Investment Risk….Stocks vs. Real Estate The Comparison

Investment Risk....Stocks vs. Real Estate The ComparisonMy equity partners and private Investors tend to ask me the comparison question. “Which do I think has higher Investment risk, stock and mutual funds or real estate?” For the average Investor looking for the least risky Investment option, the popular consensus is to hand your money over to a financial adviser and have them Invest in a mutual fund or something similar that is diversified. Or your company will tell you to put your hard earned savings into their 401k plan which by definition is also simply Invested in a mutual fund through their own financial advisers.
When the average Investor thinks they are Invested in mutual funds or a 401k they tend to separate this from stocks and the stock market and there for believe this to be less risky….maybe it’s just the terminology but they are in fact one and the same.

The idea that this strategy is less risky than investing in real estate does not make sense and the stock market shows us this all the time.
So I am going to cover this one question I get from new equity partners “Which do I think has higher Investment risk, stock and mutual funds or real estate?” The risk comparison tends to lean toward the idea of “liquidity” that stocks and mutual funds are “more liquid” than real estate investments. Meaning the more liquid an Investment the easier it is to sell or get out of the Investment and therefore “less risky.”
I believe this to be the exact opposite, let me give you a clear example. When the stock market crashed in 2008 the real cause was not the housing market or the banks going bust that was merely the “effect” not the cause.
It was average investors selling their stocks in massive amounts, albeit directly related to that news but….. if stocks would not have been sold there would not have been a stock market crash.
The easy ability to buy or sell your stock Investment in less than 5 seconds with a click of a button can create high volatility and price swings. The long term investor can loose several years’ worth of gains in one day or in the case of 2008 in just a few hours. One direct cause will always be easy liquidity for Investors.

RISK= EASY LIQUIDITY + LACK OF PRICE CONTROL

What is crazy to me is that most novice Investors want easy liquidity and consider that to be safe, today that is a popular consensus with the average Investor. Most investors are not looking at the whole picture and nobody is there to explain. When it comes down to it they want easy liquidity because the lack of “control” they have over the rise and fall of price for their stock or mutual fund Investment. This to me is the real risk, that outside factors can cause price movement for your stocks and mutual funds leaving you no control but to buy or sell.
The smartest and wealthiest Investors want their Investments or markets to not be easily accessible to buy or sell. This actually creates more value and more stability within that particular market.

Real estate especially commercial real estate is one of those markets and because of low liquidity it is not easily affected by economic factors and other world events. Though to be fair there are some risks to owning real estate as an investment and low liquidity or lack of push button selling could be considered risky.
I must say thought the number one factor of real estate investment risk is lack of education, knowledge and a strategic plan for your investment purchase. With this foundation in place we have much more control over performance.
As apartment building Investors we have more control over our Investment and value is not tied to how the property down the street is performing. Apartment buildings should be considered “Investment Businesses” and we can control the value of that investment business by 2 key factors- decreasing expenses or increasing income.
With our Private Investor Program we are able to offer Investors the ability to have more control and tax benefits through participating in Equity Partnerships with ASP Commercial Group.
For novice real estate Investors who just don’t have the time to take care of real estate Investments, participating in Equity Investments with real estate companies is a great way to start growing your portfolio and having more control over your Investment.
I won’t get into that here but I hope I did a good job explaining this risk factor when it comes to easy liquid investments. I am sure other Investors will have their own opinion but this is why I love real estate particularly apartment building Investments.

Capital Efficiency-Should you extract equity from your properties?

RETURN ON INVESTMENT handwritten chalk text on black chalkboard

When you are buying rental property more than likely you are going to be putting cash down toward your investment. This is most likely the reason you are buying rental property to make a better cash investment.  We are all looking for a better return on our cash and real estate investments or more specific rental property is by far the best option due to the multiple benefits including cash flow, principal reduction, appreciation and taxable income reduction

Let me describe how these work for you as a investment:

  • Cash Flow- rents pay for all expenses, mortgage and provide you left over income
  • Principal reduction- Your tenants rents pay down the mortgage buying the building for you!
  • Appreciation- Over time the value of your property increases if maintained
  • Taxable income reduction- real estate provides the ability to expense and depreciate a percentage of income usually enough to show a paper loss

Monopoly houses on one pound coins

So while all these benefits are working for you and should be creating wealth for you in the long run, does not mean it continues to be a good investment?……..

Meaning…….

Lets go back to when you first made your investment of cash into the property, you should have calculated your ROI or return on investment.

Return on Investment “ROI” = How fast your investment is returned back to you every year in %.

For example, let’s say you made $50,000 investment down on a 4plex worth $250,000

Now let’s assume you made that cash investment with the intention of earning a 20% ROI, every year from the cash flow.

Every year you look at your cash flow and you are happy because you have hit your target ROI, assume 10 years go by and your rents have increased showing a increase in ROI by 10%. Now your cash flow has grown to 30% ROI. Sounds pretty good right?

You would be right if your only benefit to owning rental property was cash flow but we have to go back take into account benefit #2.

Why you ask?………..

Well that benefit is a big part of your ROI because even thought you put down $50,000 investment that is no longer investment basis. In other words your purchasing power has grown. Your investment power is not your original $50,000, your investment is what equity you could recoup if you sold today.

So even though your tenants are paying down the mortgage and buying the building for you, it is creating more investment power and increasing your equity.

Let’s assume you $250,000 property is reducing its principal by $5,000 a year, that’s great for your net worth! But is your capital working as hard as it was 10 years ago?

Well lets add this up…your properties equity is growing $5,000 every year x 10.

That’s $50,000 in additional equity after 10 years which now brings your total investment equity to $100,000. If you were earning a 30% ROI on $50,000 your cash flow would be $15,000 per year.

Now your cash flow of $15,000 needs to be compared to your investment equity of $100,000. That is a significant drop…now your ROI is actual 15% and cut in half!

Look at it this way…. You are making $15,000 on an $100,000 investment. Because your investment is not what you started with its now $100,000

Not so great, your investment power has grown but your earning power has dropped!

To make you capital investment as efficient as possible you need to compare your cash flow to your “current” investment equity.

Macro photo of tooth wheel mechanism with TIME, MONEY concept words

Now your investment power is $100,000 and could double the size rental property you could purchase to $500,000. Earning you the same 30% ROI, cash flow would now be $30,000 per year!

Now your earning power has increased as you put your investment equity to better use.

Now I am not saying you own a bad deal or property but after 5,10 or 15 years your property will not only provide you will all the benefits above but will increase your investment power as your equity grows. Your earning power will simply not be able to keep up to your equity power.

What does this mean? Well it just means your capital needs to be moved to hit your target growth and you can do it a few different ways.

You could sell and realize your gains but you also give away an already excellent income stream. Not taking into account the other benefits that are still working for you. This is still a better option than accepting a continually decreasing return every year.

Or refinance and pull the equity out, this will give you the opportunity to find other properties were the ROI will be competitive.

With rental property your investment will change the longer you own it, so re evaluate the property every 5 years to decide if your equity efficiency is as competitive as when you first purchased it.

If not take action to increase your capital growth rate when it’s no longer keeping up!