The Age Old Investment Question: Stocks Or Real Estate? - Part IV, Rental Income Revisited And Stock Market Returns

|
Includes: AAPL, AMZN, BRK.B, GOOG, SPY, SSO, UPRO
by: Ryan Telford

Summary

In Part I of this series, we looked at potential rental income returns on single property portfolios.

Using leverage in real estate to access equity in existing properties to acquire additional properties is an advantage in real estate investing.

At the same time, using equity from a property is a loan, and these interest payments do limit net rental income over time.

Leverage is an edge in real estate investing over the stock market; however, if used prudently, leverage can also be used in the stock market to achieve larger gains.

In Part I of this series on the Stock Market vs. Real Estate investments, we looked at various scenarios to help forecast what a real estate investor can reasonably expect to achieve in terms of net rental income (or cash flow) returns.

Part II included a look at returns from appreciation in single properties.

In Part III, we considered different scenarios in which we used equity in our first property to acquire additional properties, and the equity in the new properties to acquire even further properties. While this leverage is a very powerful benefit of real estate investing, many aspiring real estate investors may be under the impression that additional properties result in proportionately more net rental income. An investor can increase his or her net rental income; however, the interest payments on the equity loans to acquire additional properties can have a meaningful impact on overall net rental income. In this article, we will see just how this is the case.

In this article, we will also wrap up this series by comparing our various real estate returns to those reasonably achieved in the stock market.

Rental Income, Re-Visited

Our initial rental income evaluation in Part I looked at rental income at a specific point in time, and did not consider long-term effects. Each year, landlords are permitted to raise their rent accordingly to a government standard. In Ontario, Canada, that is 1.5% this year, or roughly the average annual inflation rate. We will assume that any repair costs to properties increase the same amount per year. In other words, we will assume our net rental income values in Part I of this series are consistent over time for a given scenario.

As noted above, as we take equity out of our properties as a loan, we need to pay interest on said loan(s). For each scenario, we will start with the net profit, and subtract HELOC (home equity line of credit) interest payments as required.

From Part I, we had 5 rental scenarios:

Base case, no vacancy or maintenance costs, 4% annual vacancy $100 in monthly expenses, 4% annual vacancy & $100 in monthly expenses, 4% annual vacancy, $100 in monthly expenses and allowance for $3000 per year in maintenance and repairs.

Our summary results for rental income in these single property scenarios is repeated here from Part I:

(Source: Author table & calculations)

When looking at multi-property scenarios, the total amount of net rental income from the portfolio will vary depending on how much financing is being serviced (corresponding to how many time equity has been extracted to acquire new properties).

To reasonably look at rental income on this basis, let's take a three-dimensional approach:

Properties owned during our Period #1 (consistent 5% property appreciation, see Part II), with Rental Income Scenario (#1 through 5 above, Part I), and Property Portfolio Scenario (how much leverage is used to acquire additional properties, see Part III)

Portfolio Scenario #1 (3 properties after 20 years, see Part III)

The table below summarizes the net rental income for each property, the HELOC taken out on each property, and monthly interest charges (at an assumed annual rate of 3.5%).

(Source: Author table & calculations)

The first thing that may jump out is that the monthly interest on one HELOC loan is only $36 less than the net rental income from one property. Let's see how having additional rental incomes is affected by the HELOC interest payments. The table below list net monthly rental income per property, after interest payments. Total annual net rental income is listed per year, and over the 20-year period.

(Source: Author table & calculations)

Many novice real estate investors may be tempted to assume that a portfolio of three (3) properties means a 3X increase in net rental income. In reality, refinancing is not "free money." The table above demonstrates that when borrowing equity, rental income increases only fractionally with the addition of more properties. At years 1 through 11, our one property portfolio would provide a net rental income of $363.15. At year 12, a threefold increase in properties would only produce a 20% increase in net rental income.

For Period #1 and Rental Income Scenario #1, the following tables show total net rental income for the various property scenarios.

Property Scenario #2, Buy Two Properties Once Equity is Available

Rental income and HELOC interest summary:

(Source: Author table & calculations)

Net rental income per property per year:

(Source: Author table & calculations)

As is to be expected, from investing in property #2 once equity was available in Property #1, we were able to net more rental income in our investing period as opposed to buying property #2 and #3 at the same time (as we did in Portfolio Scenario #1).

Scenario #3, Buy Property #3 from Equity in Property #2

Rental income and HELOC interest summary:

(Source: Author table & calculations)

Net rental income per property per year:

(Source: Author table & calculations)

Interestingly, with the added property #4, the total net rental income over the period is only roughly 5% greater ($112,000 to $118,000). This is due to the added interest payments on the 3rd HELOC to acquire property #4.

