Whether you choose real estate or index funds as your primary investment, each has an outstanding track record of building wealth. But is one better than the other, if maybe only by a little bit?
This topic was inspired by this question from a reader:
This is an age-old question, and maybe it has no one answer. As a spoiler alert, I think the answer will be different for each investor.
Let’s try to break down the reasons why this is such a tough choice. But before we do, I want to let you know I’m not a heavily experienced real estate investor. My answers are based on my own limited experience, and I’ll be coming at the topic from a financial angle.
Why Invest in Real Estate?
Real estate has proven to be one of the biggest wealth generators in history. It is estimated that up to 90% of millionaires obtain their wealth primarily by investing in real estate.
What makes real estate such a special investment?
1. Long-term capital appreciation
The median price of a home in 1970 was around $23,000. But by the end of 2021, that figure has risen to $408,000. That’s an incredible 1,770% increase in 50 years. Few investments can match that performance.
2. Rental income
Properly structured, real estate investment can generate regular income, in addition to long-term capital appreciation. While the income may only cover the monthly payment of the property after purchase, returns will become increasingly positive as rents increase. And once the mortgage on the property has been paid, most of the rental income will be profit to the owner.
3. Generous tax breaks
At least with investment property, depreciation expense can be claimed to reduce any tax liability. The benefit of depreciation is that it’s a “paper expense”—you can use it to lower your income, even though there is no out-of-pocket cost involved.
But there may be an even bigger tax break when you sell the property. Investments for more than one year get the benefit of lower long-term capital gains tax rates. For example, while ordinary income and short-term capital gains are taxed at rates ranging between 10% and 37%, long-term capital gains tax rates are limited to between 0% and 20%.
Real estate is one investment where a small investor can make a big play with a small amount of money. You can purchase an investment property with 20% down and finance the rest from the bank. With an owner-occupied property, the down payment may be no more than 3%. Because of the high level of leverage, the long-term returns on real estate will be even higher than would be the case if you paid the full price in cash for the property.
5. Real estate is a tangible asset
Some investors prefer holding physical assets to paper and electronic investments, like stocks and bonds. Real estate is the ultimate tangible asset because it represents ownership of land itself.
6. It can be directly managed
When you invest in an index fund, or even in stocks and bonds, you’re turning control of your money over to the fund manager or company management. But when you invest in individual property, you control the entire process.
The Risks of Investing in Real Estate
Despite the easy and painless path the get-rich-quick-in-real-estate crowd claims it to be, real estate has real risks—and they’re not minor.
Here are some examples:
Overpaying for a property. This is more likely during hot markets, when multiple offers boost the property values. But if you buy-in at or near the top of the market, you may not recover your investment for a long time. This is made worse by leverage. Since most of the funds used to purchase real estate are borrowed, and that creates a fixed obligation, what’s really at stake is your equity. A 10% reduction in property values could cut a 20% investment in half.
Unexpected structural problems. Even if a property passes a home inspection with flying colors, it can still have structural problems. Two or three years after the purchase, the furnace could meltdown, the roof may need replacing, or you can learn the property has substantial termite damage.
Rising interest rates. These affect all investments, including stocks. Rising rates have a bigger impact on real estate because of the leverage factor. If rates rise significantly, your property value may go flat or even decline.
A deteriorating rental market. This can happen because the major employer in the area closes down a large facility, or because a huge new apartment complex goes up nearby. Either situation can cause tenants to become scarce, forcing you to lower your rent.
Legal problems. Because someone will be occupying your investment real estate, there’s always the potential for legal problems. Sure, you can have insurance to cover a lawsuit. But it will still cost you in time and aggravation. It’s also the possibility that a bad tenant could use the legal system to prevent eviction.
My Own Experience Investing in Real Estate
At the beginning of this article, I wrote that I’m not a heavily experienced real estate investor, but I do have one episode to relate to. I did try buying a rental property once, and it didn’t go well. You can read all about that experience in my article, 7 Lessons I Learned From Failing at Real Estate Investing.
