If you follow me at all you know I am a big advocate of being a buy and hold investor of Stocks. My friend is a die hard Real Estate investor who also invest in stocks but is way more focused on Real Estate. The other day we had a nice discussion on which was the better investment, the conversation started because he is helping me find a nice multi-family property to buy, however unlike him I am somewhat debt adverse so I will be making a large down payment, of course he tells me that will lower my cash on cash return but it will help me sleep at night. Alright let’s get into the meat of the debate.
Returns – Returns are the holy grail of investing, I mean what is the first thing that most people brag about, returns. Being an index fund investor and keeping it as simple as possible, I basically invest in four funds, total stock market, total international non-US, Total bond, and a REIT index fund. This gives me exposure to a diverse group of investments and helps keep my investing as passive as possible, I basically set my desired portfolio allocation of each fund and once a year make any necessary changes to get everything back on that desired allocation. Now over the past 9 years I have earned some pretty nice returns but of course that was on some large losses prior to that and of course I foresee some more losses on the horizon as interest rates begin to creep higher and trade wars continue to create havoc in the markets. The great thing about this type of investing is that it is completely passive and I only spend my time earning income from my job and spend almost no time managing my investments. Contrast this with my friend the real estate investor, he puts small down payments towards properties that he then must convince a bank or lender to put up the remaining funds, this is after he has gone back and forth with the seller of the property or the agent representing them. Once an agreement is made with the seller and the bank, he then enlist multiple professionals to help him do his due diligence of inspecting the property. This inspection involves not just structural issues but studying the rent rolls, individual leases, contractual obligations with anyone providing services, and much much more. During this time if anything jumps out as an issue he will once again open up negotiations with the seller to request a discount on the purchasing price or that the seller make the necessary repairs. Is it just me or are you getting tired and stressed just reading this. After finally closing on the property he then will assign a property management company to manage the property and begin making improvement s to the property to increase rental rates, which will increase the cash flow of the property and directly increase the overall value of the property. Now even though this sounds like a lot of work, he is mostly just coordinating with his team of people he uses like his agent, inspector, contractor, and property management company, so not as passive as index investing but he’s not breaking a sweat. As far as returns go, I’ll admit he blows my returns out of the water. By only having to put up a small down payment he can spread his personal capital around to multiple deals and since he is borrowing today’s dollars at a fixed interest rates but paying them back with tomorrow’s inflated dollars over a 30 year period he is making a killing. In fact he isn’t even paying the loan, his tenants are and they are simultaneously paying down the debt, increasing his equity stance, and giving him cash flow which is the difference between rental income and the debt repayments. So he is making out like a bandit and add this to the fact that he only buys properties that he can get at least 20% below market value and that he sees instant ways to add immediate value to the property.
So as far as returns go THE WINNER IS – REAL ESTATE………..
Taxes – Once someone begins to make a good income taxes become one of the largest cost and biggest opportunity to save money from. So for me the stock investor, I shelter $18,500 a year from taxation by maxing out my 401K and get a tax credit of about $5,500 per year by investing in an IRA. Combined that is about $24,000 that I not only don’t pay taxes on but that will also grow tax free until I begin making withdrawals, this not only shelters that money from taxes but also lowers my marginal tax rate that all my other income is taxed at. After that I put other investments into after tax accounts which I pay tax on the dividends (around 15%) and no tax on the growth or appreciation in the value of the stocks unless I sell them, this is why I only invest in growth stocks and not high dividend paying stocks in my taxable accounts. Okay now for real estate, my friend is obviously much more knowledgeable about the tax benefits of investing in real estate but here is my best shot at explaining what he does. First is depreciation, this blew me away, he get to claim a tax deduction for the property (Structure, not land) “losing value” or depreciating over time, however in reality the property is actually appreciating or growing in value. Second is just as amazing, mortgage interest deduction!!! So like I said he is borrowing in today’s dollars and paying the bank back with tomorrow’s inflated dollars but he also gets to deduct the interest he’s paying on the loan, WHAT!!! I’m pretty sure I couldn’t do that by purchasing shares on margin. Last but not least is capital appreciation, like I said his properties are not only appreciating in value over time but the tenants are actually paying down the loan, which increases his equity position in the property, equity being the difference between what he owes on the property and what it’s worth. So similar to my stocks his assets are growing in value but not being taxed on the growth, however what happens when he goes to sell them? Enter the 1031 exchange!!! My friend can actually sell his properties and roll all the profit into another investment without incurring any capital gains tax, even better he can then start the depreciation deduction all over again on new property. Another big advantage is that since he deeds all his properties to an LLC he can also write off just about every expense imaginable, mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services and travel expenses related to visiting properties. Now since I also own a company that is structured as an LLC I also benefit from many of those deductions but they aren’t related to my stock investing.
So as far as TAXES go, the winner is…………. REAL ESTATE. However we both agree that owning a business is by far the single best thing anyone can do to get ahead in America.
Income – This is something that will become even more important as we age and get closer to retirement, that is when we will both be dependent on our investments to provide income to replace our working salaries. My plan centers around 3 thoughts, first to reduce my monthly expenses as much as possible by eliminating all debt and secondly to accumulate 30 times my annual expenses and then be able to withdraw around 3.5% annually to live off of. Lastly to acquire enough shares in my after tax accounts of VNQ a REIT that pays a hefty dividend and VYM an index fund that tracks quality high paying dividend stocks, by doing this I should be able to have a nice supplemental income from the dividend payments without having to sell any shares. My friends plan blows mine away, he plans to acquire enough properties to provide a very nice income from the cash flow or profit of the rents without ever having to sell the properties. In fact he is already living rent free by staying in a vacant unit of a complex he owns. He utilizes the 1031 exchange to basically trade up his residential properties to commercial multi-family properties that he says offer better cash flow and are easier to build equity in since they are valued based off of income and operating expenses versus just comparable homes like residential, so any small improvements that he makes that allow him to increase rents or heck just the annual 2-3% rent increase he levies make the properties more valuable while simultaneously putting more profit in his pocket every month. His plan is to eventually consolidate his holdings and pay off the debts which will make all rental payments almost pure profit except for what he pays his management company and what he sets aside for repairs, so imagine 100+ people paying you hundreds of dollars every month, sounds pretty nice to me.
So as for INCOME, the winner is……………… REAL ESTATE
So as for our debate I feel like he won, in fact I am now becoming a multi-family real estate investor, my plan is to acquire one duplex or four plex and allow it to slowly pay the mortgage off so that when we get ready to retire we can down size from our current home and use it as a rental, plus have four other people sending us checks every month. With a paid off house and a frugal style that will basically function as a pension I never got to have.
Thanks for reading and I hope you enjoyed it, remember this is just my thoughts on investing and not meant to be advice, everyone should consult a professional before making any investing decisions.
CHEF ON FIRE