Scenario #4, Extract all equity once available (Max Leverage)

Rental income and HELOC interest summary:

(Source: Author table & calculations)

Net rental income per property per year:

(Source: Author table & calculations)

While we have increased the number of our properties in this portfolio by 75% (4 properties to 7), our revenue has only increased by roughly 30% from our four (4) property portfolio due to the added interest payments.

Total Rental Revenue for Different Rental Income Scenarios

We have just looked at the net rental income over different investing portfolio sizes for our ideal rental income scenario (Rental Scenario from Part I). What about rental income scenarios where we have vacancy expenses and/or additional maintenance expenses? This is what our Rental Scenario #s 2 through 5 cover.

For period #1 (consistent 5% property appreciation), the table below presents total net rental income for the different Portfolio scenarios, but in all 5 rental income scenarios:

(Source: Author Table & Calculations)

The returns listed above are in addition to the capital appreciation rates we calculated in Part III.

There are a few takeaways from this table. As we have found with our Rental Income Scenario #1, net rental income is not directly proportional to the number of properties in the portfolio. For example, having 4 properties does not correspond to a rental income 4 times greater than having only 1 property. Interest charges on the loan(s) can have a significant impact on net rental income. That being said, the additional properties can also provide significant returns long term on appreciation as we noted in Part III.

As we noted in Part I on net rental income, being as realistic as possible on potential costs is critical in forecasting net rental income to ensure positive cash flow. This need is further amplified with additional debt service charges.

In our 20-year holding period, some scenarios actually resulted in less net rental income with more properties (Portfolio scenario #s 2 & 3, with rental income scenario #s 2 & 3).

Keeping Perspective on Real Estate Returns

As has been reiterated several times in this series, forecasting real estate investment returns can be very difficult due to the many moving parts that make up the investment and portfolio. The returns in this series are based on a very specific set of conditions, and would need to be adjusted for each case on many variables.

To sum up, here are the main items to consider:

  • Initial house price(s)
  • House appreciation rates
  • Mortgage interest rates and mortgage terms
  • HELOC interest rates and terms
  • Investor's credit rating
  • Rent amount
  • Amount of work required to be invested in house
  • Monthly expenses local to the area (property tax, insurance, etc.)
  • Tax considerations specific to each investor
  • Access to financing (particularly for multi-property scenarios)

There are also several other sub-asset classes of real estate that one could invest in, including commercial real estate, or partner with someone in a joint venture (JV) deal perhaps taking on less of the day-to-day operations of the investment, or to invest in managed properties.

Answering the Question, Stocks or Real Estate?

We have spent a fair amount of time estimating long-term real estate returns. As we did in Part I, it will be helpful to review the qualitative aspects once again in comparison to holding stocks.

Investing in a physical real estate asset is fundamentally different than investing in stocks. As a stock investor, chances are you a silent investor, and are not involved in the day-to-day operations of the firm(s) you are investing in. As an index or ETF investor, this is even less the case. As a real estate investor, you are not only investing in the asset, but you are also fully responsible for the operations of the business of said asset. You are essentially running a business, and a shareholder with 100% interest (of 50% if in a joint venture). If you do not, or cannot maintain your asset(s), you run the risk of not being able to maintain tenants long term. Worse, should lack of maintenance result in an injury to your tenants, there are the legal risks. There is proportionately more time operating and maintaining your real estate assets compared with being a stock market investor.

The element of time and effort input to maintain or upgrade the asset(s), or "sweat equity" as it sometimes called, is very difficult to quantify, but needs to be considered in assessing a real estate investment. There is also the aspect of whether you enjoy, or have the inclination to maintain the house yourself, or hire someone else. This is fine; however, remember that any out-of-pocket expenses hiring others come out of your bottom line on the investment.

In running any business, there is, of course, the human element. Throughout the life cycle of your house asset(s), you will deal with many different types of people, from professionals who are on your team (lawyer, accountant, real estate agents, etc.) to your customers (tenants). At time of house purchase and sale, you will be responsible for a considerable amount of coordination between your team. During the life of the house, you will be responsible to your tenants. If you own a great rental property with great tenants, there may be little for them to complain about. The more TLC that your asset requires, and the more picky the tenant, the more likely you will have much interaction, and fixing and maintaining the house. Consider this aspect carefully in multi-property portfolios (our maximum leverage scenarios in Part III included portfolios with 6 to 9 separate properties).

The Stock Market vs. Real Estate

Over the long term, our real estate scenarios have come up with some respectable returns, with double-digit returns in multi-property scenarios in most cases (20% or greater at times). As we have seen, timing can have a considerable impact on these returns.

How do our real estate returns compare to the stock market over time?

