[Editor’s Note: Today’s WCI Network post is from Passive Income, MD, and discusses his preference for real estate over stocks. Those who came to WCICON21 will recall that Peter’s portfolio is 80%+ real estate. Mine, of course, is almost the opposite at 20% real estate. I’ve discussed the “real estate versus stocks” dilemma before. In this post, Peter gives his take. The truth is that Peter and I agree the right answer is “Both!”, but simply disagree on how much of each to include in a portfolio. There are many roads to Dublin. Pick something that is reasonable and right for you and stick with it. ]
Should you invest in stocks or real estate? It’s a big question, and there are many, many opinions out there.
While both certainly have their pros and cons, I thought I would give you an idea of exactly why I prefer real estate over stocks.
Of course, investing is different for everyone, and everything depends on your personal goals. But for wealth creation and achieving financial independence, I believe that real estate is the best and most efficient method out there.
Here are five reasons why.
#1 Cash Flow
The main reason I started investing was to replace my clinical income with other sources of income. Financially speaking, I wanted to make sure that I wasn’t reliant on medicine alone to take care of myself and my family.
I developed this goal after experiencing some issues at work, and I realized that if I ever wanted to achieve financial freedom, I needed to gain control over my time, and stop trading it for my income.
It didn’t take me long to discover just how much I’d need in monthly income in order to live the lifestyle I wanted. I simply tallied up my current expenses and made it my ultimate goal to cover these expenses with another form of income—not from my day job.
It occurred to me that I had met other doctors who’d achieved this same goal through real estate investing. As you might have guessed, I decided to follow in their footsteps.
Of course, I did heavily weigh this decision against the traditional wisdom of investing in the stock market. Obviously, stock values can increase. In fact, though my 401(k) and Roth IRA would go up and down in value, they did increase overall in value.
Still, it wasn’t spinning off cash that I could feed my family on. Just the opposite, actually; in these protected accounts, I’d have to take a penalty to withdraw those funds early or simply wait until I was 59.5 years old. I wasn’t okay with waiting that long.
There are stocks that pay off some small amount of dividends, but I discovered the portfolio size necessary to get a meaningful amount of cash flow with these dividends simply wasn’t practical. Plus, they weren’t as predictable as the cash flow I was receiving monthly from my real estate investments.
So I went about building up a real estate portfolio, using both direct ownership of properties and passive investing through private deals like syndications and funds. It’s not a get-rich scheme, but using the income from my day job, I was able to funnel a good amount of it into passive income, cash flow producing investments.
This cash flow, built up one investment at a time, allowed me to buy my time back. It allowed me to give up shifts knowing that income was coming from my passive investments reliably. This has been the greatest benefit of investing in real estate and continues to grow and pay off today.
# 2 Inefficient Market
I do know that, historically, the stock market has increased in value year after year, at an average of 7-10% annually. So I understand when people want to just park their funds there and forget it (in fact, according to many, this is the smart way to play the stock market).
However, the fact that it is an extremely efficient market means that you, as the little person, aren’t going to beat the professional investors with all the information necessary to make the big moves and make huge gains in the stock market.
Don’t get me wrong; I do know some investors (and some doctors, in particular) who have done quite well trading stocks. They’ve succeeded because of intelligence, strategy, and some luck. However, these results are not typical—especially for someone who isn’t watching and studying the market extremely closely.
However, the world of real estate is very much an inefficient market. This means that although real estate prices seem to be dictated by the overall market, in reality, many investment property values are not bought and sold at their true value.
You can find tons of good deals in many different situations. For example, maybe the seller is a mom and pop owner who hasn’t run the property to maximal operational efficiency and is now selling to cash out. The following buyer and owner can then buy the property under market value, and add value themselves.
This level of control really allows you to make profits based on your skill and effort, rather than timing and luck.
# 3 Forced Appreciation
When you buy a stock, it’s highly unlikely you have any influence over its stock price unless you’re someone like Carl Icahn or Warren Buffett. You’re more or less just along for the ride.
However, as mentioned above, a real estate investor can use strategy to improve operations and cause what’s known as “forced appreciation”.
This differs from “market appreciation”, which is driven by overall market factors, like the global and local economy. It is based on comparables (how other things are doing in the area) and is simply not under your control as an investor. You can look at trends, but even those are unpredictable.
