16 Must Read Pros and Cons of Real Estate Investing
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Why Should I Compare the Pros and Cons of Real Estate Investing?
Comparing the advantages and disadvantages of investing in real estate before diving in, will save you from future surprises in the search, purchase, and then general operating phase. One goal of any investment, is to minimize surprises. You want to be prepared so you can mitigate unplanned expenses, poor budgeting, and even bad tenants.
What Investment Should I Compare to Real Estate?
Real Estate requires more effort than other investments that happen from the comfort of your home, behind a computer. For that reason, we are comparing Real Estate to a stock investment in a S&P 500 Exchange Traded Fund (ETF). Which simply means, buying a single fund, that holds 500 of the leading public traded companies in the US, and holding it indefinitely.
Picking individual stocks and hoping for the best is not a good idea, however buying and holding large indexes is generally a recommended strategy. For that reason, the pros and cons are built around holding a S&P 500 ETF.
Compare the 16 Pros and Cons
In this list of 16 exhaustive factors, either the advantage (pro) or disadvantage (con) will apply to buying an income property, or holding the S&P 500 Stock ETF. Carefully consider all these factors before deciding if the extra effort is worth the reward.
| Factor | Real Estate | S&P 500 Stock ETF |
|---|---|---|
| Financial Entry Costs |  Real estate can be challenging due to the high cost of entry. Not only do you need the upfront down payment, but also have to get approved for a mortgage at a reasonable rate. |  Investing in the S&P 500 ETF saves money compared to buying individual stocks, allowing for a smaller initial investment in the market. |
| Transaction Costs | Additional costs like agent commissions, legal fees, and closing costs can impact the profit made from real estate investments. | Investing in the S&P 500 ETF by buying and holding shares usually involves low transaction costs, such as brokerage fees. This makes it a more affordable investment option than the expenses involved in purchasing real estate. |
| Leverage | Using borrowed funds (a bank loan) to purchase a property is a standard, low risk practice. This will allow investors to control a more significant asset value using a smaller portion of their capital. This can offer higher returns. | Using borrowed funds for stock purchases is not recommended for retail investors. It is high-risk and typically only used by professional investors. |
| Recurring Expenses | Managing an income property consists of recurring monthly expenses that can vary. These expenses include property taxes, maintenance fees, and utilities. Preparing for unexpected increases in costs is crucial by having a buffer in place. | The Management Expense Ratio (MER) refers to the annual fees for holding an ETF. These fees are fixed percentages, usually less than 0.5% and remain consistent throughout the holding period. The MER is deducted from your holdings, so you don’t have to pay it out of pocket. |
| Unexpected Expenses | Investment properties can come with unforeseen costs, such as broken appliances or leaky faucets. It’s essential to budget for emergency repairs just like you would for increases to recurring costs. | Holding an ETF does not have any unexpected expenses. |
| Cash Flow | If the revenue from rental properties exceeds the expenses, it can generate monthly cash flow. However, initially, there may be negative cash flow for the first few years. | An investment with an S&P 500 ETF can yield a small dividend, typically less than 2%. This dividend is re-invested and considered when calculating the 50-year average annual returns. |
| Appreciation | With real estate, your growth is amplified due to leverage (i.e. a $100k down payment can equal a $500k property purchase). Therefore your appreciation, is based on $500k, instead of only the $100k you invested. | Over the long term, the S&P 500 has historically demonstrated positive price appreciation. Only twice in history was there a negative 10-year period. However your appreciation is limited to the amount invested, which is $100k in this example. |
| Time and Effort | You may have to handle various tasks like maintaining the property, screening tenants, collecting rent, and dealing with unforeseen issues. These responsibilities can be time-consuming and exhausting. However, if you possess the necessary skills, you can cut costs by carrying out some of these duties yourself. | Holding a stock market investment is passive because you are not picking the underlying stocks. The ETF will automatically rebalance the stock weighting to match the S&P 500 market index. |
