REAL ESTATE VERSUS STOCKS: WHICH IS BETTER?
The following hypothetical examples demonstrate how investing in real estate often beats investment in stocks. The superior profit performance in real estate can largely be accounted for by tax benefits and leverage (the ability to buy with borrowed funds). Property owners get tax deductions for mortgage interest payments and can buy real estate for as little as 5% down. The leverage is particularly important because buyers get the benefit of appreciation on the entire value of the home, even though their cash investment is merely a fraction of the value.
These simplified examples do not account for cash flow, which would include the impact of monthly expenses for rent or mortgage payments.
Net cost figures include real estate commissions, brokerage fees and taxes on stock dividends (assumed to be 3 percentage points of the total return). Income and capital gains taxes have not been deducted from net profit figures. However, it is important to note that usually profits on the sale of a residence can be deferred by rolling the gain into another residence, but gains on stock transactions are not as easy to shelter from tax.
Rates of return on stock investments are based on the 20-year average annual performance of the Standard & Poor’s 500-stock index and the Dow Jones industrial index, with dividends reinvested. Real estate rate of return figures are based on 20-year average annual returns as reported by the National Assn. of Realtors, as well as estimates by real estate experts.
Tax brackets are for combined federal and state taxes.
1. SINGLE MAN BUYING A CONDO
Annual earnings: $45,000
Rent: $700 a month
Tax bracket: 34.7%
Mike Chen decides to buy a $130,000 condominium with 10% down, or $13,000 invested. He gets a loan for the $117,000 balance, for which he must pay a fee of 2 points (a point equals 1% of the loan amount) on a 10.5% fixed-rate loan. The condo appreciates at a 5% annual rate. He sells in five years, paying a standard 6% real estate commission.
Net Cost: $139,955
Sales Price: $165,917
Taxable Profit: $25,962
OR ... Chen uses the $13,000 investment to buy stock instead of real estate. His stock appreciates at an average annual rate of 11.5%, which reflects the impact of reinvested dividends. He sells in five years and pays standard discount brokerage commissions both when buying and selling.
Net cost (commissions plus reinvested dividends): $16,291
Sales price: $22,304
Taxable profit: $6,013
2. MARRIED COUPLE BUYING APARTMENT
COMPLEX FOR INVESTMENT
Annual earnings: $150,000
Rent: $0
Tax bracket: 39.2%
Jane and Jim Hernandez, who already own a home, buy a $500,000 apartment complex with 15%, or $75,000, down. The $425,000 balance is financed with an 11% loan plus a 1.5-point loan fee. During the first year, rental income amounts to $40,000 and appreciates at a 5% annual rate. The complex appreciates 10% annually. They sell in five years, paying a 6% real estate commission, or $48,315.
Net cost: $554,753
Depreciation: (reduces net cost): ($90,909)
Sales price: $805,255
Taxable profit: $341,411
OR ... The Hernandezes buy a $75,000 portfolio of stocks that appreciates at 11.5% annually. They sell the stock in five years and pay $375 in discount brokerage fees both when buying and selling.
Net cost (commissions plus reinvested dividends): $93,785
Sales price: $128,877
Taxable profit: $35,092
3. MARRIED COUPLE BUYING A HOME
Annual earnings: $100,000
Rent: $975 a month
Tax bracket: 34.7%*
Tom and Karen Brown buy a $300,000 home in Santa Monica with 20%, or $60,000, down. They pay 1.5 points on a 10.25% fixed-rate mortgage. The house appreciates at an average rate of 11.5% per year. They sell in five years, paying 6% real estate commission.
Net cost: $331,020
Sales price: $517,006
Taxable profit: $185,986
OR ... The Browns invest the $60,000 in the stock market, earning an 11.5% annual rate of return, assuming annual dividends of 3% are reinvested. They sell the stock in five years, paying $200 in discount brokerage fees both when buying and selling.
Net cost (commissions plus reinvested dividends): $74,928
Sales price: $103,201
Taxable profit: $28,273
* The Browns’ tax bracket is 34.7% when they buy real estate, but shoots up to 39.2% when they invest in stocks because of fewer deductions.
What happens when leverage is the same? The effect of leverage--the ability to used borrowed funds to buy an investment--is pivotal in making real estate transactions lucrative. And generally the degree of leverage available for real estate transactions is not available for many other types of investments, including stocks or bonds.
But what if investors were only able to borrow as much to buy land as they could to buy stock?
Take the Browns as an example.
They buy a $120,000 home with 50% down, pay 1.5 points on a 10.25% mortgage. The house appreciates at 11.5% per year. They sell in five years, paying a 6% real estate commission. Or . . . They buy $120,000 worth of stock, putting 50% down, and paying a total of $400 in discount brokerage fees. The stock also appreciates at 11.5% annually, including the effect of reinvested dividends that account for 3% of the total return. And they sell in five years.
REAL ESTATE: STOCK
Cost: $132,408: Cost: $149,656
Sales price: 206,802: Sales price: 206,602
Taxable profit: 74,394: Taxable profit: 56,946
The reason for the difference?
“Taxes,” said Cindy Edwards, a tax specialist at the Los Angeles accounting firm of Parks, Palmer, Turner & Yemenidjian. The cost of the stock transaction is boosted by tax liability on those dividends that were put back into the market. Although the investor many never have gotten his hands on them, Uncle Sam takes a cut because dividends don’t get the tax-deferred treatment that real estate enjoys.
Moreover, the couple who bought real estate will find themselves with better cash flow because they lose the burden of paying rent. Because of the 50% down payment, their mortgage--including interest, points and property taxes--costs less than their estimated rent. They also deduct mortgage interest payments, which allows them to drop into the 34.7% tax bracket from the 39.2% bracket when they were buying stock.
Source: Phil Holthouse and Cindy Edwards at Parks, Palmer, Turner & Yemenidjian in Los Angeles.
