Should I Invest in Stocks or Real Estate?

First, a few definitions and assumptions: when I say "investing" in real estate, I'm not talking about owning your own home. I'm talking about buying investment property such as an apartment building. I'm assuming that you're buying a stabilized property at a 5 cap or greater. "Stabilization" means a completed property that has achieved an occupancy rate of at least 80%.

"Cap rate" (capitalization rate) is the ratio of a rental property's net operating income to its purchase price. The cap rate formula does not include any mortgage expenses — since every investor uses a different combination of down payment and financing, the cap rate formula looks at the property alone. This lets you compare the risk of one property or market to another.

For purposes of this article, I am also assuming that you will not be doing any major renovations and that you know how to properly manage the asset so it will continue to operate with the same or better occupancy and cash flow.

With the advent of online brokerages like Charles Schwab, E-Trade, and Ameritrade, buying a stock is as simple as a few clicks. Since there is no minimum investment required, anyone with some money to spare can buy stocks. The price of a stock is generally determined by a multiple times earnings. Let's say a company has one dollar in earnings and a current multiple of 10 — you would pay $10 for one share. If the multiple rises to 11, the stock price rises to $11.

One thing to keep in mind: when a company's revenue goes up, there is also a corresponding increase in expenses called "cost of goods sold." For example, Apple's cost of goods sold is 38% — so for every dollar increase in sales, only 62% is reflected in the share price.

If you own stocks for a year and the value does not change, you have nothing to show for it. Some stocks pay dividends, but a typical dividend is just a few cents per share — you would need to own thousands of shares for any significant income, which would then be taxed. The only way to derive income from stocks is to sell them for more than you bought them, at which point you no longer own the investment and you are taxed on the profit.

As a stock investor, you have no control over price fluctuations, market conditions, or a company's financial health. Recent events demonstrate just how quickly things can change — the stock market had been riding high for several years, then fears about the coronavirus caused a huge drop in valuation in just a few days across all sectors.

The one big advantage to owning stocks over real estate is liquidity: you can sell your shares at any time and have the money credited to your account in seconds.

The proper way to value real estate is to look at the type of asset (multi-family, retail, office, etc.) and determine a cap rate or yield for that asset type in that location. The first number you need is the Net Operating Income (NOI):

For the most part, all expenses in real estate are fixed costs — there is no "cost of goods sold" — which means for every dollar increase in revenue, there is no associated expense. Assuming a 5% cap rate, an increase in rent of one apartment unit by one dollar per month increases the value of the property by $240 ($1 × 12 months ÷ 5% cap rate). In a 100-unit building, that one dollar rent increase per unit increases the property's value by $24,000.

With a real estate investment at a 5% cap rate, you're getting a 5%–6% return whether you sell the property or not. Even if the value of the property goes down, you will still get a 5% income return — assuming rents haven't decreased. Unlike stock prices, which can drop overnight, rents don't usually go down. They typically stay the same or increase.

When it comes to taxation, real estate is far superior to stocks. Income from rental properties is offset by depreciation — a percentage of the cost of an investment property written off every year, recognizing the effects of wear and tear. If your cash flow goes up and increases the value of the property, you can refinance the loan and take the increased value as cash — a non-taxable event. You can't do that with stocks.

When selling your investment property, you have the option of doing a 1031 exchange. This strategy allows you to defer paying capital gains taxes on the sale of an investment property by investing the profits into another property of equal or greater value. There is no limit to how many times you can do a 1031 exchange — thereby deferring capital gains taxes indefinitely. There is no equivalent strategy for stocks.

"The biggest risk in investing in rental property is accurately predicting what your future expenses will be and knowing how to properly manage the asset. If you can overcome these risks, I believe real estate is a much safer investment and will make you more money in the long run than investing in the stock market."

You will also get to keep more of your earnings in real estate because of the beneficial taxation — depreciation offsets, tax-free cash-out refinancing, and indefinite 1031 exchange deferral all work in your favor in ways the stock market simply cannot match.