New York (CNN/Money) – Real estate or stocks?
If that's the question that keeps you up at night, welcome to the club. Many investors are wondering where to park their cash. And with the stock market in the dumps and real estate going gangbusters, who hasn't wondered if becoming the next Donald Trump is where it's at?
Nationally, housing prices are up 6.4 percent as of August, but in some places they've soared more than 20 percent in the past 12 months, the National Association of Realtors (NAR) reports. Why not bag the bears and bulls, purchase a tax-friendly rental property and watch your investment grow? After all, you reason, it'll continue to appreciate while producing a steady income stream.
Trouble is, it's not that simple. Housing prices do fall from time to time and there's already word of a housing bubble that's likely to pop.
So, let's say you've got an extra $100,000 or just came into a $50,000 inheritance. Do you plow it into real estate or put your faith in Wall Street?
|Real estate calculators
The quick answer: There isn't one. Yes, real estate can pay off big time - as can stocks. But both can plummet in value. And while real estate may provide steady rental income, it's a non-liquid asset so you can't sell it in a pinch. Variables aside, however, there is some math to crunch. So pull out that calculator and let's take a look.
First, consider the two ways you can potentially make money on rental property. That'd be rental income and/or a fat payout if you sell the place at a profit.
If you've got a monster mortgage and high expenses, rent may not cover your overall costs, even though they're deductible. By the way, don't forget some of those costs could include a professional caretaker to deal with tenants if you're not the kind of person who wants to put a lot of effort into property management. (Read what it takes to become a landlord for more details on the kind of challenges you may face.)
Once you figure the costs, you've got to determine if your rent will leave you in the red or the black. In general, if you want to break even your rental income should equal 10 percent of the property's value.
So, let's say you take that $50,000 and use it as a 20 percent down payment on a $250,000 rental home – can you make at least $25,000 in rent a year? Check out ads for rental units in your area to see if your projection holds up.
These days, while the housing market remains hot, you may have trouble renting at all. If someone can buy as cheaply as renting, they'll often buy. That means landlords have to lower prices to attract tenants. In fact, they're already doing so. While rents have risen about 3.5 percent nationally in the past decade, this year they're down an average of 2 percent. And in some markets, like San Jose, San Francisco and Austin, rents have dropped 12 percent to 25 percent in the past year, according to NAR.
"We're looking at a very strong housing market so more renters are becoming homeowners," said NAR economist Sigrid Fennemore. In fact, rents should drop nationally by another 1 percent next year, she predicts, as massive layoffs take their toll.
Of course, some investors may be willing to eat some of the monthly mortgage costs if they think they can make a killing when they sell their property down the road, said Jack Harris, a research economist at the Real Estate Center at Texas A & M University.
"Back in the early '80s in Texas, when the appreciation was so high, there were people (willingly) losing money on the operation of their property," he said.
Add it up
As it turns out, it doesn't take much to beat the Street. Consider your $250,000 rental property.
- If it climbs 6 percent in value the first year - the historic average annual gain on housing nationwide - you'd be sitting on an asset worth $265,000. You would have made 30 percent on your $50,000 downpayment.
"That's the effect of leveraging," said Gerald Weiss, a certified financial planner in Dublin, CA, who notes the value of your entire investment goes up, rather than just the value of the downpayment you contributed.
The 30 percent gain, of course, excludes Realtor fees and other costs you'll incur when it's sold. The profits on investment real estate are subject to capital gains tax if you sell and don't swap it for another income producing property.
Now let's try a similar equation using stock investments.
- Assume you plunk that $50,000 into an S&P 500 index fund that returns a conservative (though difficult to achieve lately) 8 percent. That's a $4,000 gain.
- Not bad. But in order to make the same amount on your rental property, it would have had to appreciate far less – by just 1.6 percent. (To do the math, divide $4,000 by $250,000 and you'll get 1.6 percent.)
So, is real estate a slam dunk?
"First, to make it work, you have to find property where you'll get the cash flow. That's the most difficult thing," said Weiss. "Can you find a property where you'll get enough rental income to pay mortgage, taxes and expenses? Second, are you the type of person who can manage it? And the third hurdle is you've got to be in some market that won't drop on you in the next seven to 10 years."
Investors who expect real estate to pay off quick are making huge blunders, warns Gary Schatsky of the National Association of Personal Financial Advisors, who decries real estate as "the momentum stock of the decade."
"You don't want to be market timing, and that's what people are doing with real estate right now and what they did with tech a few years back," he said. "You shouldn't equate rental real estate with a [Certificate of Deposit] in a bank. "
Instead, experts like Schatsky and Weiss say they advise clients to have 5 percent to 10 percent of their portfolios in real estate – including Real Estate Investment Trusts (REITs).
REITS have earned more than 30 percent since 2000 - plus they've delivered 7 percent dividends. Best, to make this money you never have to deal with a tenant. For more details, read "REITS still have the right stuff."
Says Schatsky: "Right now it's better to have a diverse portfolio."