Buying Stocks vs Real Estate Investing -- Which is Better?

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We all know that putting some of our assets in real estate is good for diversification, but what about returns? Which asset class has produced better returns over long periods of time -- real estate or stocks?

0:18 - Real estate vs stocks
2:51 - Mistakes from the 2008 financial crisis
3:36 - How financial leverage impacts real estate investing returns
5:06 - The tax benefits of buying a house
5:29 - REIT investing and its tax advantages
7:14 - Real estate investing risks

First, it’s important to note that stocks tend to increase in value quicker than real estate.

Over long periods of time, an S&P 500 index fund has historically produced total returns in the 9–10% range. Meanwhile, real estate prices tend to outpace inflation, but not by much.

Since 1940, the median home value in the United States has increased at an annualized rate of 5.5%. However, this is misleading for several reasons.

Consider this, homes are significantly larger today, on average, than they were back then. The average home in 1940 was 1,246 square feet, roughly half of the 2,430 average of 2010. So if you adjust for home size, the annualized increase on a per-square-foot basis drops to 4.6%. And after accounting for inflation, the average home value has risen by just 1.5% per year.

Now let's compare this to stock returns.

Stocks have generated roughly 7% per year over the long run after accounting for inflation. In other words, the stock market has generated returns at more than four times the rate of real estate appreciation. If you’ve ever heard someone tell you that “your home isn’t an investment,” this is probably why.

Real estate as an investment has much stronger return potential
Real estate values tend to barely outpace inflation. However, there are a few reasons why real estate investments tend to do better.

Unlike stocks, where it’s irresponsible to invest with borrowed money, you can use significant amounts of financing for real estate investments without adding a ton of risk.

If you use debt responsibly, it's a healthy part of a real estate investing strategy. Just don't forget about the core metric of any property -- it’s ability to generate cash flow -- when you’re thinking about real estate investments.

The second reason why investment real estate can produce strong returns is that investment properties can be rented out to generate income. You can also rent out a part of a house and live in the rest, a move called house hacking.

Real estate investors enjoy tax advantages that stock investors don’t. For example, when you buy an investment property, you get to write off the purchase price over a certain number of years -- a tax deduction known as depreciation. It would be awesome if you could write off your stock investments in a similar manner, but that isn’t the case.

Even if you don’t own a property, real estate can offer tax advantages that the average equity investment can’t. Real estate investment trusts or REITs, get an extra tax benefit in that they avoid corporate taxes by paying out most of their income as dividends.

These are easy for investors to buy in an IRA or other tax-advantaged retirement account, meaning they can avoid dividend and capital gains taxes altogether in the short-term.

Together, the combination of rental income, leverage, and tax benefits can combine to produce attractive long-term gains.

So how has investment real estate compared with stocks over time?

Let's compare the total returns of the S&P 500 stock index and the Vanguard Real Estate mutual fund, a good benchmark index of equity REITs. The difference isn't too significant over the first few years but by 20 years out, the Vanguard ETF crushed the S&P 500.

If you look at the longest time period, you’ll notice that the performance is comparable but with a significant edge to real estate. This is an imperfect conclusion, as there are other ways to invest in real estate besides REITs and they have different investment dynamics. But it does illustrate the long-term return potential of real estate investments.

Now there are some downsides to real estate investing…

Actually buying real estate is a time-consuming investment.

Also, real estate is an illiquid investment. You can sell stocks with a couple clicks in no time at all. Conversely, it can take months to sell an investment property unless you want to accept a highly discounted price.

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