Real estate versus stocks: Homework may surprise

Everyone needs a roof over their head.  The tax benefits that are afforded to personal residences make this an obvious investment opportunity that should not be passed over.  Standard financial planning advice generally suggests that paying down the mortgage on your personal residence and contributing to your RRSPs should be done prior to pursuing other investment opportunities.

What if the mortgage is paid off and the RRSPs have been maximized?  Where should you invest that excess cash?  Beyond your personal residence, does it make sense to start acquiring other real estate properties or should you look at other asset classes?

A common misconception is that real estate is lower risk than investing in the stock market.  Another misconception is that real estate has better long-term returns.  Recently we were speaking with a realtor that understood and pointed out that equity markets have outperformed real estate historically.  Let’s compare real estate investments (excluding your personal residence) with other asset classes.

Irrational Exuberance

We are only a couple of weeks away from the sixth anniversary of the technology sector’s historical highs.  At that time many investors over weighted the sector while ignoring opportunities available in other sectors and other asset classes including real estate.  The technology sector sold off sharply.

Fast forward a few years later and we find investors focusing on resource companies and real estate opportunities. There are several explanations for the focus on real estate with the primary reason being low interest rates. Certain real estate markets have witnessed increased demand resulting in even greater price volatility.  In our opinion, it is this irrational exuberance that has fuelled local real estate prices. Investors have to ask themselves if valuations have gone too high too fast.

Real Estate versus the Stock Market

Many investors have the perception that real estate is a better long-term investment than the stock market.  Part of this perception may be linked to the effort involved in making the investment.  When purchasing a home, investors walk through the house, view similar houses and look at recent sales to see if the asking price is reasonable.  Many people take the time to understand what they are buying.  When a real estate purchase is made the holding period of the investment is generally long term.  These are all great characteristics of solid investing – doing your research and holding quality investments for the long term.

Do individual investors spend the same amount of time to understand the stocks that they are purchasing?  We feel that those that do spend the time to do research, or seek out a qualified advisor, will certainly fair better in the markets than those that do not spend the time.  If one is going to compare the performance of equities against real estate, research before you purchase and compare the returns over the same long term time horizon.  Your homework will reveal that equity returns, for many periods, have exceeded real estate returns.

Using Leverage

Another difference between stocks and real estate investments is that individuals are more willing to borrow money to purchase real estate than stocks.  Individuals for the most part tend to feel more comfortable with leverage on real estate.  Let’s look at the following two examples:

Investor A puts $50,000 down on a $300,000 house five years ago.  Let’s assume that today the house is worth $480,000.  The house value has increased by 60 per cent but the return on your original investment of $50,000 equals $180,000 representing a 360 per cent return on your initial investment.

Investor B puts $50,000 into stock investments within a cash account five years ago.  After the same five-year period the stock investments have climbed to $80,000.  This $30,000 also represents a 60 per cent increase.  As the investor chose not to use margin or debt to purchase the investments the return on original equity also equals the actual return.

The above highlights Investor A using leverage when market values have increased.  Take a moment to consider the results if the opposite happens and market values decline while interest rates rise.  If Investor A becomes too highly leveraged and the cost of borrowing increases this may lead to bankruptcy.

Wealth can be achieved and lost more quickly using leverage and other people’s money.

Very few investments provide the ability to extend leverage as much as real estate.  The equation is easy, greater leverage equals greater risk.  Having all your investments in one asset class such as real estate also adds risk.   The housing market has moved along at full steam for quite some time.  But how long will it last?