For an investor who is most interested in investment income (rental income), over the long term, our single-property scenarios resulted in CAGR returns of between -1% and 6%. Multi-property portfolios had CAGRs of roughly the same.

With the average dividend stocks paying between 2% and 4%, our specific rental scenarios have suggested a wider range of return. Also remember that you are also putting in the extra work and effort as landlord to earn this return; consider that there are some conditions that can result in lower returns.

In terms of long-term gains, some of our portfolio scenarios resulted in a pre-tax CAGR of about 12.6% on the lower end, to 20.3% in others (generally the more properties, the higher the CAGR). Real estate investing is often not a short-term endeavour; for several of our real estate investment cases, buying and selling properties in less than 3 years resulted in a loss.

Indices

Over time, most indices have not achieved even the lower end of our multi-property scenarios. The Russell 1000TR and 3000TR, for example, have achieved a CAGR of between 5.94 and 6.1% since 1999 respectively. The S&P 500 has performed at roughly 5.2% in the same period.

On this basis, over the long term, our real estate investing scenarios win when compared to non-leveraged index investing.

REITS

Real Estate Investment Trusts allows investors to invest in real estate, with all management being done by the real estate holding company.

Over 20 years, US REITs have averaged annual total returns (appreciation and dividends) of 11.13%. This is a decent comparison to holding single properties as we found in Part I. Compared to a multi-property portfolio (our best scenario achieved a CAGR of 20%+).

11.13% is a decent showing, beating out indices as noted above, and allows investors an opportunity to spread risk between the market and real estate without the management aspect.

Individual Stocks

What about other stock investing strategies? There is nearly an endless amount of investing strategies; so we will consider only a few scenarios here.

Some pro-stock market investors have argued stocks over real estate through investing in tech stocks. Tech stocks are a tricky bunch, many of which do not survive over time, while a handful of others go on to become giants. The problem with this argument is that it is based on hindsight bias. It is easy to say today "If you invested in Apple (NASDAQ:AAPL)/Amazon (NASDAQ:AMZN)/Google (NASDAQ:GOOG) 15 or 20 years ago, you would be a millionaire today." At the time, knowing that any of these firms would have gone on to such success, let alone survive, was very unknown. Equally important is the ability of the investor to hold on to these companies during the tech selloff of late 1999 and early 2000 (if applicable), and the drawdown of 2008.

For illustrative purposes, from IPO date of August 2004 to today, an investor in Google could have achieved a CAGR of roughly 23.6% (author calculation).

(Source: Portfolio123.com)

What about tech powerhouse Amazon (AMZN)?

(Source: Portfolio123.com)

After the split, Amazon's stock underperformed or hovered around $50 until 2007. If an investor bought in at the split, since 1999, an investor would have achieved a CAGR of 16.1%. If s/he managed to buy around 2007, that CAGR would have nearly doubled to 32.8% (author calculations).

Apple (AAPL)?

(Source: Portfolio123.com)

A CAGR of roughly 29.7% since 1999, if an investor held on, even higher if s/he took a position after 2004.

Again, for this return, the investor would have had to deal with the drawdowns both in 2008 and 2013.

On the flipside, in 1999, Nortel seemed like it was bound for greatness. The chart below speaks for itself:

(Source: Portfolio123.com)

So, yes, at CAGRs of 30% for our selection tech stocks of Amazon, Google and Apple, these returns blow our real estate investing scenarios out of the water (Amazon after 2007). But practically, these returns are limited to those who had either the foresight, or the good luck, to choose these stocks and hold on.

What about investing with super-investor/operators like Warren Buffett? Investing with Buffett's Berkshire Hathaway (NYSE:BRK.B) since 1999 would have resulted in a CAGR of just over 8%.

(Source: Portfolio123.com)

While the probability of BRK to survive over time was relatively high, the non-leveraged return of 8.1% is at the low end of a single property investment return, but pales in comparison to our multi-property portfolio returns.

But the key phrase is "non-leveraged." Let's take a look at putting leverage to work in the stock market.

Leverage

As we have discussed, one of the key aspects of real estate returns is that of leverage. Our 20% down payment is a lever to base returns. If an investor purchased 100% of the property without any leverage, returns (both rental and capital gains) would be significantly lower. In the stock returns we have covered above, leverage has not been considered. Buying on margin or using a loan with a very low interest rate to invest for higher returns can amplify returns accordingly.

The double-edged sword of leverage can make a material difference to any investment by both boosting positive returns, and amplifying negative returns and drawdown.

When investing only 20% of your own capital, real estate can be very attractive. Lenders are generally comfortable with lending this amount of money as it is attached to collateral, or the house. Asking a lender to leverage you at 5X to invest in stocks may be a challenge. Perhaps, you have a primary residence or an investment property with equity you could tap into.

