensated for taking on that additional risk.  The theoretical example proposed by OP shows that it is.

Left

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #59 on: November 10, 2015, 06:05:30 AM »
2008 doesnt make a hard argument against rentals though. it was the home buyers that got hit, i dont remember rents dropping to $0... even the people who had to leave their homes, they ended up renting until they couldnt do that either... but the landlords didnt give them free housing

the biggest hit to them would be the house value not the cash flow... i think, i could be wrong but it sounded like that was what they said over on bigger pockets

mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #60 on: November 10, 2015, 06:07:56 AM »

Does that make more sense? paying more taxes on that, undoing the less taxes you paid earlier.

I understand the point CS is making, but I don't understand how this reduces your tax shields relative to what you had when you owned the asset you exchanged from if you purchase the correct asset to exchange to.   Sure, your cost basis is higher, but so is your asset value and thus your tax shields are bigger; thus lower taxes in future years assuming you can take the passive losses. 

If you continue trading up in asset prices and you eventually die you never pay higher taxes and thus you have eliminated the tax entirely; not deferred 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

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #61 on: November 10, 2015, 08:19:13 AM »
Ok, back at my desk and with a clear head.

Rebs summarized it pretty well and he gets it; glad I was of some help. It sounds like mr_orange get's the basic point I'm making:

I understand the point CS is making

So, on to this part:

, but I don't understand how this reduces your tax shields relative to what you had when you owned the asset you exchanged from if you purchase the correct asset to exchange to.   Sure, your cost basis is higher, but so is your asset value and thus your tax shields are bigger; thus lower taxes in future years assuming you can take the passive losses. 

If you continue trading up in asset prices and you eventually die you never pay higher taxes and thus you have eliminated the tax entirely; not deferred it. 

I'm not sure what you mean by tax shields, and I know a little about tax. Is this a real estate term? Are you just referring to deductions? Shielding your positive cash flow with deductible losses?


Let me liken this to the mortgage interest deduction, of which I'm a huge fan. People often argue you shouldn't pay off your mortgage because you'll lose a tax deduction. That's a silly argument, and it's not why I keep my mortgage (You can read about that in 100 places on this forum). What those people are petitioning for is to pay $1 to save $0.25.

When you buy a more expensive property, you obviously pay more money for it. Hopefully that yields higher returns. For now let's leave that out of the equation, because we're already muddy enough. When you 1031 from $100,000 purchase, to $200,000 purchase, to $400,000 purchase, to $600,000 purchase you are likely not paying any depreciation recapture as a one time expense. Your tax deductions will continue to rise, but so will your deferred gain each time.

After doing this many times for many years you will likely end up spending $5M on a property, and then taking $3M worth of depreciation over the final 27.5 years presuming you hold your final property for that term and die anytime after that.

I'm going to attempt a quick spreadsheet detailing this and post here. Maybe that will help.

I'm all for 1031 exchanges. The alternative is a big cap gain and depreciation recapture tax. Proper tax planning can do wonders. I just don't want people to think the 1031 doesn't have an affect on your annual tax return; it does. It's just a slow bleed from a gut shot rather than a grenade.
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Fishindude

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #62 on: November 10, 2015, 08:47:45 AM »
Here is a real world example.
I purchased 100 acres of farm real estate 25 years ago for $75,000.  It's now easily worth $650,000
It has kicked me back approx. $6000 annually (after taxes) all that time, totaling $150,000
So I turned $75,000 into $800,000 in 25 years with real estate.

By my math, that same amount invested would need to consistently have yielded a 10.25% return to do the same.
Could that have been done with stocks ..... maybe?


Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #63 on: November 10, 2015, 09:07:45 AM »
Here's a spreadsheet showing what I'm talking about.

I don't know you mr_orange, so I don't know your plan. I read a little of your journal a few months back, and if I remember correctly you are going big, very big. This model might not fit what you're doing. Adjust accordingly if need be, but this is a valid strategy I've seen clients use: sell every 7 years.

What you'll notice, particularly once a gain gets rolled into a new property twice, is the cost basis and related depreciation is substantially reduced by the deferred gain. Your depreciable base is diluted. You may still have losses, particularly if you go more aggressive and buy at higher prices. However, the rolled up gain still reduces that basis, and reduces your depreciation accordingly.
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #64 on: November 10, 2015, 10:09:10 AM »
However, the rolled up gain still reduces that basis, and reduces your depreciation accordingly.

