One common trait among successful investors is deliberate exposure to numerous asset classes; commonly referred to as diversification. If you are a speculative person who aims high, we could explain that having more than one horse in the race will increase your chances of winning, and you would likely agree. If you are a conservative person, who is more motivated by avoidance of loss, we could proffer that spreading your eggs across different baskets will be the best strategy to protect them; again, you will likely agree. Where we are less likely to be met with agreement is if we venture to make the statement that “real estate investments are better than stock market investments“, or the inverse, that “stock market investments are better than real estate investments“.
It is quite uncommon to see amateur investors with a high level of competence in both investment disciplines. Instead, you are more likely to meet somebody who has had substantial success in market investments (and they are now a fully fledged stock market proponent), or somebody who has invested exclusively in real estate (and proudly flies the flag of real estate investment with zeal). Why are investors with competencies in both asset classes not more common? Firstly, time. Learning more than one discipline takes time, and mistakes in investment are paid for literally. Where resources are limited, people generally stick to what they have found to be successful in the past; hence the fixation upon the asset class that people feel they understand. Secondly, they are both very different. Extremely different. To speak in terms of musical instruments, how many of your friends that are skilled pianists can also boast of the same proficiency when holding a guitar? Understandably, for part-time investors, it can be hard to objectively weigh up the pros and cons of these two approaches, and proficiency in both will take time. What follow are a number of significant differences between real estate and stock market investments. You will note that, unlike a horse race, there is no outright winner. The arrow shall indicate “stock market” and the houses “real estate”.
Liquidity: “give ME my money back”- The Investor
If we restrict our consideration of capital markets to stocks alone, we will be hard-pressed to find an asset class more liquid (let us agree to not consider cash as an alternative). When you want your money back, you press the “sell” button and your money will ordinarily (depending on what exchange your stock is being traded on) be back in your account 48 hours after the trade has completed. Because of this, there is a certain degree of peace of mind that comes with equity investing. Of course, there will be price fluctuations during your ownership of any given security, but should you need your money back quickly, there will be no adverse consequences, delays or costs as a result of turning your asset back into cash.
Fundamentally real estate has the lowest liquidity of all asset classes if we choose to exclude private equity investments which may have “lock-in” provisions built into their terms. Real estate ‘liquidity’ is dependent upon the principles of supply and demand. For you to realise the ‘liquidity’ or value of your real estate investment somebody has to buy it from you to release your money. If demand is weak, you may not be able to sell it for what you paid for it. If supply is abundant, the same. If demand is exceptionally low, or if supply is abundantly high, you simply may not be able to sell the property whatsoever. Because of this, real estate investment (our definition being -direct- ownership of real estate assets, as opposed to Real Estate Investment Trusts ‘REITS’, or other securitised real estate assets) is inappropriate for time specific investment planning goals. For example, if you wish to make an investment that will provide a steady return for 5 years, with a return of principal on the 5th year anniversary to pay for a child’s school fees, which are non-negotiable, real estate will leave you with liquidity and short-fall risk.
Tax: “give me YOUR money back”- The Taxman
Unless you own your stock market investments in a jurisdiction which does not levy taxes upon capital gains (CGT), the gains realized within your portfolio will be taxed. Another way around this is to purchase securities via a government approved pension program. This may however not be appropriate for non-long-term investors as there will be restrictions preventing you from accessing the money until the government mandated retirement age. For investments which produce income in the form of dividends or some other form of cash distribution you will be subject to income tax. Measures can be made to plan the amount of income being received for those with high tax obligations, so as to reduce tax liability during periods when that income is not required to cover expenses. Most countries allow investors to write-off their investment losses so as to reduce the liability on money that they have earned via other means, e.g employment income. Ultimately, taxes are only owed when an investor makes money. The extent to which this tax liability is manageable is case by case.
In Japan there are number of tax breaks for real estate investors available. These benefits are nominal for those that live in the house they own, as the accounting treatment is very different. As for the rental income that you will receive, that will be treated as ‘income’ for tax purposes, and will be taxed at the prevailing marginal rate. Reducing your income tax in Japan is possible, if you are willing to put the effort in, but most will rely upon their accountant to fill out all of the required paperwork. There may be some hidden taxes owed when selling an investment property, depending on the accounting methodology used when filing tax-returns during the ownership period, so it makes sense to speak with a financial adviser when considering a purchase. The biggest tax benefit for real estate investors is not often spoken about, because it requires a holistic evaluation of an investment considering facets other then net yield after expense. This will be “passive-equity”. If your property is mortgaged and the repayments are being made from the rental income (hopefully with some money left over), then the tenant is essentially paying the mortgage for you. Sophisticated investors may go as far as to calculate the ‘internal rate of return’ (IRR), which includes this payment-on-your-behalf as part of the return you receive. Where the proposition becomes more interesting, is when you realize that annual increases in property equity are not taxed as capital gains, meaning that at the end of the mortgage term, your real IRR was actually higher once tax-adjusted.
