Real Estate Beats the Stock Market, but You Have to Work for It

I have heard and read plenty of opinions and convincing arguments as to why real estate investments beat stock market investments as a retirement strategy, but I needed to see the hard data.  And here it is.

The Bottom Line

It's not for everyone.  Saving and investing in an index fund takes a bit of planning and personal fiscal discipline, but little else.  Saving, buying, and managing investment real estate, and to do it well, is running a small business. Basically, both will get you there, but with differing levels of certainty and work.  Pick your poison!

SIMILARITIES

• Market volatility
• Luck in timing
• Effective vehicle to retirement at a reasonable age with reasonable certainty

DIFFERENCES
retirement accounts vs real estate

• Tax (dis)advantages
• CAGR: 6.7% vs 15%
• Depletion vs retention of principle in retirement
• Liquid vs less liquid
• Easy to buy well vs it's a job to buy well
• Requires little to no maintenance vs managing a small business
• Requires no emergency cash infusions vs cash will be required
  

IRA and 401k Analysis

First I found the average annual return for the US stock market.  Using moneychimp.com's calculator, I found that the lifetime compounded annual growth rate (or CAGR) of the S&P500 is 6.7%. 

Hmmm, that is quite a bit different from the 8% annual average return that most retirement calculators use. Actually, the *average*  annual return (if you take the annual return for every year and take the average) is about 8%, however this is not a very useful number since that is not how return on money invested works.  Using CAGR, we get the real growth rate of money invested in the market.

ARE YOU ONE OF THE TOP 25%?
Only half of all Americans work for an employer that offers a 401k plan.  Of those who do have a 401k option at work, about half of those people participate*, meaning that only approximately 25% of all Americans, even contribute to their 401k.  As for IRAs, only 22% of Americans have an account**. 

Ok, now let's apply this to IRAs and 401ks. For this example, assume the best case scenario of a person using both an IRA and 401k, making maximum annual contributions of $17,500 and $5,500 (a total of $23,00 annually), starting at age 25 in 2013.  This person would need to be making $90k a year to be able to afford this 25% savings allocation, but I'll assume the savings rate regardless of income.  Here is the projected result:

Source: https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementIncomeCalc.jsf

These results already account for inflation, and we can assume tax rates will remain largely the same at retirement at this income bracket.  Looks like our investor is well positioned to retire at 65 on a comfortable $45,000 - $82,000 annually.  Which seems OK, unless you require long-term care at $150k per year...or the stock market loses 30% of its value when you go to retire....or inflation really runs rampant sometime between now and then...or health care costs keep rocketing upward.  All very real possibilities.  What if one or more happens?  Then what? 

And, of course, the market doesn't move along a nice steady rate of return.  It moves in cycles of high and low return.  Unfortunately, no one can control this.  If our investor starts investing when the market is at a relative high (sort of like it is now), chances are it will return to a low at the least convenient time - at retirement.  Or maybe not.  It's just luck.

Investment Real Estate Analysis

Following the same logic we used above, let's start with the CAGR for real estate in the US.  From 1890 - 2008, US homes appreciated at about 3.5% annually***.  That doesn't sound so good when the S&P500 has returned nearly double that over the same period.  If we assume average inflation of 3%, that means that in real dollars, real estate doesn't actually appreciate over the long-term.  Sometime it does appreciate, and sometimes it loses value - I think we've all seen very good examples of both scenarios over the recent past.  So we still have volatility and up and down cycles - like the stock market - and no real growth.  So why would anyone invest in real estate?

LEVERAGE
Unlike stocks, real estate can be purchased for far less than the entire amount. 

TAX ADVANTAGE
Unlike stocks, we get to deduct the annual fees (maintenance costs, mortgage interest, property taxes) from our gains.  And, gains can be rolled over using a 1031 exchange, deferring taxes. 

OPM
Or Other People's Money.  By renting the home, the investor has contributed only $32,000 of a final value of $160,000. 

To illustrate, let's assume our investor buys a $160,000 home with 20% down, rents it for $1,400 per month, and sells it after 30 years.  Our investor experiences 8% vacancy and 15% of rent maintenance costs annually.  Here is a screen shot of my personal property analysis.

Notice in the yellow box above, my real rate of return is 15%. 

In the end, we get a CAGR of 15%, with a net present value of $162,00 (when I change my discount rate to 4.5%) on our $32,000 investment.  As a bonus, I am accumulating $3,000 annually as profit.  That's like a 10% dividend.  And, if the property isn't sold, but retained in 30 years after the mortgage is paid off (and future dollars are the same as today's dollars), we are getting about $855, net per month - indefinitely.  To get to the equivalent retirement income we used above of about $4,000 monthly, we need to compound our $855 by 4.5 homes.  If we own 5 homes outright, our annual income is $51,300, and we aren't depleting our principle, unlike our stock investments.  Should we need additional income in retirement, we can liquidate all or part of our $800,000 portfolio ($160,000 * 5 homes). 

So, am I going to quit the stock market?  No.  But, I am diversifying.

*http://theweek.com/article/index/226886/how-401ks-are-failing-millions-of-americans
**https://www.tiaa-cref.org/public/about/press/about_us/releases/articles/pressrelease418.html
***http://www.freeby50.com/2008/05/more-on-historical-home-appreciation.html