Joseph Hogue wrote a guest post on this site, 7 Rules I Learned After Going Broke in Real Estate Investing, so I know I’m not the only one who had a bad experience. Joseph still invests in real estate, but the article lists several rules you need to be aware of if you’re going to make it work.
At the same time, I don’t use my own experience to discourage you from investing in real estate. It is possible to make money, and plenty of people do. But you do need to be aware of exactly how it works and what the potential pitfalls are.
There’s one more piece of personal advice I’d like to give: you don’t need physical property to invest in real estate. There are different ways to invest in real estate, and you may want to consider one as an alternative to owning property outright.
One popular alternative is real estate crowdfunding. My choice for real estate crowdfunding is Fundrise, where I’ve earned solid returns without ever owning property directly. One of the advantages of Fundrise is that anyone can invest on the platform, and with very little cash. It’s an opportunity to diversify your portfolio into real estate, with an investment that’s never more than you’re comfortable making.
I’ve been investing for 4 years now and have been happy with the returns. But even happier with the amount of time it takes me which is basically nothing.
Here’s a video I recapped on my 3-year returns with Fundrise:
Private Real Estate Notes
In a different direction, I also invest in private real estate notes. It’s a more advanced strategy, and I don’t recommend it to everyone. That’s because it involves purchasing nonperforming mortgages, a.k.a., bad loans.
The basic idea is that you buy a nonperforming mortgage at a deep discount. Since the mortgage is fully secured by property, there’s an excellent chance you’ll ultimately collect the full amount of the loan.
But if there’s insufficient equity in the home, you can take a loss. That’s why I don’t recommend a strategy for everyone.
But if you have a high risk tolerance and an appetite for big profits, it may be a gamble worth taking.
Why Invest in Index Funds?
There are multiple reasons why stocks—and by extension, index funds—are one of the three major investments, along with bonds and real estate.
1. There are a variety of funds to invest in
You can invest in U.S. and foreign markets, and even in individual industry sectors, like technology, healthcare, or energy. You can even invest in index funds that hold other investments, like bonds, or even real estate.
2. Invest for income, growth, or both
Some funds specialize in growth stocks, while others focus on dividends. For example, the Invesco QQQ invests in the NASDAQ 100 index and has a long history of outperforming the S&P 500 index. But if you prefer dividend income, the Schwab U.S. Dividend Equity ETF (SCHD) has a dividend yield of 3%.
3. Investment diversification
When you invest in an index fund, you’re indirectly investing in shares of hundreds or thousands of companies. If any one of them fails, you barely notice the impact. This is the exact opposite of the situation with real estate. If a single property investment goes sour, you could be out of business.
4. Your portfolio is very liquid
You shouldn’t be trading investment positions on a regular basis, but it’s good to know you could liquidate a position or two if you needed to. Index funds can be traded on a daily basis.
5. There’s no legal liability
Since you’re investing in public corporations, any liability you might have is limited to your investment. A plaintiff or group of plaintiffs can’t come after you personally.
6. Index funds are truly passive investments
You invest your money, then wait for the returns to play out. In the meantime, there’s no property to maintain, no tenants to deal with, and no need for periodic renovations.
7. Index funds fit neatly into retirement plans
Index funds are probably the most common investments found in retirement plans. This is for all the reasons listed above. Unlike real estate, index funds are a clean investment. They can be held in a brokerage account, used to build a diversified portfolio, bought and sold as necessary, and require no direct management.
While it is possible to hold physical real estate in an IRA account, that requires special handling. That includes setting up a self-directed IRA account (SDIRA), which is not only complicated but involves a matrix of compliance issues that could cause the IRS to invalidate your plan completely.
The Risks of Investing in Index Funds
Stocks, and the index funds that invest in them, have become the primary investment vehicle over the past few decades. But like real estate, they’re not without risks.
Some examples include:
The market could crash. This is probably the biggest fear of anyone who invests in the stock market. It’s not entirely unjustified either. We’ve experienced a couple of crashes in just the past couple of years. Though it was short, the Dot-Com crash was deep, particularly in the NASDAQ stocks, which dropped by about 80%.
