Is Real Estate Or Stocks A Better Investment Now?

by: Neal Frankle

Summary

Both real estate and the stock market are richly priced. That increases potential risk for both.

To make a good decision, define your objective and focus on that.

Confirm that your assumptions are reasonable with regards to appreciation and income.

Make sure you haven't overlooked other alternatives.

Ask yourself if you are focused on the right questions before making a final decision.

I was recently approached by a successful young couple with $600,000 to invest. They wanted to know if they should:

a. Buy a rental in their city and hold it for rental income.

b. Buy a larger residence nearby for themselves and rent out their existing home.

c. Invest in the stock market.

If they went with real estate, they estimated that the net rental income would be about the same regardless of which home they rented out.

The couple made it clear that their main goal was to secure their future retirement some 30 years down the road. They didn't want to sacrifice their need for retirement security in order to satisfy their desire for more spacious digs.

They had bad experiences in the stock market in the past but loved real estate and it was easy to see why.

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Source: Zillow

Their current home is in an upscale neighborhood in San Francisco which has enjoyed very attractive real estate price appreciation. Currently, most of their retirement investments were in the market. Putting this $600,000 to work in real estate would balance out their allocation.

During our first interview, they told me that they expected real estate prices to grow at 6% per year. Since they bought their home in 2012, it was easy to see why they had a rosy view. And as you'll see later, their appreciation expectation could be reasonable.

To give you an example of why they were sour on the stock market, here's a graph showing how one of their funds performed compared to the S&P 500 over the last 2 years.

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The gold line shows how the S&P 500 performed over the 2 years ending 8/2016 while the black line depicts the performance of one of their funds. Since this particular fund more or less illustrates how the rest of their portfolio did, it was no wonder they were unimpressed by the market. Having said that, the couple admitted that they had more or less bought highly recommended funds and then just ignored them.

Analysis

Before running the numbers for this couple, I tried to share some perspective on both the real estate and equity markets.

With respect to real estate, their appreciation estimate looked high but reasonable given the history, but I wanted to introduce some perspective. First, as you can see from the chart above, real estate (even in San Francisco) hasn't always appreciated. Between 2008 and 2012, prices dropped about 25% and the forecast over the next 12 months calls for a slight decline as well.

The chart below provides even more perspective. It clearly shows that historically, Bay Area real estate falls into a bear market every 5-7 years.

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Source: Paragon Real Estate Group

So while their 6% appreciation assumption over the long run might be reasonable, they need to be patient and expect downturns along the way. And of course, there is always the possibility that the long-term escalation of prices could go the other way.

As far as the equity markets are concerned, the couple's viewpoint is negatively skewed because of their own poor experience. My recommendation was that they differentiate between their own disappointing performance (due to ignoring their portfolio) and an objective assessment of the opportunities and risks of the market.

2015 was a mild disappointment for investors and 2016 isn't breaking any records either. As you can see below, and as is probably no surprise to Seeking Alpha readers, the market is indeed pricey. The forward P/E for the S&P 500 and the STOXX 600 (which is an index of 600 mid and small cap European equities) are at historical highs.

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Asia, excluding Japan (as represented by the MXAPJ index) is not at its all-time high but it's on the high end of its range. Only the Japan Index [TOPIX] looks fairly priced. That could translate into greater risks ahead at least in the short run. This is especially true for investors who have all their assets in the S&P 500 or European indexes.

Perspective

Now that we see that both San Francisco real estate and stock market prices may be problematic in the near term, it's time to get back to this couple's question: How should they invest their $600,000?

In order to do that, we have to restate the purpose of this investment - to secure their future retirement. This investment decision must be evaluated through that lens.

Since their preference is to either buy a rental or a larger home and convert their existing home into a rental, let's consider those options first. And since they would ideally like to move into a larger home now, we'll run those numbers to see if it works.

In order to evaluate this option, we have to make assumptions about the net rental income after all expenses and a reasonable appreciation rate. As I said at the outset, the couple feels that they would generate roughly $2,000 in positive cash flow regardless of which house they rent out. My first request was that they confirm that number by doing their homework. After doing so, they confirmed that the property would clear $2,000 a month after all costs.

