Comparing Real Estate to Other Investment Options

Choosing where to invest is a big decision for any investor.

There are many options, like stocks, bonds, mutual funds, and government securities, but real estate has its own set of benefits.

By looking closely at the benefits and challenges of each option, you can make better choices that match your financial goals and risk level.

This guide covers everything you need to know about comparing real estate to other investment options, as well as the key things you need to know within real estate as an asset class.

Let's dive in.

The Global Landscape of Real Estate Investment

Real estate is a super broad term and covers approximately [$100] trillion dollars of assets around the world as of 2020. 

These numbers are likely to vary, but the relative composition is expected to remain relatively stable.

Agricultural land represents the largest portion at 40%, followed by commercial real estate at 35% and residential real estate at 25%.

Risk-Adjusted Returns

Investing in any asset class is about balancing risk and reward. Real estate is no different. 

There are trade-offs that investors have to make, and while there are many ways to compare asset classes, one of the simplest is risk-adjusted returns.

Consider this: You could go to Crown Casino, place a bet on black, and potentially double your money, clocking a 100% return.

This, however, comes with a significant risk—there's an almost even chance you'll lose everything. Alternatively, you could opt for the security of a government bond offering a 4% return, accompanied by a negligible risk of loss.

So why does this matter when thinking about real estate?

Because real estate has the best risk and return trade-off compared to other asset classes.

You’ll find lots of studies that slice and dice data in different ways to tell stories.

One of the most comprehensive and insightful ones by Thomson Reuters, covering the period 1993–2013, which illuminated the strength of real estate.

Real estate was not only able to provide the highest returns, but it did so with relatively lower risk compared to everything else they looked at.

Now the Australian market is unique for a variety of reasons, but the data tells a simple story, which you probably already know.

Real estate investing works. 

But why is real estate so good? We'll cover that next.

The Fundamentals

There are three fundamental advantages of real estate ownership.

Cash Flow

Real estate is higher-yielding than most other forms of investment. 

It provides cash flow. Tenants pay rent, and the landlord can use those revenues to cover expenses such as taxes, insurance, and maintenance.

This may be the most attractive aspect of real estate, as it allows investors to collect passive income at a greater rate than other traditional investments, with the net income distributed back to investors, typically on a weekly or monthly basis. 

Mortgages (excluding interest-only loans) involve repayments consisting of interest and principal. 

Interest is the cost of borrowing money from a lender, while the principal payment is used to reduce the balance of the loan amount. 

Combined, principal paydown can also be thought of as buying shares of the property from the lender (where the investor and the lender are the only two shareholders). 

Appreciation

Appreciation in real estate offers a unique advantage, enhancing property value as market demand grows and diversifying investment risk.

The demand for real estate increases as markets expand, resulting in inflationary pressures that pass directly through properties in the form of tenants paying higher rents. 

This boosts cash flow but also directly affects property values. 

This appreciation is even better when considering that while REITs are much more closely tied to the performance of traditional investments such as stocks and bonds, direct real estate investment correlations are much closer to 0. 

This is a really important point to remember. 

You want assets that “zig” while others “zag” in order to reduce downside. 

Depreciation

Real estate's tax-efficient depreciation benefits incentivize private investment in housing, often leading to minimal tax burdens until sale.

Governments don’t want to be responsible for housing people. So they provide incentives for private investors to do it instead. 

The key thing to note here is that real estate investments offer considerable tax benefits. 

This makes real estate investing one of the most tax-advantageous investments available, making it common for investors to pay minimum tax until a property is sold.

Those interested in expanding their financial portfolios typically look beyond simple bank deposits. Many have a strong interest in business and the stock market.

The following section will compare how real estate measures up to these investment options for capital allocation.

Other

Real estate is a super broad category, but if you're going to group some high-level advantages and disadvantages, you'll end up with something like this.

Advantages of Real Estate Investment

• Tangibility: Real estate is a physical asset, often regarded as a more secure investment due to its tangible nature.
• Leverage Potential: Investors have the ability to leverage their investment through debt, typically obtaining favourable interest rates.
• Inflation Hedge: As property values and rental rates tend to increase with inflation, real estate can serve as an effective hedge.
• Tax Benefits: There are often tax exemptions available, such as deductions for mortgage interest and property depreciation.

Disadvantages of Real Estate Investment

• Capital Requirement: Acquiring real estate requires a significant initial investment, which can be a barrier to entry for some investors.
• Liquidity: Real estate is less liquid than other investments like stocks or bonds, meaning it can take longer to sell without impacting the asset's price.
• Management Demands: Ownership, especially of rental properties, demands active management and maintenance.
• Transaction Costs: The costs associated with buying and selling real estate, including stamp duty, legal fees, and agent commissions, can add up to a substantial amount.

Comparing Real Estate and the Stock Market

Investing in public businesses in the share market is a very common gateway for people investing for themselves.

The Australian Stock Exchange (ASX), which is the primary securities exchange in Australia, plays a pivotal role in this sector.

It provides a platform for the trading of various financial instruments such as equities, derivatives, and fixed-income products, offering a gateway to a range of public business investments.

