Possibilities for Passive Income – Real Estate and Stock MarketBeau Ruff
With the Tri-Cities housing market about as hot as it has ever been, why would an investor want to consider investing in the stock market? Let’s compare and contrast some of the common characteristics of investing (whether in real estate or the stock market) and see if the proposition of investing in the stock market is equally compelling. For comparison’s sake, let’s also assume we are not talking about a personal residence but instead the acquisition of additional real property.
Leverage. One virtue of real estate investing is the ability to leverage money by way of a down payment and bank financing for the remainder. A buyer can take her $30,000 and end up buying a property valued at $150,000. If the real estate market goes up just 5%, then the buyer’s $30,000 of equity just increased to $37,500 (or a 25% gain on equity), but she is also taking on a debt (leveraging her money 5:1). A person can similarly leverage her cash in the stock market by way of “margin.” This is effectively the same as leveraging cash to buy real estate. Instead of borrowing money from a bank, the individual is usually borrowing from a brokerage firm to buy stock.
Diversification. A real estate investment is typically in addition to the investor’s personal residence. And, usually both properties are in the same geographic location. A well-recognized rule of investing is the Prudent Investor rule (codified in the laws of virtually every state in one form or another). This rule is predicated upon Modern Portfolio Theory and has an explicit requirement for diversification of investments. The caution for the real estate investor in this situation is to consider diversification – is it met by the acquisition of another residential property? Or might the additional investment into operating companies (via the stock market) provide better diversification. Conversely, the same could be said if the investor owned no real estate but had a large retirement account invested in the stock market.
Transaction Costs. Normally, real estate has a relatively high transaction cost. When a person sells a stock, the cost of selling the stock is very low or free with some brokers. When a person sells real estate, the situation is different. Typically, the seller of real estate hires a real estate agent that charges around 6% of the total value of the real estate. On top of that, the seller pays customary closing costs, cost of title insurance, and real estate excise tax (around 1.78% here locally). All told, the transaction cost on selling a real estate asset can reach 10%. Additionally, the real estate investor must consider the cost of property management.
Liquidity. If liquidity were a spectrum, then the purchase of real estate would tilt towards more illiquid. If you want to sell it and even if you have an immediate buyer, it takes time. Once a renter moves out, it might take two to three weeks to get the property list-ready. Then, once listed on the Multiple Listing Service (MLS) it could take anywhere from 1 day to several months to find a buyer. Once the buyer is found, it might take another 30 days to get the paperwork drawn up for the contract, obtain title insurance, conduct inspections, and to close the transaction with a closing agent. By contrast, a stock or mutual fund can be sold instantly, and the proceeds deposited back into the investors account within 1-3 days.
Volatility. While either asset class experiences volatility in price, stocks are generally considered more volatile than real estate.
Tax Considerations. If the investor is using real estate as income producing property, then the investor gets to depreciate the property and deduct that, as well as all expenses, against the income of the property. The investment in stocks and mutual funds do not have a similar feature to the individual investor. Of course, the company in which the investor is investing is able to use tax deductions in its favor, and the investor indirectly benefits from this. So, real estate can provide some big tax breaks for those that want to shelter income. But, note that upon the sale of the real estate, the investor must recapture the depreciation at a rate of about 25%. Beyond that, both real estate and stocks are taxed at similar capital gains rates.
Passive Income. Many people value investing in real estate as it provides a passive income stream. As mentioned above, rental properties are not entirely passive – there is the necessary management (which became more complicated for landlords in Washington recently with the new Landlord Tenant Act). The stock market does provide passive income. If you buy a share of ABC, Inc. you probably couldn’t work for ABC even if you wanted to (well, most of us can’t). Instead, you are a passive investor whose sole role is to vote in annual director elections or other mega corporate issues all while participating in the company’s success (or failure).
Investing in either real estate or the broader stock market can be financially rewarding. Consider the characteristics of each to determine what works best for you…and remember to diversify.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect actual current or future interest rates. The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company. Stock investing includes risks including fluctuating prices and loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
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