One great way to force appreciation is to take units that are underperforming in rent because they’re in relatively poor condition compared to the market, renovate those units, and command a much higher rent.
It’s also possible to decrease expenses by more strategic overall management. Perhaps you find a property manager that has better resources to maintain the building at a better price. If you take better care of tenants, perhaps you’d get less turnover and the repairs/fix-up that goes along with that.
Changes like these result in a higher net operating income, which in turn can increase the value of the property significantly—regardless of what the overall market is doing around the property.
You simply don’t have this opportunity with stocks.
# 4 Leverage
Leverage is one of the most powerful aspects of real estate investing. You’re able to control 100% of an asset by only utilizing a smaller portion of capital (say, 20% of the value of the property for example) and using a lender’s capital for the rest. However, as an investor, you get 100% of the upside of the investment.
Let me show you why this is powerful.
Let’s say you purchase a $1 million rental property by investing $250,000 into a property and borrowing $750,000. Through market and forced appreciation, you’re able to increase the value of the property by 25%, so the value is now $1.25 million. That’s a 25% increase for you as the investor, right? Well, actually, it’s a 100% return on investment.
Remember, you only invested $250,000, and the property increased in value 25%–or $250,000. So, based on the return on investment formula (return ÷ amount you invested), that’s a 100% increase.
That’s the power of leverage. It’s how investors are able to generate outsized gains and create massive wealth.
Of course, leverage is a double-edged sword. It can multiply returns, but it can also magnify losses. That’s why it’s absolutely crucial to mitigate risk and understand the downside. But again, with real estate being an inefficient market, it is possible to mitigate that risk.
Plus, since real estate grants the level of control we discussed previously, you are fully able to use a sound strategy to not only mitigate risk, but set yourself up for greater returns.
Sure, with stocks there is some ability to use leverage through a margin account. However, these are for short-term plays, and you’ll likely come across something called a “margin call”. In this scenario, the investor will have to come up with capital to cover what they borrowed immediately. It’s not a long-term solution and can be extremely risky.
# 5 Tax Benefits
Investing in real estate brings numerous tax benefits—too many to list here (be sure to check out this post for the full details).
Suffice it to say that there are many, many amazing tax benefits available to real estate investors. These are not loopholes, but incentives put in place by the government to encourage the holding of real estate. After all, it serves a need by providing housing, jobs, revenue for local governments.
Arguably the two biggest tax benefits are depreciation and 1031 exchanges.
In general, rental properties depreciate at 3.636% yearly (for up to 27.5 years in the case of residential properties). This reduction in value can be deducted from your reported income, which can greatly reduce the amount of taxes you owe for the year.
For example, let’s say you bought a residential rental property for $400,000. A quick method would be to divide the purchase amount by the maximum years of deprecation (27.5). This allows you to offset your passive gains by $14,500 each year.
With current laws in place, something called bonus depreciation allows you to accelerate depreciation for much of the property, resulting in a massive deduction in the first year of owning the property.
This tax benefit gets passed along to you as both a direct owner of the property and a passive investor in a syndication or fund.
A 1031 exchange allows you to defer capital gains tax indefinitely. Normally, you’d have to pay a very large amount of taxes upon the sale of an investment property. But if you were to use the money from that sale to purchase another property, this is considered an “exchange” by the IRS.
In other words, you can essentially defer paying capital gains taxes forever, simply by using the profits of a sale to purchase a property of equal or lesser value. This is a powerful tax benefit for real estate investors.
When it comes to stocks, you are able to get a few tax benefits from qualified dividends and certain write-offs. However, they all pale in comparison to the massive benefits you gain from real estate investments.
These five benefits are some of the biggest reasons I chose to go with (and continue to go with) real estate over stocks as my main vehicle to create financial freedom. Real estate allows for significant wealth creation (and preservation, if that’s your goal) and it’s created an amazing side income stream for myself and many other physicians.
Don’t get me wrong, I still have some investments in the market, but that’s purely for diversification (as you know, I’m a big fan of diversification).
But since my ultimate goal is to create income for financial freedom now and to live how I want to live, I believe real estate is the best way to get there—for myself and for many others.
Do you take a side in the stocks vs real estate debate? Which do you prefer for building wealth? Sound off below!
Originally posted at https://www.whitecoatinvestor.com/real-estate-over-stocks/