To me this is the key.  I don't think we're disagreeing on anything other than the strategy.  I'm saying that you continue buying bigger properties and getting more basis to depreciate and thus I am not losing this paper expense to shield my taxes.  In fact, it gets bigger with each purchase if done properly. 

You're saying that each time you exchange that which you can depreciate relative to purchasing for cash is reduced.  That's fine, but my goal is to increase my depreciation expense that shields passive income with passive losses. 

So the answer to me is that it depends.  That is why this comparison exercise is difficult.  It depends on what you're doing.  Depreciation is really a small benefit as compared with the inexpensive leverage and inflation hedging.  So maybe we should agree that we're looking at things differently and move on ;-)
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

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #65 on: November 10, 2015, 10:12:04 AM »
So maybe we should agree that we're looking at things differently and move on ;-)

I can't agree to that! (Sorry, Simpsons quote).

Yeah, we are just looking from different angles here. We both understand what's going on.

Hopefully the banter helped someone.
Indecision may or may not be my problem.

Left

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #66 on: November 10, 2015, 11:13:54 AM »
Quick question that might sway this in investor's favor...
You have many rentals and know what to look for...

If your example, the guy only wants one rental... how likely is he to make the best choices in it if he is the new to it? What kind of missteps do people take with first rental?

It seems easier to dig a bigger hole with rental than putting into a total index. Higher learning curve + leverage...

This would be me being so hesitant on rentals... I don't know what could go wrong
« Last Edit: November 10, 2015, 11:29:54 AM by eyem »

Jack

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #67 on: November 10, 2015, 11:49:46 AM »
So maybe we should agree that we're looking at things differently and move on ;-)

I can't agree to that! (Sorry, Simpsons quote).

Yeah, we are just looking from different angles here. We both understand what's going on.

Hopefully the banter helped someone.

It helped me! (Well, sort of; I can't claim I grok it yet.)

However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?

mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #68 on: November 10, 2015, 11:58:55 AM »
Quick question that might sway this in investor's favor...
You have many rentals and know what to look for...

If your example, the guy only wants one rental... how likely is he to make the best choices in it if he is the new to it? What kind of missteps do people take with first rental?

It seems easier to dig a bigger hole with rental than putting into a total index. Higher learning curve + leverage...

This would be me being so hesitant on rentals... I don't know what could go wrong

These are very valid points.  You have to assume that the purchaser knows what they're doing and most people won't when they get started.  So to me this is the most valid reason to select index funds of those that are presented in this thread. 

Another issue with purchasing rentals is that sourcing the right ones takes a lot of work or access to insiders that can help you do it for a fee of some sort.  People that are new to the game are unlikely to have either of these.   
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

mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #69 on: November 10, 2015, 12:07:09 PM »
It helped me! (Well, sort of; I can't claim I grok it yet.)

However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?

At some point you'll likely need properties with higher density or commercial properties to keep the tax shields.  Note that commercial properties are generally depreciated over 39 years instead of 27.5.  Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory.  It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion. 

The upside is that the denser properties are probably going to give you better yields with level leverage assumptions.  Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it.  The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years. 
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

Cheddar Stacker

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #70 on: November 10, 2015, 12:41:06 PM »
It helped me! (Well, sort of; I can't claim I grok it yet.)

However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?

At some point you'll likely need properties with higher density or commercial properties to keep the tax shields.  Note that commercial properties are generally depreciated over 39 years instead of 27.5.  Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory.  It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion. 

The upside is that the denser properties are probably going to give you better yields with level leverage assumptions.  Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it.  The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years.

One other note related to your question Jack: You MUST upgrade to completely avoid tax. You have to buy a property for higher than the rolled up gain. You have to obtain a mortgage bigger than your current mortgage. If you don't, at least part of the gain becomes subject to tax. You could also do multiple properties, and have multiple 1031's. You could buy 1 property/year, then in year 7 sell 3 of those 7 and roll up the gain from those 3 into a single larger property.
Indecision may or may not be my problem.