The Financial Meltdown of 2008 was also short, but it dropped enough to scare plenty of people out of the market. And even those who held on through the crash had to wait years to get back to their original positions. You’ll need the kind of risk tolerance that enables you to wait out these major setbacks.
The market can go into a prolonged bear market. Though market crashes may be scarier on the surface, a long bear market has the potential to do even more damage. What makes it worse is that so many of today’s investors have never experienced that type of market and how much damage it can do.
Inflation could hurt long-term returns. There’s really good news and bad news on this front. The good news is that stocks have outperformed inflation over the long term. While inflation has averaged about 3% over the past several decades, stock returns have been close to 10%.
But the bad news is that inflation can depress stock prices over the short run. Inflation causes prices to rise, which cuts business profitability. It also puts upward pressure on interest rates, adding to the negative effect on stock prices. The long-term effect of inflation could hurt stock returns for several years.
Real Estate Returns vs. Index Funds Returns
All the above advantages and disadvantages aside, return on investment is the single biggest factor in determining the desirability of an asset. And as it turns out, the returns on both real estate and index funds are very positive.
We can get an idea of the returns on real estate by looking at two different examples.
First, let’s look at the 10-year returns of the SP 500 index vs the U.S. Real Estate Index (chart courtesy of Koyfin.com):
Looking at this chart the S&P 500 is the clear winner with a cumulative return of 112.67% compared to U.S. Real Estate at 83.44%.
Another comparison we can look at are ETFs of both indexes. First, let’s look at the Vanguard Real Estate ETF (VNQ). Results from that fund are as follows:
Now let’s look at the average returns on stock-based index funds. We’ll use the Vanguard S&P 500 ETF (VOO):
When you look at the “Returns before taxes” in the first column (1-year) from each of the two screenshots above, real estate comes up as the clear winner. In 2021, it easily outdistanced stocks from 40.33% to 20.60%.
That certainly made real estate investment the choice in 2021, but what about the longer-term trend?
That clearly favors stocks. They easily outperformed real estate during the three-year and five-year terms, and most importantly for 10 years. In fact, stocks outperformed real estate by a full five percentage points each year for 10 years, 16.51% to 11.50%.
Unfortunately, the comparison of returns between real estate and index funds is hardly a pure-play. First, there are different ways to own real estate. An owner-occupied home is only the most obvious, but there is also rental real estate, which can be either residential or commercial.
Leverage also plays a role, since a property with a higher percentage of financing is likely to provide higher long-term returns than one paid for in cash.
The same is true of index funds. Since there are so many different ones to choose from, there are also a variety of returns. For example, the long-term returns on a growth fund are generally higher than they are for an income fund.
Real Estate or Index Funds – Which is the Better Way to Build Long-term Wealth?
Now let me get back to answering Patrick’s question more directly: are real estate or index funds the better investment?
Based on my analysis above, the combination of higher returns over the past 10 years, greater liquidity, ability to diversify, and suitability for retirement plans, clearly favors index funds over real estate.
But when it comes to investing, it’s never quite that simple. If Patrick, or one of his clients (he’s a CPA), prefers the control and direct ownership real estate provides and is willing to invest over several decades, real estate could be the better investment.
But for anyone who doesn’t want to get their hands dirty with an investment, index funds are the better choice.
Personally, I favor index funds. But at the same time, I’m well aware of the importance of diversification. In a best-of-all-worlds scenario, you want to have both index funds and real estate. After all, there are certain market conditions where stocks perform better, and others where real estate is the better play. If you hold both, you’ll benefit from either outcome.
But since both investment classes are so popular—and for so many obvious reasons—and are a regular part of the American wealth-building scene, you really can’t go wrong with either.
Think of it as one of those rare opportunities where you’re presented with a choice of two equally profitable investments.
Patrick, I hope I’ve answered your question, or at least given you some concrete criteria to use in judging one investment against the other.
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