Wednesday, March 7, 2012

Investing in Real Estate: How Does It Compare to Stock Investing?

For those of us who are on Canada, the value of our condos and houses was left luckily unscathed after the Great Recession.  In fact, the prices took a breather during those dark days and continued its upward trajectory shortly thereafter.  As an example, the value of the townhouse we bought back in 2006 gained about 30% in value by 2011.

If we factor in the leveraging effects of owning a mortgage, my return of investment would have been about 100% in 5 years.  That's about 15% per year, not a bad investment at all!  Naturally, the question that gets frequently asked is whether investing in real estate or in stocks is more profitable.  Obviously, circumstances play a big role, but in general, which gives better returns?

Was the Last Decade a Particularly Good Decade for Real Estate in Canada?
Most of us have very good short term memory.  In fact, we tend to extrapolate scenarios to predict future events.  Tell me that you've never looked at a stock chart and extrapolated the line to see where the price would be 6 or 12 months in the future!

Here at The Catholic Investor, we look for hard and fast data to back up our claims.  I'll use a website that I frequently visit to obtain this data.  It's the Toronto Real Estate Board website at  They publish, on a monthly basis, a summary of the transactions made in the prior month.  They also show the average price of homes in the Toronto Area for the past 45 years on a yearly basis.

If we look at the long term trend of the Toronto house prices (i.e. from 1966 until 2011), the average home price has grown from $21,360 to $465,412.  This translates into an annual growth of 7.1%.  Although it feels like the last 15 years have been exceptional in terms of real estate price appreciation, the fact is the average annual growth was only 5.9% per year during this period.  Looking at Figure 1, where housing prices are plotted on a log scale, we can readily see that the past 15 years have actually been pretty average.  On the other hand, housing prices went through the roof in the late 1980s and quickly came back down in the early 1990s.

Figure 1: Average GTA Housing Prices Over the Last 45 Years

So, the conclusion I will draw is that the last one and a half decade had been pretty average in terms of housing price appreciation.  Perhaps it was because of the downturn in the early 1990s that made the last decade seem like it was too good to be true.  That's just not the case.  In some major US cities, housing prices doubled between 2003 and 2006, during the peak of the housing bubble.  That translates to approximately 20% growth per year.  We were nowhere near those numbers in Toronto.

Free Money?
There is a common strategy in real estate investing that can increase your growth and that is rental income.  If you are one of the few people who can afford to buy a second piece of property and rent it out, it seems like it's a no brainer.

In Toronto, a typical 1-bedroom condo apartment typically costs around $250-350K, depending on location, amenities, etc.  That same condo unit can fetch around $1000-1500 per month in rent. After deducting property taxes, maintenance fees, one has about $600-900 left per month, which would be enough to cover the payment of a mortgage if one had put 25% down payment and a 25 to 30 year amortization in a mortgage.  It's essentially free money, as they say!  The unit is self sufficient and as it grows in value, so does one's net worth.  One assumption, and a big one at that, is that mortgage rates would remain relatively low.  If mortgage rates were to rise, one may have to put money into the investment as rent would not be able to cover the expenses.

So, what do the numbers looks like if we were to buy a condo unit and rent it out today?  Let's say we buy a 2-bedroom unit for $400K and we rent it out for $1500.  I'm a little conservative on the rent, but let's see what we get.  Assumptions made are also shown below.  The one thing that I want to point out is that I have not factored in inflation into the mortgage payments.  Since the mortgage payments are locked in and do not rise, they effectively get cheaper and cheaper in the future as prices of everything else rises.  As for the monthly rent and taxes/fees, they would likely rise with inflation.  So, the present value of these would be whatever they are currently.  If I've lost you on this...not to worry, in the end, the annual growth would only deviate by a percentage point or so.

I've used 4 different scenarios.  The first is an optimistic one where variable mortgage rates would remain at around today's rates for the next 10 years.  The second is a very realistic scenario where one can get a 10-year fixed mortgage at 3.8% (this is available today and is likely a smart move if you were to lock in today for 10 years).  The third is a pessimistic scenario where the average mortgage rate is seen to be at 6.5%.  The last is if we had purchased the property outright from the start.  The average return per year are 13.5%, 11.7%, 8.2%, and 9.6%, respectively.  Not bad at all!  In fact, it's a pretty good investment, especially since I had used a quite conservative rental income.

What's the Catch?
From the scenarios above, it does seem like investing in real estate is free money.  As we know, there's no free lunch in this world, what's the catch?  There are a number of disadvantages with real estate investing that  do not exist with investing in stocks or funds.  They include finding renters and collecting rent, work in maintaining the property, using the "room" that you could have used in buying a bigger house for yourself, etc.  However, the biggest catch is quite apparent, especially to home owners across the border, in the United States.  They would quickly tell you that the housing bust of 2008 wiped out a huge portion of their net worth.

By owning a mortgage, one is essentially leveraging up on the investment.  By taking advantage of the low mortgage rates (Scenario 1 and 2), we were able to increase our returns.  But as we can see in Scenario 3, if the rates rise, it actually hurts us to borrow.  In any case, because we are likely not able to buy a property outright from the start, we would have to leverage up.  It's great when the market goes up, but if we see a repeat of the US housing market in 2008 here in Canada, it would be disastrous.  Let's say the market goes down 20%...doesn't sound too bad, right?  Wrong.  In our case, 20% of $400K is $80K.  We put down $100K initially.  So, if we were to sell the house right there and then, we would have banked a -80% return!  Yikes!

In fact, this is the main reason there are so many foreclosures in the US.  It's not that people could not afford the mortgage payments, it's because the house value has dropped so much that it makes no sense to keep paying the payments because the home owners are so deep in the red.  So, the biggest risk in real estate investing is a housing market downturn.

So Which Is Better?  Real Estate or Stocks?
It is true that the real estate market is less volatile than the stock market, but it is also important to remember that volatility does not equate to risk.  While some may argue that real estate investing is safer, a much longer debate is required for that topic.  Here's the summary for real estate investing: 1) it takes more work (renting out, etc.), 2) there is less volatility, 3) if you own a mortgage, in the less likely event of a market downturn, your losses are amplified.

As for stocks, since most people do not buy on margin or trade options exclusively, the leveraging effects are not as large.  Individual stocks and even the market in general are more volatile than the real estate market.  However, if you know what you are doing, you may be able to capitalize on this volatility.

In the end, it's about your comfort level.  Most people feel safer with real estate, because of its tangibility and the notion that people always need to live somewhere.  Fair enough.  However, if you look at the richest people on the planet, a large majority got there by owning awesome businesses, and only a handful got there through real estate.  I believe that speaks volumes.  As such, I'm still a stocks kinda guy!