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Investing is not only a good choice, but also the obvious one. The indisputable fact is that, regardless of the asset class you decide to put your money in, you will be much better off in the long -term than if you just kept your money in a simple savings or checking account.
So in terms of investment, where is a logical place to start? Both real estate and public market securities are common investment channels, and both appear to have their own set of advantages and disadvantages. The following post serves to outline some of the key factors that may help any beginner investor choose where to allocate their hard-earned capital.
In the interests of full disclosure, I’m biased towards real estate investment. The majority of my portfolio comprises real estate assets, whereby my share and bond holdings are limited to my superannuation scheme (which comprises less than 10% of my total equity). However, I want this to be an educational post so I have sought to present a factually driven, neutral and impartial overview of the two asset classes.
I would also caveat that I am not a tax professional or financial advisor. Any information provided below is based on my own research and experience and should not be relied upon as advice. Please consult a licensed accounting or financial professional prior to investing into these asset classes.
Liquidity and cash flow will vary depending on the asset class
This is arguably one of the most significant considerations when determining which asset to choose from as a first investment. The very obvious fact is that an individual home is more expensive than a share (well… most shares; see Berkshire Hathaway’s current share price if you’re interested). In terms of raising capital for real estate investment, the two most common ways are 1) funding through internally generated equity or 2) obtaining a mortgage. The second option is arguably the more commonly used, and perhaps a more favourable option for a number of reasons, namely:
- You can amortise the cost of a home over a number of years
- While you have additional costs that you wouldn’t have under option 1), you can most likely take these costs as tax deductions
Securing debt to purchase a home can be challenging. You need a strong credit standing, and in some instances, may need co-signers or guarantors to underwrite the debt for you. Secondly, depending on the interest covenants of your loan (e.g. fixed vs. floating – we will discuss these concepts in greater detail in subsequent posts), you may be potentially locked in to an unfavourable rate, particularly if there are prolonged interest rate trends following the mortgage start date.
This barrier to entry does not exist in share investment – in the last decade, the stock market has been democratised through the advent of numerous online brokerage firms. Anyone with access to a bank account and, in some cases, a minimum contribution amount, will be able to purchase an individual stock in a public company.
The reliability of the return may be more important that the size of the return
Both asset classes benefit from price appreciation and provide additional periodic returns for the investor. In the case of real estate, you receive your return in the form of rental income, and indirectly, through tax refunds. With share purchases, your periodic returns are provided via dividends.
A real estate investor is guaranteed weekly/monthly/periodic rental payments, whereby failure to pay the rental amounts may be subject to breach of contract and potential termination of the lease agreement (provided the rent is not being withheld for a legal purpose). This may be contrasted with share ownership, whereby companies maintain, in their full discretion, the right to pay out dividends to shareholders. Some companies may never pay out a dividend, choosing to instead reinvest it into the company. While this may result in price appreciation of the stock, it may not align with your investment strategy, particularly if you wish to rely on regular dividend income.
In times of economic downturns, the income streams of both asset classes may be potentially impacted. However, you have greater recourse under real estate investment, given your returns are contractually governed and you can enforce rental payments; you cannot compel a company to distribute dividends. Conversely, you can cut your losses quicker under share ownership, as there is a considerable time lag between putting a property on the market and the settlement of the sale.
Taxes Vary depending on the asset class
The tax treatments of the two asset classes vary considerably. For real estate investments, your rental income is taxed at your progressive income tax bracket rate. However, a large benefit of real estate ownership is the tax deductions you can take against your rental income – such as depreciation, interest expenses, repairs and maintenance expenses, water, utility and council rates. Therefore, your gross rental income will likely translate to a lower net rental income, which in turn will reduce your overall tax liability. This certainly presents a greater advantage in the early years of ownership, whereby property costs significantly outweigh the income stream.
For share ownership, the dividends flowing from the share are also subject to your progressive tax rate, but a dividend is typically taxed twice – once at the company level (where it is taxed at a flat rate of 30%), and then again at the beneficiary level. If your progressive income tax rate is less than 30%, the tax office will refund you the difference between the 30% tax paid and your progressive tax rate. In Australia, this is known as the franking credits system. Given Australia’s current income tax rate thresholds, the highest amount of tax to be paid on a dividend (by the individual) will be 15%. This is similar to other jurisdictions that may not have franking credit regimes, such as the U.S.
If you decide to sell either asset, you will likely be subject to capital gains tax. Depending on the jurisdiction of the beneficiary, this may be consistent with the progressive income tax rates, or a separate tax rate altogether. Furthermore, you may be able to enjoy reduced rates depending on the term of holding the asset. In the case of Australia, you may enjoy a 50% discount to any capital gains tax paid, regardless if it is shares or real estate. However, this is likely the only concession available against the tax owed on dividends, and you will be unable to avail yourself of the host of deductible expenses that you could obtain under real estate ownership.
Your level of control will vary depending on the asset class
Under real estate, there are a finite and somewhat controllable number of players – you (the landlord), the tenant, and in some instances, the bank. You have a sufficient degree of visibility, foresight and, most importantly, control in your investment and its growth potential. You can renegotiate your mortgage terms if there are more favourable rates available. As a landlord, you can also select the type of tenant that will stay in your rental property. Further, there are protections offered to you in the event of damage or loss arising to your property.
This control is somewhat lacking with share ownership. Owning a share provides you the right to vote on specific company matters, but you do not have any control or oversight on the day-to-day operations of the business. To be clear, you may not want to know this level of control.
The point is that there are a few degrees of separation between your ownership in the company and its overall performance. Further, there are considerable external factors impacting the performance of a stock price, none of which you have any extensive control over (e.g. negative public relations news impacting the CEO may have detrimental consequences to the overall share price that you could not have anticipated).
Control can also be a double-edged sword when it comes to real estate. In real estate investment, you are solely responsible for the operation of your property, both physically and financially. You can outsource some of this responsibility to third party property managers, however depending on that manager’s experience and overall “interest” in the job, it can be good money washed down the drain. For real estate investment, you have to be comfortable with the significant time and financial commitment.
You can buy a slice in shares, but you can't do this with real estate (however this is changing)
So which one wins out – shares or real estate? The answer is a frustrating one, in that it purely depends on the investor’s personal circumstances, time commitment and risk profile. Below are a few key examples where share ownership would represent an appropriate investment:
- You value liquidity and fluidity with investment funds
- You aren’t interested in the overall operation of the underlying company
- You may be looking for rapid growth/appreciation over a shortened time horizon, and would be willing to cut losses from an underperforming investment fairly quickly
- You would be interested in receiving an income stream from the underlying asset, however this is not imperative and does not take precedence over growth.
Here are a few examples where investing in real estate may be preferable to share ownership:
- You’re comfortable in exercising full control and authority over the underlying asset
- You wish to remain connected to the asset for a significant time period, and are willing to make accommodations for the ups and downs associated with owning this asset
- You value a guaranteed income stream where it can compel payment from the tenant
- You appreciate the tangibility of the asset.
I hope the above provides some assistance in guiding you on your path towards investment and wealth creation. Please bear in mind that this is a very complex area, therefore it is sensible and prudent to complete extensive research on each asset class before making any concrete decisions. I would love to hear from those who have made investments in either/both asset classes, and would be comfortable sharing any other advantages or disadvantages relating to these assets.
The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.