by Nathan Moeder

The fall of housing values over the past couple of years has spurred the debate over which is the better investment: stocks or housing? With each article that is published, I find myself confused or just not getting the whole — analytical — story. It’s easy to make an argument that since 1980 the stock market outperformed the housing market considering the huge stock market run up in the ’80s. Conversely, you can start in 2000 and make the claim that housing was better than stocks taking into account the most recent housing frenzy.

The fact is, however, that only a slim minority in America actually purchased their home in 1980 or 2000. So the problem is that you can’t make an analytical argument because you don’t have a concrete starting point.

A flaw seen particularly in real estate people is that they argue for real estate because they have made money on past real estate investments. That may be true, and the same can be said for stock market investors. But when analyzing stocks versus housing, you have to look at it from the viewpoint of those I would call “average Americans”. Average Americans are not real estate investors. When they become homeowners, chances are that they remain homeowners. When they sell their house, they trade “laterally” into a new one. They don’t time the market precisely to buy low and sell high.

Residential Realities

More now than ever, the average Americans are back to making home buying decisions based on emotion and lifestyle reasons. While they are also looking to buy at affordable prices, they are not concerned about exactly timing to enter the market at the bottom or whether they will be able sell it in five years at a profit. They are back to buying homes with the viewpoint that they will be living there for a while and want long-term stability and quality of life.

Along the lines of real estate as an “investment,” Average Americans (except those close to retirement) do not monitor their home value as they would their 401k or stock holdings. When setting long-term goals for financial planning, I don’t think people are doing 30-year forecasts of their home value and then determining how much they can net when they retire. You can’t be certain about housing or how much net equity you will end up with because life changes (or you may decide to refinance and buy a new boat or pay for your kids’ college education). Home equity would ultimately be icing on the cake and play a more important role in personal finances when you get closer to retirement.

Looking Ahead

To really understand whether stocks or housing is a better investment, we need to start with reasonable expectations. In other words, for the Average Americans who are both buying a home and investing in stocks, what is a reasonable assumption for long-term growth?

Reliable housing data sources go back to 1980. Since then, housing has increased annually by 3.6 percent through 2010 — it’s only fair to include both the bubble and the bust to even things out. Also, if you use the Standard & Poor’s Case-Shiller Home Price Indexes which start in 1987, the annual increase is 3.3 percent.

The stock market is a little trickier. There was a pretty good run in the 1980s. Since 1980, the market averaged 9.7 percent annually through 2010. However, if you look at the years 1950, 1960, 1970, and 1980 as starting points, then the market average is 8.2 percent. Coincidentally, long-term corporate bonds averaged the same 8.2 percent when looking at the same four decades as starting points.

So the conclusion, which many real estate people will concede, is that the stock market (8.2 percent annually) outperforms real estate (3.6 percent annually) over the long term. However, real estate folks will quickly point out that this does not include the power of leverage, which boosts the returns for real estate.

Cashing In on Borrowing

Leverage is an essential tool for real estate. The ability to use other people’s money (a bank’s) to acquire assets results in higher returns because the bank only receives fixed interest. But the homeowner receives all the additional upside in value appreciation. This is not possible in stocks, unless trading on risky margin accounts, which Average Americans do not do.

Consider the case of a home being purchased for $400,000 with a 20 percent down payment — $80,000. Assuming homeowners trade homes every 7 years, the sale price would be $512,364 based on the long-term appreciation of 3.6 percent annually. When the home is sold, a total of $166,745 is netted by the seller, which represents an annualized return of 11.1 percent. However, the costs of homeownership over 7 years must also be considered — interest, property taxes, insurance and maintenance. Subtracting these costs results in a total realized profit of $153,012, or an average annual return of 9.7 percent.

It’s important to note that the homeownership costs represent the “after tax benefit” of homeownership. Meaning, only 20 percent of property tax and interest deduction is the actual added benefit of owning a home. The remaining 80 percent is still a true cost. The reason is that you have to consider the “incremental tax savings” between taking the standardized deduction or the itemized deduction on your taxes, which is 20 percent. In addition, this example also accounts for the fact that if you did not purchase a home, you would have to pay rent somewhere else. To account for this, the homeownership costs are reduced by an assumed rent of $1,800 per month.

At first glance, the 9.7 percent leveraged return for real estate looks better than the stock market return of 8.2 percent. But you cannot look at the total return on a percentage basis. You need to consider the total dollars achieved over this time.

If an individual chose to forgo purchasing a home and invested the $80,000 in the stock market (Dow index fund), then the person would earn 8.2 percent annually on the money. In addition, they could invest an additional $1,962 each year because they do not have the added costs of homeownership. The total investment balance after 7 years would be $156,506.

A Photo Finish

To summarize, the homeowner would make $153,012 compared to $156,506 by investing in the stock market. And by this, it’s best to call it “a wash.”

There are also other factors to consider such as deferred gains from the sale of real property. Uncle Sam allows homeowners to forgo taxes on $250,000 of gain ($500,000 if you are a couple) as long as the house has been your primary residence for at least two years. To make this up in the stock market, you would have to make an extra 1.5 percent to 2.0 percent, which is possible if you are fortunate enough to have good advisers successfully manage your money. The percentage could also be less if you consider that part of the stock investment is in a Roth IRA.

There might be a slight advantage for buying real estate, but I wouldn’t call it compelling.

It is best to invest in both. One is not better than the other unless you have a specialized skill as a real estate or stock market investor, in which case, you would focus your efforts. But to Average Americans, the investments are equal.