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 …
The Decision:
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:
Which Is Better – Rental Income or a Stock Market Index Fund
Readers: Which one do you think is better? What have your “real” experiences been with either scenario?
Related Posts:
1) Which is Better – Paying Off Your Mortgage or Investing the Money? – Part 1
2) Which Is Better – Paying Down Your Auto Loan or Mortgage?
3) Which is Better – Points or No Points on Your Mortgage?
Photo Credit: Microsoft Clip Art
Or… I am lazy and hate stress => index funds for the win!
Curious what your numbers are if you include the cost of a house manager, since with rental income some of that earning is from effort, not just investment. (Since my hourly rate is far higher than that of a house manager, my time would be better spent in the labor market. Index funds take almost zero time, especially if you “set and forget” for the long-haul, only looking when rebalancing.)
I think you just summed up why I don’t have an investment property yet! No, there’s no factoring in for management which would clearly eat up some of the profit. I agree that in terms of actual effort required, the Index Fund is much better suited to working professionals with little time to spare.
Great write-up MMD! I’ve never really sat down and crunched the numbers but this is surely impressive!
I can’t speak on renting yet because I haven’t done it but I’m going to assume my long-term ROI will be better than your projected scenario as I look to get my eventual rental properties on a 15-year mortgage (and eventually pay cash for others).
Thanks Jason! When you put together your model, just be careful of upkeep costs. That was one of the things I left out of this example because they could range from small to incredibly large (new roof, plumbing issues, AC, new paint, new carpet, sump pump, etc). Even over 15 years I’m sure it will add up quick!
Well, over 30 years at least you will need a new A/C 4 or 5 times…add 20k to 30k in expenses. What about home insurance? What about fixing the house every time that a renter destroy it before you evict them? What about lawyer fees for each eviction? Stock market return in the last 10 years was over 10%/year. Keep in mind that 30 years from now your house will be 30 years older…how old is it now? Your house will lose value as it gets older unless you fix and renovate it. How many times you will need a new roof over the next 30 years????
Sounds like you’ve had some great times with your tenants! All of these items are definitely real world concerns that should be considered before anyone just runs out and starts renting out homes. You’ve got to consider your risks.
Great read! One more thing, the bank would never lend you money on your portfolio but it will on your rental property. Totally agree with you.Would be nice to run an article using a REIT ETF as well vs renting a house.
Thanks! Interesting battle – sounds like you’ve just created your next blog post idea!
I think a lot comes down to where you live too. In some areas there is just so much more potential for housing prices to increase and it would be easier to find tenants. The other thing to consider is property taxes. Overall real estate should be the better investment if you can afford to spend the time managing it. Personally I’m going to get into the stock market first and then look into real estate investing down the road when I’m a little less busy.
Thanks Jeremy!
Property taxes should already be factored into the $519 you’re paying per month (P&I with an escrow containing taxes, insurance, and HOA).
I agree with your path, and that is somewhat the road I am on now. Stocks truly are passive whereas this sort of venture will require much more involvement.
I think your method of combining both is the best most lucrative option. And from your other article you could also use the profits to have a property manager to avoid getting call about broken water heaters and the like.
I agree. Although I left out a property manager from the example, I would personally probably need to use one mostly for the convenience factor.
Nice analysis! For me, I understand people and the economy as a whole better than individual companies. This makes me gravitate towards investing income.
Thanks! I feel as though the investments are more hands-off which is what has enticed me for so long.
I have to say that I was a bit surprised to find out that the winner was Rental Income. Given the risk income loss due from having stretches of no tenancy and repairs, I was so sure that a Stock Market Index Fund would’ve been the better option. But, your numbers crunching made sense. Now, I get it.
You’re right, and the intent was more to demonstrate the full potential of both outcomes. We could take a more realistic or even pessimistic approach to this model and run the numbers where we have 50% rental occupancy or something similar. Then we’d see who would be the winner! Of course, there’s no guarantee that says at the end of 30 years stocks will be at 8% either ….
Great exercise. The biggest argument I would see would have to do with the time and stress involved with managing the property or paying a management company. It totally depends on the person but both options seem good to me so why not mix like you say.