| Complexity | For novice investors, navigating the complexities of the local market, property regulations, financing options, and property management strategies can take time and effort. It’s helpful to have an experienced agent or property manager to assist you, though these services will incur more fees. | Choosing your own basket of individual stocks is complex. However, in this situation, we are comparing it to investing in an S&P 500 ETF, which maintains the group of stocks on your behalf. |
| Taxes (no winner) | Each tax situation varies; therefore check this with your financial advisor or accountant. | Selling your ETF holdings may generate taxable events. You may have options to own in a tax-sheltered account. Although less complex than real estate taxes, you should still review your options to minimize taxes with your financial advisor or accountant. |
| Inflation Protection | The value of properties typically increases along with inflation, which can help maintain purchasing power and lead to long-term growth. | An S&P 500 ETF offers consistent long-term growth and acts as a hedge against inflation. As the underlying companies grow and generate profits, the value of the ETF tends to appreciate. |
| Liquidity | Property holdings are not very liquid and require a long sales process. Even if you only need half of your cash, you still have to sell the entire property. | The top S&P 500 ETFs are highly liquid, allowing investors to buy or sell shares on major stock exchanges throughout the trading day. This provides fast access to funds, and the ability to liquidate only what you need. |
| Volatility | Real estate markets experience less volatility than ETFs and stock markets. This means that real estate prices are more stable over time, allowing you to build equity and benefit from long-term price cycles. | The S&P 500 ETF is subject to market volatility. It will experience fluctuations in price due to various factors, including economic conditions, company performance, and investor sentiment. Investors need to consider their risk tolerance and long-term investment horizon. |
| Using Growth as Collateral | As you build equity through appreciation, cash flow, and having someone else pay down your mortgage, you can use this equity as collateral, letting you access your equity for other investment opportunities. For instance, if your property value has grown $150k after a few years, you can work with the bank to reassess your value, and provide you with access to that $150k of equity. | Investing in the S&P 500 ETF does not directly allow you to use your equity as collateral, as it is a separate investment vehicle. However, the potential returns from the ETF can increase your overall net worth, providing additional financial flexibility for collateral-based borrowing in other areas. |
| Exit Costs | Exit costs associated with a property sale, such as agent commissions and capital gains taxes, should be factored into the overall investment strategy. Exit costs can eat from 2% – 5% of your sale price, which doesn’t include tax implications. For example, a $600k sale could have up to $30k in fees. As noted in the line above, avoid selling, and try to leverage your equity. | When selling your ETF, most brokerages provide this service with a small trading fee attached. These fees are typically less than $100 even if you sell a $100k investment. Compared to real estate, the exit costs are practically negligible. |
| Bad Tenants | Dealing with difficult tenants can lead to financial losses, legal expenses, and wasted time resolving issues such as missed rent payments, property damage, unauthorized subletting, lease violations, eviction proceedings, and finding replacements. The importance of validating your tenant’s history, credit checks, references, employment, etc., cannot be overlooked. | The S&P 500 ETF does not carry tenant risks. Your only risk is if your stock brokerage is insolvent and goes out of business. Although it’s low-risk, make sure to pick a reputable company. |
Will I have an Advantage with Real Estate over Stocks?
This is a great question that needs to take into account all the factors listed above. However, the difficulty in forecasting your investment returns depends on global and local trends, and the location of you income property. Theory is good, but numbers matter then trying to estimate this major financial decision.
To help with the process, the business case guy blog posts and tools can help you estimate a 10-year forecast, which you can review with your financial advisor, accountant, or real estate agent.
Blog Posts and Calculators to Compare Real Estate vs Stocks
- Blog Post:
- Investment Calculators and Tools
Disclaimer
This guide is for informational purposes only. It is not meant to decide for you. All figures are inputted based on your best estimate and can fluctuate based on the variety of risks outlined. Business Case Guy is not responsible for the outcomes, good or bad, of any decisions made using this guide. Please review all financial choices in detail with your financial advisor, real estate agent, accountant, or any related, qualified professional.
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