Have you thought much about the real estate market in recent months? Sales of new construction and resale homes have a tremendous impact on the
Is it better to invest in rental properties or dividend stocks?
I bought my first 2 bed, 1 bath condo for $252,500 in 2004 just before the real estate market took off. I still own it today – its a beautiful home in one of the most popular neighborhoods in Seattle overlooking the emerald city skyline.
Since then, my investment has done very well. It has lived through the subprime credit boom and bust. And now that I have it rented, it consistently pays me a nice dividend every month. Obviously the investment could have gone south – and still can. I could have sold it for a loss after I moved away in 2009 (like many others did around that time). But convincing myself to be in the real estate game long term has completely changed my mindset on investing.
That same mindset is what compels me to purchase more homes now. Much like stocks, the value of the real estate asset will always fluctuate over the short term. However, over the long term, real estate – like stocks – will continue to pay dividends to patient and prudent investors.
Why am I so confident about this dividend payment? Our growing population will always need a roof over their heads. In addition, there is only a fixed amount of buildable land. The population is steadily increasing and is expected to grow substantially into the future. This is especially true in urban areas that surround major metropolitan cities like Seattle. And since supply and demand determine the market price for rent, the price of rent will necessarily increase over time. Sure, we could get hit with a major earthquake or our booming technology industry could go bust. Sure, they can always build more skyscrapers and condos. But long term, I’d argue the hypothesis holds. I’m not talking about short 2-3 years of ownership; the investment needs to be held for at least 10-15 years, and sometimes longer.
In addition, when you add the power of leverage – the ability to control a large asset with a smaller investment – I’d argue this form of investing provides superior risk adjusted returns to a portfolio of dividend paying stocks, over the long term.
Lets take a simple example.
Suppose we purchase a 300k home with a 60k down payment using the following assumptions:
- 15 year fixed loan @ 3.5% (closing costs are added into the rate and spread throughout the loan)
- rental income only covers the principal and interest initially (conservative)
- rent increases 3% per year (US BLS average inflation since 1913 is 3.22%)
- vacancy factor of 10% (again, conservative)
- the home appreciates at 2.5% (Case-Schiller average since 1987)
- taxes, Insurance and HOA expenses (if any) increase every year at 5%.
- set aside $300 per month for any maintenance, which increases 10% every 5 years
As mentioned before, no investment will provide smooth returns year to year. But for simplicity sake we’ll apply these fairly conservative averages to our analysis. Probably our biggest assumption is the fact rent covers our principal and interest after vacancies. In a growing city like Seattle, this is easily achievable.
Making the above assumptions, after 5 years our original 60k investment has grown to 165k. We will ignore the value of the underlying asset, since we are really focused on cash flow (i.e. our dividend payment).
First off, you’ll notice we are actually losing money on this investment. Obviously this isn’t ideal – we would rather have cash flow right off the bat. But for the purposes of this example we’ll let this loss stay put. Its important to note that later we will compare this investment to a similar investment in stocks where we contribute monthly to the stock portfolio. In addition, we are using pretty conservative numbers to further build our case that real estate investing is superior to a portfolio of dividend paying stocks, over the long term.
Moving ahead the results continue to improve. Making the same assumptions, after 10 years, we are still taking a monthly loss on the property although it has decreased since the growth in rent is outpacing the growth in expenses. Again, we are using fairly conservative assumptions to illustrate the point.
Keep in mind, this doesn’t take advantage of the tax benefits such as writing off the loan interest or the depreciation from the building. Other tax write offs include maintenance repairs, insurance, real estate taxes and travel (improvements are not considered tax deductible).
Month after month, year after year, we patiently hold the investment. Sure there will be times when we’ll replace the roof or repaint the interior, especially during the out years of our investment. But that’s why we’ve set aside our monthly maintenance budget.
Finally, after 15 years, the loan will be fully paid off. The original 60k investment will have grown to 434k (again assuming the 2.5% average appreciation, per Case-Schiller home data). However, more importantly, we’ll be taking home an impressive $1,651 per month after all expenses are paid ($19,812 annually).
Again, keep in mind we didn’t factor in the tax advantages of owning real estate which can provide for additional savings.
Now, lets compare this to a similar investment in a portfolio of dividend paying stocks.
Recall we have $60k in original capital. In this example we will make monthly contributions to the portfolio, identical to the monthly profit we realized from real estate. And since the profit is negative, we will assume those funds are invested into the portfolio on a monthly basis. Dividends are reinvested and compounding is done monthly.
Using the FV function in excel, we find that we would need to find a portfolio of dividend paying stocks that consistently grows 9.9% over 15 years. The annual dividend payout at year 16 would need to be around 4.5% to match our real estate investment annual yield. (NOTE: The real estate dividend tracks inflation. Dividend stocks won’t necessarily track inflation.)
If anyone knows of such a long term investment – with similar risk characteristics we have assumed here for real estate – then please tell me immediately.
The analysis here assumes just one home. But the logic applies for multiple properties. Our personal plan is to purchase 3 before the end of the year. And we choose the 15 year loan since we want to realize the higher annual income at a point earlier in our lives. You can certainly do the same calculations using a traditional 30 year loan; you’ll have a higher monthly profit sooner but will need to wait longer to realize the return on the investment. It’s all about opportunity cost and your personal preference for the time value of your money.
The beauty of our strategy is that we will be patient and diligent investors who will use the power of leverage to multiply our returns. One by one – year after year – our tenants will pay down our loans. Sure there will be times when we need to evict people, fix broken washing machines or repair the windows (this is why we set aside the generous monthly maintenance allowance). But based on our 10 year real estate investing experience, instances such as evicting tenants are few and far between. In our eyes, the rewards for maintaining and running the business far outweigh those risks.
Right around the time my future son will be entering 5th grade, we will be earning a healthy ~$20,000 annual dividend after all expenses. Not bad for an initial $60k investment and 15 year time horizon. And keep in mind we don’t plan to sell the underlying asset (which is now valued at $430k+). Instead, the rent payments will be our monthly dividend check which we’ll likely use to buy more property.
Another benefit to owning real estate is that you become the owner and operator of a real business. You determine how much to charge for rent, the amount of maintenance, and anything else around your real asset. And you can even do cool things such as adding a rooftop view deck or redoing the kitchen – what people in the business call “sweat equity”. These improvements generally get you higher rent (try doing that with stocks). Obviously this takes time and funds, but done correctly it makes the investment worth more. Taking it a step further, you can look into building multiple units on the same lot provided City zoning allows it. Unlike stocks, real estate gives you the flexibility to enhance the returns on your investment.
And if you think your dividend portfolio doesn’t require maintenance, think again. Money managers are always rebalancing portfolios based on general market trends; you’ll be expected to do the same over the life of your investment.
Some say they like the liquidity stocks provide. However, I’d argue this is a bad thing. Highly liquid investments allow you to sell out of fear (like many did in 2008). On the other hand, the illiquidity of real estate prevents you from selling on emotion. You are truly locked in for the long term.
Its worth mentioning that past performance is not always indicative of future returns. Our entire model is based on the assumption that previous trends will apply into the future. The same holds for stocks or any other investment you chose to follow.
Considering we are long term investor with about 20 years of runway until retirement, we can’t think of a better place to put our money. And thanks to record low interest rates combined with the power of compound returns and leverage, there’s no better time than now to get started. Rental properties provide fantastic returns and reward patient and diligent investors.
So what do you think? Are you convinced that real estate provides better long term returns than the stock market?