Jack

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #71 on: November 10, 2015, 02:46:12 PM »
At some point you'll likely need properties with higher density or commercial properties to keep the tax shields.  Note that commercial properties are generally depreciated over 39 years instead of 27.5.  Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory.  It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion. 

The upside is that the denser properties are probably going to give you better yields with level leverage assumptions.  Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it.  The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years.

Oh, I get it! I was thinking in terms of switching to nicer and nicer single-family houses but you're talking about switching to apartment complexes with more and more units. That makes more sense, then.

mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #72 on: November 10, 2015, 02:51:12 PM »
Yes....apartments or other projects like single-tenant NNN leased buildings, retail space, etc. 
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

markbrynn

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #73 on: November 12, 2015, 03:02:58 AM »
Quote
ēYour interest rate is 4.5%, so your P&I payment on 80k for 30 years is 405.35 monthly.
ēYou will put down 20% (20k), and finance 80% (80k), and pay 2k closing costs.  No PMI.
ēInflation runs 3%, and the house appreciates at the rate of inflation.
ēStocks return 7% real, so 10% including the 3% inflation.

I looked over the assumptions you made and could come up with one possible inconsistency. Your interest rate is 4.5% and the inflation rate is 3%. When I checked some historical data (quickly searched online) it seems like those numbers don't occur at the same time. Inflation is close to zero at the moment and interest rates are just under 4.5%. A quick look at years when inflation was around 3% show interest rates between 6 and 9%.

I don't know how this will affect the final numbers in your calculation (I imagine it will hurt the case for owning the rental), but perhaps something to consider.

For what it's worth, I'm a firm believer that people should be careful not to assume too easily that owning a house (whether you rent it out or not) is a good investment. In many case it can be a fantastic investment, but just because in many US markets (which have been strongly growing markets) it has been a good investment, doesn't mean that it will be always or everywhere. Success stories tend to be shared more readily than failures.

Thanks for the work on the simplified calculation. These are helpful for understanding the trade-offs.

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #74 on: November 12, 2015, 04:34:42 AM »
I agree that those don't happen together historically traditionally, however the reason why I used those is because you're locking in a 30 year fixed loan, and that's the current rate.  Yet for inflation, our calculations are for the next 30 years and 50 years.  Even if inflation is about 0% now, while that loan rate is locked in, do you think there will be 0% inflation over the next 30 years?  0% over the next 50 years?  I think 3% is a reasonable guess for inflation over the next 30 or 50 years.  I actually think it could be higher, which would help the real estate numbers, but I don't think it will be below 3% for that whole time period.

It's just an artifact of our rates being low now, but being able to lock them in for a long time period, while there will be inflation over that long time period.

Does that reasoning make sense?
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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #75 on: November 12, 2015, 06:09:27 AM »
Since leverage is the dominant component of why real estate tops stocks the fact that debt is historically cheap right now is a big deal.  One could argue that the asset prices are higher now because of this, but I am not sure how much this really matters when developers are putting new product into service. 
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

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #76 on: November 12, 2015, 06:32:00 AM »
Since leverage is the dominant component of why real estate tops stocks the fact that debt is historically cheap right now is a big deal.  One could argue that the asset prices are higher now because of this, but I am not sure how much this really matters when developers are putting new product into service.

I agree.  Also, as long as the numbers make sense and it cash flows at a return one is happy with, it doesn't matter if asset prices are higher than they theoretically "should be."
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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #77 on: November 13, 2015, 09:27:55 AM »
Does your assumption include the investor increasing his contributions (the P&I 405.35/month) to the stock market after the mortgage(30yr) is paid off? Or what does he do with the $405.35 after 30yrs?
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arebelspy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #78 on: November 13, 2015, 10:51:35 AM »
Does your assumption include the investor increasing his contributions (the P&I 405.35/month) to the stock market after the mortgage(30yr) is paid off? Or what does he do with the $405.35 after 30yrs?

Dammit!  Great catch.

No, so that's another factor I missed, that's in favor of the RE scenario.
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Bearded Man

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #79 on: November 13, 2015, 11:10:26 AM »
Here is a real world example.
I purchased 100 acres of farm real estate 25 years ago for $75,000.  It's now easily worth $650,000
It has kicked me back approx. $6000 annually (after taxes) all that time, totaling $150,000
So I turned $75,000 into $800,000 in 25 years with real estate.

