Stock Market vs Real Estate: Which Is The Best Passive Investment? - The Art of FI (2024)

• S.A. FI
• October 6, 2022

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Before comparing the graphs, let’s define each of the columns so we are all under the same understanding.

Year – The year of the return

Annual Return – The return that investment reached each year

Balance – Results of invested capital in the given year plus all gains/losses from prior years

Total Return – Return on investment on your Amount Invested

Annualized Return – The average annual performance of your invested capital by dividing the Total Return from the number of years invested. This is a common return used with real estate investing.

Compounded Return – The rate of return of your invested capital compounded over time. This is a common return used with stock market investing.

At first glance, the stock market had a handful of down years (in red). In early 2000, you have the dotcom bubble that tanked the stock market. Then the market started to recover and then in 2008 we entered the Great Recession. These two events were not kind to investors. This period has been called the lost decade because you would not have made any gains on your investments during the 10 year period in the 2000s. However, you then came to the decade of recovery and saw stocks at all-time highs. If you invested after 2009, then you likely have seen amazing returns on your investment.

You may be asking if the stock market has gone up double-digits in multiple years, how is it possible it does not outperform a 4% return? If you had an investment that lost 10% in one year, then went up 10% the following year, are you back at the same amount you started with? The answer is no.

Let’s do the math:

From the graphic above, in year 1, the investment went from $100,000 to $90,000 with the -10% return. In year 2, the $90,000 returned 10%, so your balance is now $99,000. The balance in year 2 does not go back to the original balance, $100,000, with a 10% return and would need an 11.11% return in year 2 to get your investment back to $100,000.

In year 3, a loss of 25% would need a positive return of over 30% just to breakeven.

Looking back at the stock market returns, it had multiple years of losses from 2000-2002 before multiple years of recovery, even gaining over 20%+ in returns in one year that would have brought the investment close to breaking even by 2007. Then in 2008 came the crash that tanked the investments nearly 40% in one year. It isn’t until five years later before stocks finally break even again with multiple years of gains over 20%.

Although the 20-year period in question was unique with two major crashes in the stock market, it is not unique to have different events that can tank the market. For this reason, the historic stock market returns over the last 50 years was 6.8%. This implies there were years of positive double digit returns along with years of negative double-digit losses. With all this, the stock market only steadily increased.

What’s important to also consider is real estate and stocks use different formulas when discussing returns. For the stock market, compounded returns are the most used formula.

When discussing real estate, IRR (Internal Rate of Return) and AAR (Average Annualized Returns) are the most common.

IRR

IRR incorporates the concept of time value of money (TVM), which means that it adjusts returns since money received today is more valuable than money received in the future.

This is one of the most common returns used in real estate for the fact that the timing of returns is taken into consideration. However, calculating IRR is very complicated and is not easily done by hand. Excel has a very handy formula that will quickly calculate it for you.

AAR

To calculate the AAR, you will add up all the cash received from cash flow and any capital event(s), including refinances and sale. Next, subtract the capital invested from the total, then divide this number by the capital invested. This will give you the return on investment (ROI) as a percentage. From here, divide this percentage by the number of years invested and the result is the AAR.

Analysis of Stock Market vs Real Estate Returns

So, was this real estate investor correct in his statement? Sort of. At the end of 2019, the S&P 500 had a compounded return of 4.02%. This would be equal to a flat 4% annual distribution during the same period.

The annualized return, commonly used for real estate, was 5.99% and 5.96%, for the S&P 500 and 4% distribution, respectively. Again, this shows the returns were very similar.

What these numbers tell us is investing in the stock market from 2000 through 2019 would have had the same returns as just getting a 4% compounded distribution. With the real estate expert saying that giving investors 4% distribution would perform better is true if using compound returns. The real estate expert was likely referring to compound returns but should have used annualized returns or IRR to make the comparison, but I am nitpicking here.

What’s interesting is the IRR, the other very popular real estate return formula, outperformed the S&P 500 (7.86% vs 5.37%). However, this is taking into consideration you sell the entire investment at the end of the year of calculation (2019).

What does this all mean?

The point is clear with what this investor was trying to get across, which is that the stock market is not necessarily the best place to put all your hard-earned savings. While the stock market has had large swings up in recent years, there is an expectation that things will always balance itself out through the law of averages.

The common saying, “past performance is not a guarantee of future results” holds true here. Even though the consistent 4% distribution outperformed the stock market through 2018 using compounded returns, the stock market has now started to outperform the former. However, even with this outperformance, it should be expected the stock market will continue its historical trend and average around a 7%-8% return.

On the other hand, it is possible to find real estate investments averaging returns of more than 4%, which is considered very conservative investment. It is also easy to find returns matching the average stock market returns (7%-8%) or higher, no matter if you invest actively or passively. For example, a syndicated passive investment can average returns between 14%-16%, if you look in the right places.

How would average real estate returns faired compare to the other returns during the same period?

Summary

From the analysis above, even with returns from the stock market in the last 20 years that included the lost decade plus the longest bull market in stock market history, stock market returns were still only in the mid to high single digits during that period.

The stock market has a role in your investment portfolio, but it should not be the sole or primary source of your investment.

On the other hand, real estate is not influenced by the ups and downs of the stock market and the average returns can be much higher than the historic average stock market returns.

In the debate between the stock market vs real estate as a passive investment, real estate has the upper hand in overall returns. This is one of the several advantage real estate has over the stock market. This can accelerate your journey to financial independence and make work optional.

Discussing how to improve your personal finances is one of the things I discuss in myFREE Financial Independence Plan Frameworkguide that you can download below.

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