Who’s ready for some financial smack-down? If there’s any two groups of investors I can think of that are more divided, it’s those who invest in real estate and those who invest in stocks – like a North and the South of financial planning if you will.
So the question here is this: Which one actually has a better chance of making you more money in the long run? This may be a controversial debate, but we’re going to settle this argument the MyMoneyDesign way – by running the numbers! So let’s see what we come up with …
In my post “How Much Money Would I Make If I Rented Out A House?”, I toyed with idea of buying a vacant house in my neighborhood and becoming a landlord. I’d use the house to make some extra money by creating rental income.
While that may be fine plan, there would be many that would argue that there are just too many risks! So instead of gambling on real estate, why not take the money for the down payment and closing costs and stash it away in a stock market Index Fund? The only thing to worry about then would be the performance of the market – period!
Well, in order to find out which one is better, we’ll have to agree on some assumptions, build a model for each senerio, and see what the money will look like in 30 years.
Year 0 – Rental Income:
To recap my post on buying a rental house, here were the financial details:
• Rental Home Sale Price: $79,900 (Actual sale price of the house)
• Down Payment (20% Down): $15,980 (Verified with a local bank)
• Closing Costs: $2,000 (Estimated – I added in this one for this example)
• Loan Amount: $63,920 (Sale Price minus Down Payment)
• Interest Rate for 30-Year Mortgage: 4.00% (Verified with a local bank)
• Monthly Principal and Interest Payments for the next 30 Years: $305.16
• Total Monthly Mortgage Payment (Including taxes, etc): $519
Now if I were to create a balance sheet for this point in time, it would look like this:
• ASSETS: House Market Value: $79,900 (what I’d get if I sold the house)
• LIABILITIES: Total Mortgage Debt: -$109,859 ($305 P&I payment x 30 x 12)
• EQUITY: Net Equity: -$29,959 (the difference between Assets and Liabilities)
So to start, I’d be in debt! And in order to climb my way out, I’d need to bring in some rental income. Hypothetically if I could rent the house for $800 per month and use this income to pay the $519 mortgage, that would make me:
• Monthly Profit: $281 ($800 – $519)
• Total Annual Profit: $3,372 ($281 x 12)
Year 0 – Stock Market Index Fund:
This side of the argument is easy. If I took the $15,980 down payment and $2,000 in closing costs, and just bought an S&P 500 Index Fund through Vanguard, then my balance sheet would look like this:
• ASSETS: Stock Fund Value: $17,980 ($15,980 + $2,000)
• LIABILITIES: None: $0 (I don’t owe anyone anything when I buy a mutual fund – just a small percentage each year)
• EQUITY: Net Equity: $17,980
Year 30 – Rental Income:
Here we are 30 years in the future! Let’s pretend a few things have happened:
• I managed to rent the house out every month for the last 30 years
• Both the house value and rental income increased with inflation at 3% per year
• No other costs were incurred (I know that’s not likely – we’ll get back to this assumption later)
If you build your model around these assumptions, then our balance sheet would look like this:
• ASSETS: House Market Value: $193,938, Rental Income: $163,749
• LIABILITIES: Total Mortgage Debt: $0 (We completely paid the house off in 30 years)
• EQUITY: Net Equity: $357,687
Not bad! So how’s that Index Fund doing?
Year 30 – Stock Market Index Fund:
Again, this side of the coin is easy to figure out. Because we didn’t “add” any money each month the same way we would have if we had rental income, the only thing that would increase is our initial balance of $17,980. If you believe that the stock market will continue to deliver an average annualized return of 8% as it classically has, then our balance sheet would look like this:
• ASSETS: Stock Fund Value: $180,927 (the future-value of our initial $17,980)
• LIABILITIES: None: $0
• EQUITY: Net Equity: $180,927
And the Winner Is ….
Comparing $357,687 against $180,927, the numbers favor Rental Income as the winner!
And I can hear it now … “But MMD, your assumptions are complete BS! What about home repairs? What if you weren’t always able to get renters? What if the home value didn’t increase? What if? What if? What if?????
Okay, these are fair questions! Of course within 30 years there will be lots of problems, home repairs, and periods of no income. So to be fair, let’s look at two fundamental points:
1) If we assume home values will only increase modestly (not crazy like they did from 2000 to 2008) by the rate of inflation at 3%, then the home value alone will be worth more than the Index Fund: $193,938 > $180,927.
2) Suppose we did lose money on rental income. We can easily calculate a break-even point between the two scenarios to see what our minimum failure can be. If we take our Index Fund Value of $180,927 and subtract the future home value of $193,938, then we have a difference of -$13,012. So what does that work out to over 30 years? The answer: -$22.33 per month (if you factor in 3% inflation). That means you could rent the house for $22 less than what you’re paying for the mortgage and it would come out the same as the Index Fund. To put it in other words, you could literally spend your entire rental income profit each month on home repairs, whatever, and you’d still come out ahead!
Of course, I don’t advise you do that!! This model is built on a ton of optimistic assumptions that should all be heavily, heavily considered before you truly act on one of these strategies.
In closing, why not combine the best of both worlds? Use a rental house to bring in rental income and then invest the profits in an Index Fund (or another rental property)!! Now you’ll own both real estate and stocks! There’s nothing that says you can’t double-dip!
Show Your Work:
If anyone wants to check my numbers or try different scenarios, here is my spreadsheet:
Readers: Which one do you think is better? What have your “real” experiences been with either scenario?
Photo Credit: Microsoft Clip Art