By my math, that same amount invested would need to consistently have yielded a 10.25% return to do the same.
Could that have been done with stocks ..... maybe?

Only read a couple of posts but, Yes, If you had invested in a single stock called Microsoft, you'd be a billionaire probably. You're comparing real estate picking to stock picking. There's a lot of real estate that people bought 25 years ago in a city called Detroit. What do you suppose that is worth now?

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #80 on: November 13, 2015, 12:27:58 PM »
I'll keep playing, please feel free to poke holes in this...

going by your OP...

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

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

After 30 years,
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 3% return, you get $14,563 per year profit in rent.
(Assumes 1%, or $2,427/month rent gross, and 50% expenses)

But, if the house/rent senario, you assume you never have to touch your principal (house) but the stock senario (4%swr) assumes you do/might have to.

Thoughts???
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arebelspy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #81 on: November 13, 2015, 12:37:21 PM »
I'll keep playing, please feel free to poke holes in this...

going by your OP...

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

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

After 30 years,
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 3% return, you get $14,563 per year profit in rent.
(Assumes 1%, or $2,427/month rent gross, and 50% expenses)

But, if the house/rent senario, you assume you never have to touch your principal (house) but the stock senario (4%swr) assumes you do/might have to.

Thoughts???

Good idea for the comparison, but you forgot about all the rents received along the way.  So those rents, which totaled an extra $186,832.31 (and that was with my mistake of not increasing them yearly, it'll actually be much more than that).. taking 4% SWR of that investment, $7,473.29, and adding it to the rents, you're at:
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 1% and 50% rule for the house, you get $14,563 per year profit in rent + $7,473.29 from 4% of the rent stache = $22,036.29 annually. (or about 44% higher than the stock 4% WR scenario).

Plus, yes, the stability of rents and less sequence of returns risk (assuming proper reserves).
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Dr. Pepper

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #82 on: November 13, 2015, 10:45:27 PM »
1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.

2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.

Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.

undercover

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #83 on: November 14, 2015, 04:56:59 AM »
1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.

2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.

Returns are returns, no? I don't care if I'm using leverage or margin, both are simply tools. What matters isn't how you finance the deal, it's what the returns are. Where can I put my money to make the most amount of money back?

Most people only correlate risk with reward. Reward truly comes from both risk AND work. Real estate returns are generally higher not because of leverage alone, but because there is considerably more work involved than simply investing in index funds. One is remiss to not calculate their time and work spent into their "rewards"/yields. I think there are many investors out there who obviously have control over their stock holdings, Warren Buffett being the most notable example. I think with both stocks and real estate, there are things you can control and things you can't. So I guess the more appropriate comparison is individual stock picking and individual house buying, since I think there is a level of control to both (and plenty of things you can't control in both).

Anyway, I think most small time investors are perfectly justified in comparing real estate to indexes, since both are in the realm of understandability until you start to add in lots of business knowledge specific to starting a business or stock picking. I do definitely consider owning rental property to be a business, but it's probably one of the simplest and most straight-forward, something nearly anyone can understand.
« Last Edit: November 14, 2015, 05:13:21 AM by undercover »
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #84 on: November 14, 2015, 05:15:39 AM »
Nice post Undercover. 

Yes, the investments are very different in their nature.  Comparing real estate levered to a stock or index levered is apples and oranges as well because the nature of the leverage is very different.  One set requires margin calls, mark to market, etc.  The other is fixed-rate, long term, and government subsidized both from a rate perspective and with depreciation to shield taxes.  Thus the margin accounts impute significantly more risk daily than that of real estate leverage. 

Real estate also has significant transfer or exchange costs ("transaction costs") and is not traded by supercomputers on standardized exchanges.  Thus the ability to exploit market inefficiencies is far greater when sellers need access to liquidity in a hurry. 

For the average small investor that takes the time to understand real estate I think that they can make far more over the long haul than they can with indexing.  The time component should include not only the time spent sourcing deals, but all of the extra time and effort spent learning and putting a given strategy into practice in a given market.  The extent to which this is job-like depends on the person and the strategy employed.  Most of the people I know that are successful at finding projects consistently below market do spend a lot of time on these activities and thus it is fair to consider this more of a business.  However, the example herein does not rely on the ability to find a project below market and thus these criticisms carry less weight for this thread. 
« Last Edit: November 14, 2015, 05:17:31 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

monarda

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #85 on: November 14, 2015, 09:56:25 AM »
Thanks for this thread.

