Update: Adjusted numbers in last case study to reflect actual earnings and expenses, corrected an error in a calculation.

As I mentioned in the first post in this series, you can use real estate as a way to diversify your investments, perhaps as a hedge against your other investments doing poorly. To intelligently balance a portfolio of investments between stocks, bonds and real estate we need to get the best estimate possible of how each sector performs. As a start, it’s worth comparing a pure stock investment and an actively managed real estate investment over a long time period. For the biggest picture view, refer to “The Total Return on Everything Since 1870.”

Here I’ll examine real world results from the last ten years from my own experience. Was the real estate business worth it? By “worth it” I mean (1) Did real estate serve as a useful hedge or balance compared to other investments and (2) Did it perform well enough to consider as any part of an overall portfolio?

On the one hand this kind of analysis ignores luck; the exact timing of investments will substantially change how the deal compares with a comparable investment in an index fund over that same time. On the other hand only by being willing to reckon with the numbers can we find out if we’re on a good track or lying to ourselves about our skillfullness as a investor. The factor of skill is hard to judge; there’s no skill in index investing; with real estate there’s some skill and some luck. You pick from the deals available, not your ideal scenario. You have to execute the project (flipping, remodeling, long-term rental whatever the plan may be,) well or poorly, but it’s not all up to you.

In the following four cases, real estate data on individual transactions are from my business, S&P 500 total return (includes dividend reinvestments) from here , and the FTSE REIT index is from NAREIT site.

Conclusions below.

Case 1: From August 2011 to September 2014 (time from purchase to sale)

The increase in my real estate investment over this time roughly paralleled the U.S. stock market returns. Here are four measures of “average” market investments and my RE gains:

S&P mutual fund VFINX: 111 to 181 (includes dividend reinvestment)
63% increase

Equal Weight S&P RSP: 44 to 76 +  2.3 for accumulated dividends
77% increase

NASDAQ QQQ: 53 to 97 + 2.25 accumulated dividents
87% increase

S&P 500 total return 

RE: $97K ($56K + 41K improvements)  to $155K net + $18K net rent income 
78% increase.

NAREIT index: 811.00 to  950.56 

Case 2: July 2015 to May 2016

S&P 500 total return 
0.51% over the same period.

RE: $$146,500 ($117,000 +  $29,500 improvements, holding costs) to $165000
annualized rate of 15.15%

NAREIT index: 1189.55 to 1306.97 
(9.8%, 10.6% annualized.)

Case 3: Dec 2015 to Dec 2016

S&P 500 total return 

RE: $144,000 ($110,000 + $34,000 expenses and holding costs) to 168,800
Annual rate of return of 16.43%

NAREIT index: 1295.24 to 1354.07 

Case 4: April 2013 to Jun 2018

S&P 500 total return (dividends re-invested) 
77.02% over the same period.

NAREIT index: 874.59 to 1380.40  
Illustrating the Power of Leverage

Here are two scenarios. In real life I used financing for this real estate.

Hypothetical all cash version:

Investment: $196,000 ($147,000 + $50,000 improvements)

Returns: $87,300 gross rental income , $49,300 Net operating income $37,500 operating expenses +$285,000 estimated value June 2018

$89,000increase in equity + $49,300 = $138,300. , total equity and income of $334,300. total return on initial investment of $196,000 would be 70.5% over five years.

Real version With financing:

$69,000 down and initial expenses, additional $19,000 improvements $110,000 loan, now paid down $10,000, current value $285,000, current equity $185,000

Net income after financing, principle paid accounted for above, close to $250 per month, $15,000 total neatly just happened to be $200000 income and equity

total return on investment of $88,000: 127% over five years. In reality we must account for closing costs and comissions; after those costs the sale yielded $166300 + $15000 gives $181,300 or 106% over five years.

Fairly Comparing Leveraged and Unleveraged Real Estate Investments

The hypothetical cash version of the deal would have slightly under-performed the stock market while locking up a lot of capital ($110,000 to be exact.)

In the financed version, debt service lowered net income by $26,000 compared to the all-cash scenario. But even if that income were invested into the market it wouldn’t make up for the $110,000 that couldn’t have been immediately invested into the U.S. stock market. That would have yielded an additional $84,000. So the “real” return on the financed deal was more like:

$84,000 return on the $110,000 not invested + $181300 on the $88000 invested in the RE

($194000 + $181300) on $196000 total investment giving 89.5% return over five years

Not quite as nice as 106%, but better (and market-beating) compared to the all cash hypothetical, where the return was 70.5% over five years with a similar amount of money tied up.

Without going through the detailed simulation of investing rental income from the cash deal over time, we could estimate on the high end an additional $20,000 of investment income (77% * $26,000) to put it in the best light possible. That still gives only a 81% gain compared to 77% for the market and 89% for the financed real estate + market investment.

Of course this presumes you had that extra $110,000 just lying around to choose to invest after getting financing for your real estate deal. If not, an 81% return would still have slightly beat the market but your investment would have been less diversified.

We can spin out all sorts of hypotheticals, for example what if the $110,000 borrowed to buy the property (so free for other investments) had been used to buy another financed property rather than an index fund, and that one tanked? Not likely, since the market all over the city generally moves in the same direction… Which leads to the scenario in which the market turned down all over, sticking us with two underwater properties instead of simply a little less equity in one property.

In a rising market , leverage can really boost your returns, just as buying stock on margin in a rising market can boost your returns (though finance terms for margin aren’t as favorable as for real estate – rates are higher and you can’t lock in rates.) If the market turns on you, just as with stocks you can get a “margin call” if you try to sell: You’ll have to cover the balance of your mortgage, or at least walk away with terrible credit. Getting another loan soon after defaulting won’t happen easily, though our current President seems to have managed it.

Finally, Consider Passive Real Estate Investments with REITs

A REIT (Real Estate Investment Trust) is an investment vehicle that lets you buy a share of a trust investing in the real estate market. There are REITs specializing in residential property, commercial property (office buildings, hospitals, hotels, retail.) REITs can also invest in real estate finance.

With a REIT you get the benefit of rising property values, rental income and the mortgage finance industry without directly participating.

In my lucky experience all four deals did as well or better than the stock market. However, directly comparing active real estate investing with passive investing in REITs or stock index funds requires that you account for your own time; and in addition there are intangibles such as stress (how much do you really like doing this?) and risks uniquely associated with direct ownership of real estate. With that in mind, the lower (in my case at least) return of a REIT compared to direct ownership may be worth it.

Looking at the NAREIT index, we can see the difference between the national residential real estate market and my local market; there were substantial differences. The NAREIT index did significantly less well, but compared to the market was in the same direction as my investments except in “case 1”, where our market seems to have bounced back faster than the national market.

Had I simply held a REIT matching NAREIT from August 2011 to Jan 2018 the return would have been 71%, compared to a 167% return for S&P500 index including divident reinvestment. For the periods where I was invested in the RE market I actually out-performed the stock market, and out-performed the REIT index even more. My luck in the real estate market would seem to come down to being in a better than national average market combined with good timing and decent execution.

Over a longer period (1970s to present) the NAREIT index actually outperforms the U.S. stock market; but as they say past results do not predict future performance and I’d take that line especially seriously here.