Real Estate vs. High Yield Equities: What's the Better Choice for Investors?

Includes: COP, CYS, PM
by: Nicholas Pardini

Many investors and economists believe that we have reached a bottom in the housing market. Whether this is the case or not, is it still a good idea to buy investment property as part of your financial portfolio.

As a prerequisite, an individual's own home is not a investment (hopefully people have learned this from the current housing bust), rather it is consumption because you are forgoing the returns of rental income to live in the property yourself. There are plenty of other reasons to own a home instead of renting (stability, customization, replacing rent with forced saving, etc.), but capital gains is not one of them.

First lets look at the performance of real estate versus the stock market and high yield stocks over the past thirty years:

Case Shiller Housing Index

As you can see with the exception of the early 2000's housing boom, housing prices have been flat when adjusted for inflation. Stocks on the other hand have risen significantly over the past thirty years (particularly high yield stocks). Over any thirty year period since 1802, US stocks have always outperformed the bond market. A house trades like a fixed income instrument as prices rise and fall with changes in interest rates. A lower interest rates makes mortgage payments more affordable and therefore demand for housing and the reverse occurs with rate hikes.

So in reality, buying a house is like a bond with a roof. Since real capital gains have been pretty flat historically, the return from a property is a fixed rent check every month.

In this chart, I am going to compare the rental income from a renting out a house in an expensive real estate market (suburban Orange County, CA) and cheap housing market (Austin, TX) to buying three blue chip dividend stocks (Philip Morris (NYSE:PM) and Conoco Phillips (NYSE:COP) have the same yield), and a speculative REIT. My assumptions are that their is no maintenance costs or vacancy period for the houses, and the that the tax benefits of dividends and mortgage interest deduction even themselves out.

COP/PM Cypress (NYSE:CYS) LA House Texas House Intel
Initial Cost: $100,000 $100,000 $100,000 $100,000 $100,000
Remaining Debt n/a n/a $400,000 $150,000 n/a
Leverage: 0% built into stock 400% 150% 0%
Annual Mortgage n/a n/a $27,000 $12,000 n/a
Annual Rent: n/a n/a $36,000 $24,000 n/a
Property Taxes: n/a n/a $7,500 7,500 n/a
Dividend/Net Rent $3,630 $18,830 $1,500 $5,500 $3,820

Dividend/Rent Yield:

Philip Morris International: 3.63% Orange County House: 1.5%
Conoco Philips: 3.63% Austin Texas House: 5.5%
Intel: 3.82% Cypress Sharpridge: 18.83%

The chart below shows that with zero percent margin all of the stocks outperform the Los Angeles real estate and if you adjust for leverage, outperform the Texas house as well. Except for Cypress Sharpridge Investments (CYS), these were two low risk blue chip stocks who are not at risk of cutting dividends. Despite generous assumptions favorable to housing and low mortgage interest rates (~5%), the stocks still outperform the house on a return basis with dividend yields alone. The blue chip stocks also have significantly more capital appreciation potential than the house. This analysis has not also factored in a liquidity premium that buying a house should have versus a stock due to the inability to sell the property at will. Maintenance costs and the cost of managing the property (whether opportunity cost of investors time or hiring a manager), and the risk of vacancy are liabilities a land lord faces that a blue chip stock holder does not have.

Overall, I believe that long term investors and short term traders are better off buying stocks over real estate. Real estate is usually either forced savings or an inflation hedge at best, where there is real growth in dividend payouts and market appreciation along with the peace of mind of liquidity. If you have the bug for real estate nevertheless, try a liquid high yield REIT instead.

Disclosure: I am long CYS, PM.