The point that I'm taking home is that the returns are not all that different. We choose to do the extra work that real estate entails because of the feeling of control. We can control who we select as tenants. We can control the rent we charge and the upgrades to choose. We can control in which neighborhoods we choose to buy. It's a feeling of comfort. Sure there is risk, but we can do something to manage it. We're much better at screening tenants now.  Wall Street is out of my control, so I don't like that feeling. That has value for us. So, that's why we're 80% real estate and 20% index funds.

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #86 on: November 14, 2015, 01:29:49 PM »
1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.

Because equities typically don't come with leverage, and real estate typically does.  Real estate leverage is much more common (many more people will get mortgages than margin loans), and is much safer--there is no margin call on a mortgage.  Pay your minimum payment, and you're good.

The reason this comparison is made is NOT because it's apples-to-apples.  It's because it's the choice people often make.

The scenario in the OP was someone in their mid-20s with a chunk of cash saved up (22k) who's wondering if they should buy a rental or invest in stocks.  This is a very common scenario, and we see people on here all the time wondering if they should get a rental.

That is the comparison they're making, and that's why it's comparing these two. Not because they're the same, but because they're different, and the person is wondering which is better.  That's a larger question than just the money aspect, but this attempts to show some numbers to help think through the scenario monetarily.

2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.

Absolutely.

Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.

Starting a business comes with a lot more paperwork, legal and financial filings, etc.  You should treat your RE like a business, and be professional towards your tenants, but having a rental property is nowhere near the work a business is (not to mention the fact that it may only take you a few minutes a month, a far cry from most businesses).

Your objections are valid, but not the point of this thread.

Someone in their mid-20s looking to invest isn't going "should I start a business?".  They aren't saying "REITs or stocks?" (well sometimes they are, but that's a more straightforward question).  They're asking "is a rental right for me"? 

And they need to look into if they want to be a landlord.  If they want the extra work.  But they also want to know the math on which is better.  Even if stocks aren't apples-to-apples.

Does the comparison make sense now?  :)
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cheddarpie

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #87 on: November 18, 2015, 09:46:51 AM »
Thanks for this analysis! I am responding mostly just to follow, but also a question. How do you factor in the cost of PAYING rent if you don't own a home? Where I live, my mortgage is under $1500 but to rent a comparable place would be about $3500/month (which raises a very good question about whether I should be renting my place out and living somewhere else, but that's not on the table right now...). This additional amount is money I can invest now, but couldn't if I didn't own my home.

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #88 on: November 18, 2015, 09:51:48 AM »
Thanks for this analysis! I am responding mostly just to follow, but also a question. How do you factor in the cost of PAYING rent if you don't own a home? Where I live, my mortgage is under $1500 but to rent a comparable place would be about $3500/month (which raises a very good question about whether I should be renting my place out and living somewhere else, but that's not on the table right now...). This additional amount is money I can invest now, but couldn't if I didn't own my home.

That's a totally different question..and whether or not you should buy vs. rent has a lot of different factors, monetary and non.

I prefer the NYT Buy vs. Rent calculator for the monetary aspects of it.

http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #89 on: November 18, 2015, 10:27:11 AM »
That's not my question, or at least I didn't intend it to be. Let's say I have $300k to invest. I can buy a house and live in it for almost-free, or I can invest it and instead pay $1k/month in rent. I know this obviously relates to the rent v. buy question, but it seems like it should also factor into the REI v. stocks question where there are different expenses associated with each approach.
   
« Last Edit: November 18, 2015, 10:53:56 AM by cheddarpie »

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #90 on: November 18, 2015, 10:36:59 AM »
That's not my question, or at least I didn't intend it to be. Let's say I have $300k to invest. I can buy a house and live in it for almost-free, or I can invest it and instead pay $1k/month in rent. I know this obviously relates to the rent v. but question, but it seems like it should also factor into the REI v. stocks question where there are different expenses associated with each approach.

