real estate vs stocks: comparing returns

In short

A friend of mine spent two years arguing with his brother in law about whether a rental house beats a stock fund, and neither one ever changed his mind. If you are weighing the two, you have probably noticed that the headline return numbers rarely tell the whole story. A fair comparison counts every dollar going out, not only the dollars coming in. For a house, that means the mortgage interest, taxes, insurance, repairs, and the months it sits empty. For stocks, it means fund fees and the tax on gains and dividends. Put both on the same after cost, after tax footing, and the picture gets clearer. This page shows how to do that math with your own numbers.

The whole of it

What it is

I once watched a retired schoolteacher lay two napkins side by side at a diner. On one she wrote "house." On the other she wrote "stocks." She said the trouble was that nobody ever compared them on the same terms. She had a point.

If you are holding some savings and wondering where it might grow, you are really asking about total return. Total return is everything an asset earns you, whether as income along the way or as a higher price when you sell, minus everything it costs you to hold it. A rental house earns rent and may rise in value. A stock fund pays dividends, which are small cash payments from the companies, and may rise in price.

The two differ in shape. A house is one big, lumpy purchase, often bought with borrowed money. A stock fund can be bought in small slices, a little at a time. You can sell a few shares in a day. Selling a house takes months, and the seller must pay closing costs.

Shape matters. It changes the math.

How it works

A neighbor of mine bought a small duplex some years back, and he told me the first lesson was that rent is not profit. The tenant pays the rent. Then the owner pays the property tax, the insurance, the water line that broke, and the roof that finally gave out. What is left over is the real income.

Real estate return comes from two places. The first is net rent, which is rent collected minus the costs of running the place. The second is appreciation, which is the rise in the home's price over time. Many owners also use a mortgage, which is a loan secured by the property. A mortgage can magnify gains, because the borrower earns on the whole house while only putting down part of the price. It magnifies losses the same way. The borrower has to repay the loan whether the rent comes in or not.

Stock return also comes from two places. The first is dividends. The second is price growth. A broad index fund, which holds a little of hundreds of companies, charges a small yearly fee called an expense ratio. That fee comes out of the fund before you ever see the return.

Taxes shape both. Under federal law, a gain on an asset held longer than a year is taxed as a long term capital gain, usually at lower rates than ordinary pay. Rental income is taxed as ordinary income, though the owner may subtract expenses and depreciation, which is a yearly tax deduction for the wear on the building. The Internal Revenue Service explains these rules in Publication 527, Residential Rental Property, and in Publication 550, Investment Income and Expenses. Both are free on irs.gov.

One more thing deserves a plain word. The seller of a home may owe tax on the gain when it sells, and the owner who took depreciation may owe some of it back. The tax code calls this depreciation recapture. A good tax preparer can walk through it.

The numbers, and where to find yours

You have probably seen a chart showing the long run average return of stocks and another for home prices. Those averages are handy, but I would be careful leaning on any single figure. The averages shift depending on the years you pick, and no past number promises a future one.

Better to gather your own inputs. For a house, you want the purchase price, the down payment, the mortgage rate, the yearly property tax, the insurance quote, a repair budget, and a fair guess at rent and empty months. Your county assessor's website lists property tax. Your insurance agent gives the premium. Local rent listings show what similar places charge.

For stocks, you want the fund's expense ratio, which sits on the first page of its prospectus, the fund's own plain document. You also want your tax rate on gains. The IRS sets the brackets each year, and the long term capital gains rates and income thresholds are the current figure, which the official source publishes each year. The federal rule on how much of a rental loss you may deduct against other income is also set by law, and the current limit is the current figure, which the official source publishes each year.

For price history, the Federal Reserve Bank of St. Louis keeps public data on home price indexes and stock indexes at its FRED site. Pull the years that match your own timeline, and remember that your own result will differ from any index.

A worked example

I want to tell you about a woman named Dana, because her story shows the whole idea in one place. Dana has $60,000 saved and is trying to decide between two paths over one year. She wants to compare them honestly, so she keeps the figures simple.

Path one is a rental. She puts $60,000 down on a small condo. It rents for $1,500 a month. Over twelve months, that is 12 months at $1,500, which is $18,000 in rent. She expects the place to sit empty one month, so she collects 11 months at $1,500, which is $16,500.

Now come the costs. Property tax is $3,000. Insurance is $1,200. Repairs and upkeep are $1,800. The mortgage interest for the year is $6,000. Add them up. $3,000 plus $1,200 plus $1,800 plus $6,000 is $12,000 in costs. Net rent is $16,500 minus $12,000, which is $4,500.

Say the condo's value rises 3 percent on a $300,000 price. That is $300,000 times 0.03, or $9,000. Add the $4,500 net rent and the total gain is $13,500. Against her $60,000 down payment, that is $13,500 divided by $60,000, or 22.5 percent. Sounds grand. But she has not counted closing costs or taxes yet, and the loan magnified a modest 3 percent price rise.

Path two is a stock fund. She puts the same $60,000 into a broad index fund with an expense ratio of 0.10 percent. The fee is $60,000 times 0.001, which is $60. Suppose the fund earns 7 percent before fees, or $60,000 times 0.07, which is $4,200. After the $60 fee, she keeps $4,140. That is 6.9 percent.

Look how different the two stories feel. The house shows a bigger number, but it carries borrowed money, a vacancy risk, and a repair bill that could double. The fund shows a smaller number with fewer moving parts. I am not telling Dana which to pick. I am only saying her numbers deserve to sit side by side, with every cost counted.

Where it goes wrong

I have seen plenty of good folks trip on the same few stones. The first is forgetting the hidden costs. Closing costs, agent fees, and long empty spells can eat a year of rent. The seller of a home must often pay real estate agent commissions, and that cuts the gain.

The second is comparing a leveraged house to an unleveraged fund. Leverage means using borrowed money. A house bought with a loan will swing harder in both directions than a fund bought with cash. Compare them on equal footing, or at least say out loud that they are not equal.

The third is leaning on one lucky stretch of years. A home that doubled in one market tells you little about the next. The same goes for a fund. Short windows fool people.

The fourth is ignoring your own time. A rental asks for phone calls, showings, and fixes. A fund asks for very little. Your hours have worth, and a fair comparison should count them.

The fifth is the tax surprise. Depreciation recapture and capital gains can shrink what you keep. Read the IRS publications named above, or sit down with a tax preparer.

Ordinary people get this wrong. It is nothing to be ashamed of.

Questions to answer before you leave this page

What would I truly keep from each choice after every cost and every tax is counted? If the roof fails or the tenant leaves, could I cover the loan without losing sleep? How many hours a month am I willing to give a rental, and what is that time worth to me? Do I know the expense ratio of the fund I am looking at, and have I read its prospectus? Have I pulled my own local rent, tax, and insurance figures instead of trusting someone else's average? Am I comparing a house bought with a loan to a fund bought with cash, and have I said so plainly? Which risk would bother me more, a long empty month or a bad year in the market? And who could I sit down with, a tax preparer or a fee only planner, to check my math before I commit a single dollar?