Understanding the historical returns for a particular type of investment is one of the ways investors determine the potential future earnings from that investment. Even if they don’t mirror the current performance, the past returns from an investment give you an idea of what is possible.
However, when looking at how a specific investment has performed in the past, it is always best to have a yardstick against which you can measure the results. This is often done by comparing the rate of return for that specific investment against the rate of return for another type of investment.
This comparison shows you the opportunity cost of putting your money in one investment versus the other. You get a clear picture of what you could earn from investment option A, in contrast to what you will lose by not taking advantage of investment option B. This comparison helps you to make a more informed decision.
In this post, we will compare two of the most popular investment options: investing in real estate versus investing in the stock market. This article aims to show which option has the better historical return and which investment should be getting your money.
Real estate vs. stocks: The historical returns
Before we go into the figures, here is a note of caution. How one investment performed in the past does not necessarily indicate what it will do in the future. Many variables affect the performance of a specific asset, and those variables are themselves affected by other factors.
As long as forces outside your control influence the outcome of your investment, you can only make intelligent guesses about what the investment will do. But one of the good things about studying historical trends when investing is that you get to see both the best and worst-case scenarios for that investment.
That being said, here is what you can expect when you invest in real estate or stocks, based on the historical returns for each.
The stock market
On average, over long periods, the S&P 500 index fund (which tries to replicate the stock index’s performance) has produced historical returns in the range of 9 – 10%. After adjusting for inflation, stocks have typically made a yearly return of around 7%, which by all standards is good.
The real estate market
On the other hand, median home value increased at an annual rate of around 5.5%, well below the returns for stocks. But even this figure is misleading because it is partly based on an average home size of 1,246 square feet (1940) versus 2,430 square feet (2010). When the home size is factored in, the annual return per square foot of housing drops to 4.6%. This figure falls even lower, up to 1.5%, when you account for inflation. (Here is a glossary of property investment terms to follow the article easier.)
Putting the stock market and the real estate market side-by-side, the stock market outperforms at four times the rate of real estate. This makes sense when you consider that investing in stocks is equivalent to buying a piece of a business and that business will typically grow faster than a property’s value. But this calculation is missing one vital element: the impact of leverage in real estate.
Why real estate has greater return potential
It is considered risky to borrow money to buy shares of stock due to the stock market’s volatility. But leveraging – investing by using borrowed money – is a standard practice when buying real estate.
The ability to leverage completely changes the picture for real estate investors and makes real estate investing a much better investment option than stocks. What would happen if you had $200,000 and put $100,000 of that money into stocks and the other $100,000 in real estate?
If the $100,000 invested in stocks increased by 4%, your return on investment would be $4,000. If you used the other $100,000 to make a down payment on a $500,000 property and got a $400,000 loan from the bank to buy the house, your result would look like this:
Assuming the property increased its value by the same margin as the stock by at least 4%, your return on that property would be $20,000. The real estate will be performing at the rate of 20% of the initial investment of $100,000, which is five times more than what you can get with stocks.
This is not an unlikely scenario, but the kind of return possible when you invest in real estate using leverage. Even after paying the fees associated with real estate transactions, the property will still come out ahead with returns that beat what you get from the stock market.
But these kinds of returns are only possible when the mortgage rate for that property is less than the property return rate. If interest rates rise, mortgage rates will also go up, and the increase in the cost of borrowing could effectively wipe out any profits you make on the property.