It's just an opportunity cost question, and likely depends on if it's better to buy or rent in your area (the rent v buy question).  If you have a specific scenario in mind, feel free to start a thread with the numbers.  :)
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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #91 on: November 19, 2015, 10:19:28 AM »
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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #92 on: November 21, 2015, 09:42:38 PM »
1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.

Because equities typically don't come with leverage, and real estate typically does.  Real estate leverage is much more common (many more people will get mortgages than margin loans), and is much safer--there is no margin call on a mortgage.  Pay your minimum payment, and you're good.

The reason this comparison is made is NOT because it's apples-to-apples.  It's because it's the choice people often make.

The scenario in the OP was someone in their mid-20s with a chunk of cash saved up (22k) who's wondering if they should buy a rental or invest in stocks.  This is a very common scenario, and we see people on here all the time wondering if they should get a rental.

That is the comparison they're making, and that's why it's comparing these two. Not because they're the same, but because they're different, and the person is wondering which is better.  That's a larger question than just the money aspect, but this attempts to show some numbers to help think through the scenario monetarily.

2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.

Absolutely.

Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.

Starting a business comes with a lot more paperwork, legal and financial filings, etc.  You should treat your RE like a business, and be professional towards your tenants, but having a rental property is nowhere near the work a business is (not to mention the fact that it may only take you a few minutes a month, a far cry from most businesses).

Your objections are valid, but not the point of this thread.

Someone in their mid-20s looking to invest isn't going "should I start a business?".  They aren't saying "REITs or stocks?" (well sometimes they are, but that's a more straightforward question).  They're asking "is a rental right for me"? 

And they need to look into if they want to be a landlord.  If they want the extra work.  But they also want to know the math on which is better.  Even if stocks aren't apples-to-apples.

Does the comparison make sense now?  :)

No and I don't say it just to be argumentative, I just feel strongly that the comparison is dangerous without context. While I can understand people may ask themselves which is better a leveraged real estate investment or indexing (stocks), I think making the comparison is a false dilemma and may lead to erroneous conclusions. In my way of thinking when you say 'better' it should encompass both the upside and the downside possibilities. I mentioned it before but an investment in a single house carries much more risk then an investment in an index. To be more specific what happens if you can't rent it for a period of time? What happens if you get tenants that trash it, or don't pay the rent? What about if you become ill and cannot manage the property for a period of time? What about accounting for the expenses of repairs (most will say 10-20% of the per month rents). All of these things and others eat into the returns over time and will defy your original assumptions. Also the liquidity of the house is much lower then that of stocks. In addition if you are just renting the house out like you mention and not treating it like a business, you are opening yourself up to a great deal of personal liability, not the case with stocks.

Second in you original comparison you make some assumptions about what you can get for rent. By doing that you are in essence setting some value criteria on which you would or would not buy a house (the 1% rule). 1% of the house price per month is a 12% annualized return , then you add in the leverage and the 3% appreciation of course the house will come out ahead. The problem is that when people go to buy the house, they must find a house with the correct criteria, if they can't then they will be missing out on the returns in the interim. So that is another risk, maybe call it deal risk? What happens if you can't find a deal that meets your criteria? Also to apply leverage interest rates are obviously a factor, what about interest rate risk? A corollary to that is there are stocks that can offer the same or better return unleveraged, if like the house you select companies based specific criteria, which obviously entails more risk and specific knowledge.

Third, Tax efficiency, the building but not the land can be depreciated over the useful life of the property, shielding some income from tax depending on your tax bracket. However when that is used up you are liable for more tax on the rental income. Because a large part of the return from the house is from the rental income you are paying more tax over the life of the investment. When you have capital appreciation in stocks, and don't sell the stock there is no tax, allowing the money to compound tax free which is very powerful. Some investors have written specifically about this principle, Tweedy Browne comes to mind. In the house case you do get some tax free compounding, but taking your assumption of 3% it's much less. Not to mention the transaction cost of buying and selling the house compared to stocks.