Let's look at a few leverage scenarios.

Leveraged ETFs

Instead of having to take out your own loan, several leveraged ETFs take on debt for you. Recall in Part I we briefly discussed leveraged indices. SSO and UPRO are leveraged versions of the S&P 500 at 2X and 3X respectively. Recall that our real estate example is approximately 5X (after an initial 20% down payment).

Charts for SSO and UPRO are shown below. Note that performance before the ETF's inception date is calculated by Portfolio123.

(Source: Portfolio123.com)

The SSO strategy actually lost value over the 19 years, while UPRO (3X leveraged) managed to double in value over the period (about a CAGR of 4% over the period, compared to 5.2% of the S&P 500 (NYSEARCA:SPY) non-leveraged). Also note the significant periods of drawdown from 2000-2002 and 2008-2009.

Another leverage option is to leverage a reputable stock. Many would argue that "reputable stock" is an oxymoron; however, I believe there are a handful that have truly stood the test of time. Not only in hindsight, but a timeless firm or stock of sorts. To me, Berkshire Hathaway is one of these stocks.

Leveraging at 5X may not be available to all investors, so assume that an investor has access to 3X his initial investment. This may be through a home equity line of credit on his/her principal residence, or even on an investment property.

This investor puts down his $60,000 and uses debt to purchase the stock. S/he will be responsible for interest payments on the loan, assume this amount is cashed out of his holdings at year-end from his BRK holdings. We'll assume a holding period since 1999. Similar to our real estate portfolios, s/he will cash out the stocks at the end of the period, and pay off the loan.

The following table assumes an average lending rate of 5% on the loan:

(Source: Author table & calculations)

While not necessarily historical, if you assumed a loan rate of 3% over the period and investor would theoretically net an additional $100,000:

(Source: Author table & calculations)

Keep in mind that these are simple calculations in that it assumes that each year returns the CAGR, and that the interest rates are consistent. Suffice it to say, the larger the spread between the expected CAGR and the loan rate, the better. The more leverage the investor has access to, the better as well.

While we have managed to improve BRK's return from 8.14% to 12.1% best case, I don't believe investing in a single stock over a long period of time is a realistic investment strategy either. As diversified as BRK's operations are, having all of your eggs in one basket is not for the faint of heart through drawdown periods. Still, this is a more realistic single holding than technology stocks in my opinion.

Higher returns still prevail from multi-property real estate investing, keeping in mind all of the additional work required in real estate management.

Quantitative Portfolio Investing

I am a portfolio investor, meaning I invest in baskets of stocks based on a specific investing strategy. These strategies are buy and hold, with holding times as long as one year, and as short as 3 months. Some of these types of strategies have done particularly well over time. To date, I have written about two of these strategies on SeekingAlpha, Greenblatt's Magic Formula investing (cheap companies at bargain prices), and the low enterprise value to earnings before interest and taxes (EV/EBIT) strategy, which looks for cigar-butt type companies.

Both of these strategies have performed well over time. Magic Formula investing in large-cap stocks has achieved a CAGR of from Jan. 1999 to Dec. 2015 of 15.5%. Low EV/EBIT strategies have performed at a CAGR of 17.5% for the same period (see articles above). Other strategies have provided greater returns, which I have yet to write about.

Real Estate or Stocks?

Over the course of this series, we have looked at several different investing scenarios. If one thing is clear, it should be that investing in any of these scenarios has many moving parts, and requires a particular skill set and/or investor personality.

To add, the element of timing cannot be neglected in any investing scenario. The point at which an investor enters or leaves a position can have a significant impact on the end result.

Generally, real estate returns over the long term can provide very attractive returns. Leverage also plays a very important role in the investment. While using leverage can benefit investors in the stock market, it can also amplify losses if not put to use prudently.

This being said, investing in single family homes takes effort. As a landlord, at a minimum, the investor must keep his/her properties in good condition to maintain the asset value. He or she is also responsible for several tenants, and has legal obligations to them. On the other hand, as a real estate investor, you have the potential to have more control over your investment than you would in the stock market.

So, as much as I dislike sitting on the fence, I believe that a prudent answer to our question is "it depends." Real estate and stocks really are different asset classes, and both should ideally be a part of any investor's portfolio.

I hope this series of articles has provided some food for thought. We have looked at a very specific real estate investment case, and there are many variations. As with any investment, be sure to do your own due diligence, and ensure that forecast returns and risks are in line with your investment goals.

Until next time, happy investing.

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.

Additional disclosure: I am a user of Portfolio123.com, and have included affiliate links in article.