Leverage: Investing more than you have
The use of leverage can be defined as borrowing money to deploy in an investment for the purpose of amplifying the return of your invested capital. This borrowed money is subject to interest in the same way as any other loan. If you are able to control a $120 stake in an asset using $100 of your own money, you are employing 20% leverage. Understandably, this cuts both ways. If the asset you bought increases in price by 10%, the actual increase on your committed capital will be 12%. If the asset decreases in price by 10%, you will be subject to a 12% decrease in your principal investment. Because of this, leverage is ordinarily only used by professionals and people with both significant experience, and capacity for loss. Most banks and brokerages have tests for those investors wishing to leverage their accounts using the institutions money. It is very uncommon to see amateur investors successfully utilizing leverage consistently in their investments. That withstanding, if your investment strategy and risk management protocols are robust, there is nothing to stop you from taking advantage of gearing in your investments.
Many people would read the above explanation of leverage or gearing and feel that it sounds ‘risky’. It perhaps seems less risky however, when we apply it to real estate investing, where it is simply called a “mortgage”. Borrowing money which is subject to annual interest, to purchase an asset that you cannot, or are not willing to purchase using your own cash is employing leverage. By putting down a 10% – 30% down-payment you are able to leverage your annual earnings to buy real estate assets. Potentially, this could enable somebody earning 10 million JPY p.a to buy a house or apartment building at a cost of 100 million JPY. If the mortgage loan is to buy a home, you, living in the house, are meeting the expense of the leverage out of your own pocket. If it is for an investment, you are likely having the repayment costs met by the tenants, and are successfully employing leverage in a traditional investment sense. For those not comfortable with securities, that still wish to command large capital sums in assets, real estate is likely the least perilous of the two methods. This is also probably the reason that you have met numerous people that have been hugely “successful in real estate” and fewer that have been “successful in stocks”. The barrier to entry for each discipline is quite different…
Difficulty: How easy is this ‘easy money’?
Purchasing a portfolio of securities is simple. Picking the right mix of assets however, can and should require more substantial effort. Once the correct balance is achieved, there is probably not much that needs to be done, aside from keeping abreast with large-scale shifts in the global investment environment and the occasional re-balance. Presently, you can purchase securities from as little as 100 dollars and depending on your time-horizon and attitude to risk, there are appropriate assets available without having to search too hard. Without doubt the largest barrier to success in securities is dealing with your emotions. Because securities -are- so liquid, it can be easy to make the mistake of selling an asset in a moment of distress when its price goes down. Investors have historically been rewarded with inflation adjusted (CAGR) annual returns in excess of +8% p.a since the beginning of the 20th century. These returns are earned by remaining rational, and sticking to a long-term plan, and not getting caught up in cycles or greed or panic.
Unlike securities, ‘accidentally’ selling your real estate is virtually impossible owing to the lengthy process-based sales transaction. Because of this, it is certainly easy to hold on to. Historically, the returns for fixed assets like real estate are lower than those realized in the stock market once adjusted for inflation. In Japan, owing to the accounting treatment of real estate structures, there is in fact zero history of capital appreciation for fixed assets, and a relatively mute history of price appreciation for land since the implosion of the real estate bubble in the 1990’s. This would appear to be changing, and many would speculate as to the beginnings of a ‘new cycle’. There are many pitfalls when buying a multi-million yen asset with the banks money, from land-coverage ratios to building regulations, to ownership rights and zoning. Real estate brokers are not incentivised to provide advice pertaining to what goes on after-purchase so you should probably consult with somebody who deals with all of your financial planning to avoid making a multi-million dollar mistake.
Maintenance: Your second job
As long as you are comfortable with the reasons why you purchased the assets that you chose to include in your portfolio, there is not a lot of work to do to maintain your portfolio. Admittedly, creating a robust investment portfolio does require a certain amount of technical understanding if you wish to minimise risk, but you will probably not blow up your account, even with poor asset choices, as long as you remain sufficiently diversified among asset classes. Many people will choose to outsource the portfolio management to their advisor to free up their spare time for other things, but if you are just starting out, and have never done any investing before, it would certainly be a good use of your time to acquaint yourself with the basics.
Owning real estate is like owning a small business. The nature of the returns during the ownership period are fixed in nature (like a bond) and the basis of the cash-flow is itself a transaction between you (the landlord), and your renters. Even if you employ a property agent to take care of marketing for tenants when a room becomes vacant, and a property manager, to ensure that the property upkeep (cleaning, repairs, etc.) is taken care of, you will still have to dedicate time to interacting with these contractors. Further, unlike a portfolio of securities, a property will often incur unforeseen expense for repairs and improvements which may require you to commit further capital, or require your time to locate reasonably priced third party contractors (painters, air conditioning servicing companies, propane gas providers, internet and cable service providers, guarantor companies etc.) that are necessary to maintain the marketability of the property. “Self managing” is only realistic for those already retired, or managing real estate assets full time as a profession. Even outsourcing the “management” aspect of ownership, you will still be required to use your time and money on the property throughout the life of the mortgage to ensure an equitable return on your investment.