To sum it up, I think that the investment you understand the best is going to be the best one. I think simply extrapolating out returns for both a house and stocks ignores many factors which make comparing raw returns meaningless. Because you are not accounting for risk/time commitment/personal liability etc, which all have real probabilities associated, which don't show up in the calculation but will effect the results in the end.


arebelspy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #93 on: November 22, 2015, 01:49:49 AM »

To be more specific what happens if you can't rent it for a period of time? What happens if you get tenants that trash it, or don't pay the rent? What about if you become ill and cannot manage the property for a period of time? What about accounting for the expenses of repairs (most will say 10-20% of the per month rents). All of these things and others eat into the returns over time and will defy your original assumptions.

All of those were accounted for in my numbers. Did you read the scenario?  I didn't just take gross rents, I subtracted out vacancy (your first question),  repairs (second question), management (3rd question), repairs again, etc. 

Of course those numbers eat into your return, but they don't "defy" my original assumptions, because I assumed they would happen and accounted for them.

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Also the liquidity of the house is much lower then that of stocks. In addition if you are just renting the house out like you mention and not treating it like a business, you are opening yourself up to a great deal of personal liability, not the case with stocks.

Yes, liquidity is lower. Irrelevant if you aren't selling. And might even be a good thing--how many people panic sell stocks over bad feelings in the market and lose on returns?  A little illiquidity could help prevent that.  And insurance was included in the numbers for liability purposes.

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Second in you original comparison you make some assumptions about what you can get for rent. By doing that you are in essence setting some value criteria on which you would or would not buy a house (the 1% rule). 1% of the house price per month is a 12% annualized return , then you add in the leverage and the 3% appreciation of course the house will come out ahead.

12% gross return, but with half going to expenses, it's a 6% net on the rents. You seem (with this comment, and the above) to have missed all the money going to expenses.

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The problem is that when people go to buy the house, they must find a house with the correct criteria, if they can't then they will be missing out on the returns in the interim. So that is another risk, maybe call it deal risk? What happens if you can't find a deal that meets your criteria?

You don't buy it.

There's no "deal risk" as you term it, because if you can't find a property that meets that minimum criteria, you don't invest.  Plenty of markets offer it, but if you can't find it, you go with the equities scenario.  Why would you buy into a suboptimal deal?  To claim the scenario doesn't work because it doesn't account for people buying bad deals is like claiming my stock comparison doesn't work because it doesn't account for the fact that most people buy high and sell low, so I should compound at a number closer to 2-3% real instead of 7% real.

No, I'd rather do a pure comparison and not assume my investor is an idiot. :)

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Also to apply leverage interest rates are obviously a factor, what about interest rate risk? A corollary to that is there are stocks that can offer the same or better return unleveraged, if like the house you select companies based specific criteria, which obviously entails more risk and specific knowledge.

It was a fixed interest rate. There is no interest rate risk in this scenario.

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Third, Tax efficiency, the building but not the land can be depreciated over the useful life of the property, shielding some income from tax depending on your tax bracket.

Yes, I didn't even count that benefit for real estate. It would certainly help the RE scenario.

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However when that is used up you are liable for more tax on the rental income. Because a large part of the return from the house is from the rental income you are paying more tax over the life of the investment. When you have capital appreciation in stocks, and don't sell the stock there is no tax, allowing the money to compound tax free which is very powerful.

You get depreciation for 27.5 years.  In our 30 year scenario it's almost the full time, enough that it will much more help than hurt the RE case.

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Not to mention the transaction cost of buying and selling the house compared to stocks.

I counted the buying transaction costs (see: closing costs paid in the scenario), but not selling because they never sold.

Most of the criticisms on the thread have been complaints from people who didn't read, or didn't understand, the scenario.

Complaints about not taking into account things that actually were taken into account, or complaints about it not being apples to apples. It's not supposed to be. See earlier reply to this Dr Pepper guy. :)

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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #94 on: November 22, 2015, 06:43:17 AM »
I just wanted to point out that depreciating a normally-priced rental over 27.5 years generally gives you more paper losses than your actual realized cash flow.  Thus you may be able to actually lower your income depending on your tax situation.  This does not heighten your tax burden at your top marginal rate; it lowers it in many cases.  This is a major benefit of real estate that indexing will not give you. 
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

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #95 on: November 22, 2015, 07:21:35 AM »

I just wanted to point out that depreciating a normally-priced rental over 27.5 years generally gives you more paper losses than your actual realized cash flow.  Thus you may be able to actually lower your income depending on your tax situation.  This does not heighten your tax burden at your top marginal rate; it lowers it in many cases.  This is a major benefit of real estate that indexing will not give you.