Exactly the reason I haven’t bought a rental property yet. There would definitely be a lot more effort going in than what I’m doing now with my stock market funds. This blog already takes up what free time I have 🙂
You are a creative writer. I’d say that, first and foremost, you have to be comfortable with the instrument that you use to grow your money. If you are good at picking rental properties, and enjoy running an active business then invest in the rentals. On the other hand, if you love investing in the markets, there’s nothing better than index fund investment. You also have to consider the risk associated with unforeseen events like 2008 real estate bubble. If you purchased a rental at the peak of 2007, you are in for the long haul. 🙂
Thanks Shilpan! And you are absolutely right – no matter what the numbers say, you have to do what’s right for you. If you want to be great at real estate, then learn about it and be great. But if you’re more comfortable with stocks, then stick to that. It’s all about your sphere of competence.
I think the real estate is much better. Of course their are the naysayers about rental properties with their what ifs…but I think what if the stock market crashed? I mean it’s obviously done it before. Real estate makes me feel a lot safer.
True – People will always need a place to live, so rental income may be less susceptible to economic cycles than the market value of stocks.
“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.”
So…here’s my thought pattern as I read this. Headline: This is gonna be awesome! Rental: Okay (a little shaky), Index: Yeah, I got it (looking for comments quickly to refer to above sentence).
Awesome post. Actually, if you compare the NAREIT Index against the S&P 500 over the long term the results are eerily similar. So, I think you have three choices with long term money: buy stocks and invest dividends in real estate, buy real estate and invest dividends in stock (your idea and more practical) or 50-50 into each.
Another fun post, MMD!
Ha – you know I have to disclaimer my work! I’m not sure I’ve ever looked too deeply into the NAREIT. I’ll have to check that out. Glad to entertain – sometimes it’s just fun to play out these what-if scenarios.
Out of curiosity, where did you get 8% return for the stock market from? I have always seen 10%, but that’s usually including dividends which I noticed were not considered in your analysis. I wonder how the two would match up if you took average dividends into account…
Also, taxes were missing from the mix too… I suspect those would balance out much of the benefit to real estate depending on where you live. I live in New York state and I can tell you that taxes increase well over 3% per year. Of course, the nominal amount is less than the increase in property value in most years, but it still takes a bite out the bottom line.
Great post by the way, and I think it’s great you’ve put in so much effort. It really gives us all a lot to argue about! 😉
Thanks and I’m glad you enjoyed this.
Good question on the stock returns. I have seen many variations of the 8% and 10% average quoted in dozens of different books I’ve read – more often I see the 8% number. The figure usually refers to the total annualized average return of the S&P 500 stock Index (although sometimes people refer to the Dow). I believe it includes dividends but is not inflation adjusted – I will need to check on this. As you probably already know, that number is pretty subjective depending whether your data starts in the 1920’s when the index started or in the 1950’s when it actually reached 500 companies. It also depends on when the data ends – in 2008 when the market crashed or 2011 when markets were somewhat higher.
Taxes are included as part of the escrow in the $519 figure. $305 was just P&I.
I also suspect that location as has a great deal to do with outcome (in addition to many other variables like IF you could actually get someone to rent from you for a full 30 years). All the same, it was interesting to run both scenarios and see what would happen.
You nailed it all down. Looks very clear, and there is always be “IFs”. What I cannot comprehend is this:
I have never heard before about rental property cost $80,000 being rented out for $800 a month. It is almost 10% a year…
There only other if , that the house you are buying is not new. After 30 yrs ,,you will need to build new one. And amortization is missing from the calculation.
My area was hit hard in real estate, and the $80K and $800 are real prices I found from research. Not long ago one of my neighbors who that has the same style of house as me rented it out to a family for $1200 per month. If you think 10% is good, then you should see what my style of house goes for in foreclosure. I don’t even want to tell you because it is embarrassingly lower than what I originally paid for it.
On amortization, I intentionally selected 30 years so we could ignore the schedule of payments. From a balance sheet perspective at the end of 30 years, it makes no difference when you paid your P&I so long as you paid it in full.
MMD,
In your calculations, the homeowner is paying $305.16 towards his home every month after the initial money spent. However, the investor is assumed to only have invested the initial amount. In the interest of fair comparison, shouldn’t the $305.16 be viewed as an opportunity cost that could have otherwise been invested? If so, a FV calculation using an 8% return and $305.16 monthly investment should be added to the $180,927 equity of the investor.
Hi Raymond,
It took me a few times to review, but you are correct. It wouldn’t really be fair to assume that in one situation you pay $305 for the next 30 years and in the other you do nothing but let your initial investment grow. Thank you for diving deep. I’ll have to update this.
According to my analysis
If the rental income covers a 10 to 15 years mortgage (not 30) then rental property wins, else the Index Fund Wins.