Advantages of the Stock Market

• Liquidity: Stocks offer high liquidity, allowing investors to buy and sell shares quickly.
• Diversification: The stock market enables easy diversification across different sectors and geographies.
• Lower Transaction Costs: Buying and selling stocks usually incurs lower costs than real estate transactions.
• Income Through Dividends: Stocks can provide an ongoing income stream through dividends.
• Tax-Advantaged Investing: Superannuation accounts and other tax-advantaged investment vehicles can offer significant tax benefits.

Disadvantages of the Stock Market

• Volatility: The stock market can experience rapid and significant fluctuations, impacting wealth.
• Emotional Trading: The ease of trading can sometimes lead to impulsive, emotion-driven decisions.
• Dividend Taxation: Dividends can be subject to taxation, although franking credits in Australia can mitigate this issue.
• Market Complexity: Successful stock market investing often requires thorough due diligence and a deep understanding of market dynamics.

Investors also navigate a junction where the realms of real estate and equity markets intersect on the ASX—through Real Estate Investment Trusts, known as REITs.

These trusts manage income-generating properties and are obliged to distribute a significant portion of income—typically 90%—to shareholders as dividends.

This not only provides a consistent revenue stream but also potential for capital growth.

Learn more about investing in Real Estate Investment Trusts (REITs) in this article, where we dive into the different paths to investment.

Competition

Where great founders and ideas can drive businesses and economic rents, which attracts competition, driving profits down, and eventually technology innovation becomes commoditized and everything becomes a toaster.

Clearly, this is a simplification, and there are indeed incredible companies essential for progress, much like real estate, which also follows its own cycle of demand and supply.

The point, however, is that business often resembles a war without bullets, where most entities cannot afford to remain static without losing ground to competitors.

On the other hand, real estate operates differently. It is generally more forgiving for investors and difficult to lose money on if given sufficient time.

Continuing with the business analogy, it's almost as though there's an inherent competitive moat that stems from strategic location and inflation, which drives up replacement values.

This advantage often becomes apparent on the scoreboard, as even moderately leveraged real estate can double an investment over a few years.

Residential vs Commercial

Now that we have a good high level understanding of real estate, it's important to distinguish between residential and commercial as they can offer different value propositions for investors.

Residential Real Estate

“Residential” real estate is the umbrella term used to describe several housing types, including single-family homes, apartment buildings, student housing, and assisted living communities. 

The entry barriers for residential properties are usually lower, welcoming new investors.

Many investors start by investing in SFRs because they are relatively affordable, offer a more consistent investment climate, and residential property investing is more achievable financially. 

You generally won't find much residential real estate syndicated because they are usually dealing with smaller parcel sizes. 

However, that excludes unit blocks, which can often be a great syndication path because they are valued on logic (not emotion), which makes the incentives to create value much clearer.

Commercial Real Estate

Initially, it might seem that commercial real estate merely consists of tall office towers like those that define the Sydney CBD skyline.

However, it encompasses a much wider range of property types.

Investing in commercial real estate is a nuanced and diverse category, requiring an understanding of different functional needs—people need places to live, and businesses need spaces to operate.

To understand the commercial real estate sector, it's key to first define its scope.

Commercial real estate includes any property utilised for business operations—ranging from shopping centres, retail stores, industrial sites, office buildings, to data centres. These varied properties are often categorised into distinct 'product' types, each serving a specific business purpose.

It's easy to see that investing in commercial real estate is a far more nuanced and diverse investment category.

People need a place to live, and businesses need a place to work.

And to keep things in order, councils in Australia have strategic directions and plans that everyone has to abide by. 

Zoning regulations play a crucial role in this system by defining permissible land uses and construction standards. 

These regulations help maintain community standards—for instance, preventing the establishment of a strip club in a residential area or a family home in a central business district.

Investment Barriers in Large-Scale Real Estate

Australia has a strong property market, but surprisingly, large-scale residential and commercial properties often see less investment from everyday Australians. The reasons are multifaceted.

First, education and experience play a significant role. Investing in substantial real estate requires specialised knowledge and skills, which many lack.

The bigger the property, the more expertise you need, which can be a barrier but also an opportunity for the well-informed.

Smaller investors often find themselves on the outside looking in. The high-quality, larger properties seem out of reach. Meanwhile, at the top end, public REITs claim the premier properties.

They offer quality and stability, but with limited growth prospects—aa situation that presents little opportunity for significant gains.

Finding Opportunity in Property Syndicates

Property syndicates often thrive in what's been called the 'messy middle,' a sector filled with properties just beyond the reach of individual investors yet not on the radar of large REITs. In this space, savvy investments can lead to substantial property value increases.

Contrary to popular belief, residential real estate isn't solely for capital growth, nor are commercial properties exclusively for generating cash flow.

Opportunities for income exist in residential investments, and commercial real estate can also see significant growth.

Investment success requires a tailored approach. The varied landscape of real estate means that strategies effective for one investor may not suit another.

It's vital to select investments that align with personal goals, whether they be for immediate returns or long-term growth.

Conclusion

Understanding different investment choices can be straightforward when you know what each offers. 

Real estate investment, known for its stable cash flow and potential for growth, stands out for those looking to add variety to their portfolios and invest in something solid. 

As you think about growing your investments, consider these points against your own financial plans. 

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