Only if your deal is pretty poor.

Even using our assumptions in the OP (a mediocre 1% rule), your depreciation on a 100k property is about 2.9k/yr (say 20k land, so 80k to depreciate over 27.5 yrs), and our cash flow is right around that, at 1135/yr plus the $1300 and growing to principal each year is $2400ish. So it shields a little (as mentioned in the OP, but not accounted for).

But if you purchase a much better deal (say 1.5% or higher), it'll cash flow much more, with no more depreciation, so the depreciation won't even cover the cash flow, let alone other income.

If you purchase a poor deal with little cash flow (say, 0.5% rule) the depreciation would cover the small cash flow and some extra other income.

But shielding other income with depreciation isn't something to be proud of, as it's likely an indication you have a mediocre to poor deal (or bought in an area with no cash flow and are gambling on appreciation).
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.
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mr_orange

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #96 on: November 22, 2015, 08:29:26 AM »
"Gambling on appreciation" is really in the eye of the beholder.  Much of the money on real estate is made on appreciation from most of the wealthy investors I know.  There are probably 1000 threads on this on Biggerpockets so if people want to read about them there is plenty of information over there.  Suffice it to say that each person's situation is unique and you can't paint with a broad brush. 

$100k with an $80k depreciable basis is also not typical in many locales.  Many markets have asset prices much higher than that and thus will have larger tax shields with lower cash flows.  Someone that buys in this manner is not doing it because they're an idiot.  They're doing it because they wish to take advantage of some combination of the other reasons to purchase real estate.  Cash flow is one item, but appreciation, tax shields, and amortization of the loan are all big factors as well. 

The "1% rule" or any derivative of it is, at best, a blunt instrument for evaluating a purchase.  You really need to do a full-up financial model and price in what your equity is worth.  Ray Alcorn has a great article about this I think folks following this thread would benefit from reading:

http://www.reiclub.com/articles/deriving-cap-rate

Simple rule of thumb investing using the 50% rule, 2% rule, etc. are good for newbs, but people really should do a full analysis of each project before they make the leap. 
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

Another Reader

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #97 on: November 22, 2015, 08:45:37 AM »
Gambling on appreciation has largely worked in highly desired markets - Manhattan, San Francisco, Silicon Valley, Orange County, and Hawaii, to name a few.  Not so much in areas that appreciate at rates close to inflation.  Timing of the transactions and buying right are also important.  I will also note that buy and hold is not a major factor in your current investing strategy.  It will be interesting to see how those properties you bought as long term rentals perform for you over time.

We will see if you feel the same way about appreciation after an extended downturn in your market.  Check back with us then.

arebelspy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #98 on: November 22, 2015, 10:04:12 AM »

"Gambling on appreciation" is really in the eye of the beholder.  Much of the money on real estate is made on appreciation from most of the wealthy investors I know.  There are probably 1000 threads on this on Biggerpockets so if people want to read about them there is plenty of information over there.  Suffice it to say that each person's situation is unique and you can't paint with a broad brush. 

$100k with an $80k depreciable basis is also not typical in many locales.  Many markets have asset prices much higher than that and thus will have larger tax shields with lower cash flows.  Someone that buys in this manner is not doing it because they're an idiot.  They're doing it because they wish to take advantage of some combination of the other reasons to purchase real estate.  Cash flow is one item, but appreciation, tax shields, and amortization of the loan are all big factors as well. 

All of this is true. And also irrelevant to this thread. Relevant to a "how to speculate on real estate" thread, absolutely.  Relevant to a scenario of someone wanting to buy a single rental property for cash flow if and only if it puts them ahead of that same money in index funds (while using a mortgage)?  Not so much. :)
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

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #99 on: November 22, 2015, 10:05:46 AM »
We will see if you feel the same way about appreciation after an extended downturn in your market.  Check back with us then.

I haven't purchased a rental in a long time.  I like to wait until the market craters to buy rentals.  Right now I am busy selling development projects to generate cash. 

This isn't my first rodeo.  I have been investing in property for 13 years now and am well-aware of the market cycles. 
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