They are optimistic about price appreciation and they have good reason for that. In fact, if you consider the net growth since the mid-80s, 6% might even be too conservative. But the appreciation rate is only important if they decide to sell one (or both) properties sometime in the future. Their initial plan is to hold on to both properties as long as possible, so that's what I modeled for them.

The clients need to understand that while the properties might appreciate handsomely, the rents won't. That's because San Francisco property is subject to rent control. Currently, landlords are precluded from raising rents more than 1.6% per year. Worse (for landlords) going forward, allowable increases are capped at 60% of the increase in the Bay Area CPI.

Based on this and other financial information the couple provided, I ran a Monte Carlo simulation which yielded a sobering result.

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This shows the likelihood of this couple achieving their goals using the $600,000 to purchase a rental property and holding on to it. As you can see, the odds are not favorable. In fact, they are 0.

So if all other things remain constant and they buy and hold real estate, their plan will not likely work. The appreciation is of no use to them and the rental income will not be enough. They will be house-rich and retirement-poor. No bueno.

We spoke about buying property outside their local area with a better rent/price ratio. I suggested they investigate nearby areas that were in high demand, had strong appreciation, better rents and no rent control. This was something they never considered and agreed to look into.

Other options.

I ran the projection again this time assuming a 4% appreciation rate (to be more realistic/conservative) and a sale of one of the properties at retirement. Since their preference was to buy a larger home now and rent out their existing home, that's the scenario I ran.

As you can see, things look a lot better:

This means that if they stay on track with other inputs of their plan, they have an 87% chance of achieving their financial goals and not running out of money in retirement. This has the added goal of increasing their diversification as stated above.

Next we run the scenario of investing the $600,000 in equity markets rather than buying a rental. The result is a little better but not by much:

Based on all this information, you might conclude that as long as the couple is willing to sell the rental when they retire and invest the proceeds to create income, it doesn't matter if they buy property or invest in the market. That might be the case, but it's still too early to say. Here's why.

These projections are calculated based on this couple being able to net $2,000 a month from the rental (whichever property that is) and to maintain their other savings plans which include contributions to both before- and after-tax plans. That means these people have to be as certain as they can about all the costs associated with owning rentals. In addition, they have to objectively assess whether or not they will be able to maintain their savings commitments. That of course will depend on their spending patterns and their income.

Also since their home and their rental will be nearby, they must accept the risk of having a non-diversified real estate portfolio. For the time being, let's put that aside.

Bottom line, in order for them to achieve their prime objective, they have to make savings THE priority. If they feel that buying property jeopardizes saving for whatever reason, the market might be a better route.

This couple approached me because they wanted to determine if it was smarter for them to invest in the market or to buy property. Once we dissected their situation, we saw that both decisions have risks over the short run. (Since they are long-term investors, that doesn't have to be a major problem; but they do have to be aware of the potential for significant drawdowns in either market.)

They also learned that if they bought property, they'd probably do well over the long run but would almost certainly have to plan on selling one property when they retire. That's because rents in San Francisco are structured to rise slower than inflation. Finally, they learned that the most important success ingredient to help them achieve their long-term goal is to maintain their savings plans. That is the single most important thing they can do and they must evaluate their decision through that filter.

These people were willing to see me to answer their investment question and would have been satisfied with a simple answer; a. buy real estate or b. invest in the market.

What they really needed however was a fair assessment of the risks of either decision, better perspective, and clarity on what the most important question was, i.e., which alternative helps them achieve their most important task (answer: monthly saving).

In conclusion, as long as this couple stays on the savings path, they will probably achieve their retirement goals regardless of which decision they make. Perhaps the best decision would be to use the $600,000 to buy the larger home. Then they might sell their existing home and buy in another market with better rent/price numbers. (This would have the additional benefit of providing a tax-free realization of the first $500,000 in capital gain on the sale.)

That would also mitigate the risk of having all of their real estate in one location and it would decrease their current lopsided allocation to stocks. This was an idea that they had not considered at first but one that became clear once everything was laid out on the table and they focused on their ultimate goal.

If that option is not acceptable, I would opt for investing the money in the market. That's because I don't like the rent control, the high concentration of their net worth in one geographical location (prone to having earthquakes) and I would be concerned about the sustainability of those high appreciation rates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.