(Originally written February 5, 2009, though the subject still applies in May 2010)
On the Wealth Virtues Twitter “Tweet” http://twitter.com/WealthVirtues of 4 February 2009, I stated “Young employees – now is the time to invest big in your 401K and IRA. This is the best down market in years, so max your gains now!” As my Twitter comments feed into my Facebook page, I had a couple of Facebook responses. One was from one of my oldest friends since elementary school, who states”
“Heck NO!! Not me baby!! I cashed mine out just before the down turn and it paid off… Put it into Real Estate!!. No way will I donate to the Second Social Security slush fund ever again!! Too many people I know lost a few hundred thousand! actually a quarter of a million on a couple! Not me… REAL ESTATE!”
Is he correct? His statement is by no means wrong at all, and for my friend, within his personal financial strategy, this may be the #1 answer. However, on the average, what is the better option for investing; stocks, or real estate investments?
My statement referred to younger investors – those just entering the job market (those most likely to use Twitter and Facebook) who are looking for a place to invest. My friend is correct to a point (though I do not know what the second Social Security slush fund refers to as I view Social Security as more of a Ponzi scheme, but with less merit) if the decision for someone who does not own a home is whether to keep renting, or to buy a house. By all means, NOW is the time to start looking to buy a house. Low interest rates and a flood of houses on the market make this an extraordinary buyers market. In this case take both his and my advice; buy a home (that you can afford at a fixed interest rate and is not beyond your means) and put a lot of your pre-tax earnings into stock based investments.
Between the two, which is the better option in the long term? I did some digging using data from before the hyperinflation in the housing markets between 2006 and 2008, and the results are interesting.
Historical Investment Data
In an article on Forbes.com from 2005, Sara Clemence wrote an article called Real Estate Vs. Stocks. in it she states, “in the short term. U.S. real estate sale prices increased more than 56% from the beginning of 1999 to the end of 2004, as tracked by the Office of Federal Housing Enterprise Oversight, part of the U.S. Department of Housing and Urban Development. The S&P 500 index dipped nearly 6% during that same period. But if you take a longer view–say 25 years–you’ll find that the S&P 500 has actually stomped the real estate market, from Boston to Detroit to Dallas. From the start of 1980 to the end of 2004, home sale prices increased 247%. A pretty sweet deal, it would seem. Over the same period, however, the S&P 500 shot up more than 1,000%.”
In a 2007 article by Marlys Harris of Money Magazine, she took at look at both investments from both a short and long-term perspective. “Real estate has packed quite a punch of late, appreciating 12.4% annually between 2001 and 2006, according to the S&P/Case-Shiller U.S. Home Price index. That clobbered stock prices, which gained only 4.3% a year as measured by the S&P 500. But over the long run stocks win easily. A new study by Jack Clark Francis, a finance and economics professor at Baruch College in New York City, and Yale’s Roger G. Ibbotson compared the annual returns of real estate from 1978 to 2004 compared with those of 15 different “paper” investments, including stocks, bonds, commodities futures, mortgage securities and real estate investment trusts (REITs). The results? Housing delivered a solid but unimpressive annualized return of 8.6%. Commercial property did better at 9.5%. The S&P, however, delivered a crushing 13.4%.”
How to Decide Which is Right for You
Real Estate is a wonderful investment and I recommend it as well, but it is dependent on location, demand, and good timing. Would you buy a rental property in Detroit right now? If you do not have any renters, do you have the capitol to pay the mortgage while waiting to get someone to rent your property? Remember that real estate is an asset ONLY when you are making more money from the property than you are paying to the bank.
We bought our current home for $175,000 in 1996 in a rural are a near many waterfront properties. In 2006, we were offered over $480,000. We liked the area and so decided to stay, actually amused at the thought our home would be valued that much, though we did make many improvements. If someone bought the house then at that price, they would be disappointed to know that the current property value is closer to $350,000 to $400,000, and they would have had an apparent loss. Of course, value is only “on paper”, and you only make money if you sell or are making money from your property by renting or by commercial uses.
One other issue is that many people of any age may not have the best credit rating to qualify for lower interest rates. With the new scrutiny (and fear) by banks from the 2008 real estate and financial market crash, a person with a low FICO score (credit rating) may not qualify to buy a home little less buy real estate as an investment. However, anyone regardless of credit rating can invest in a retirement fund.
As of May 2010, housung prices are still dropping and mortgage rates are very low. The summer of 2010 could very well be the best time to buy into the housing market. If you decide to do so, do a little research to see if the home you are interested in has the potential for increased value over the next 10 to 20 years. You do not want to end up with an underwater, or upside-down mortgage where the value of the home drops lower than your mortgage balance.
To avoid investing in the wrong items in your fund, use tools like FinancialEngines.com to help you analyze risk based on age, income, and investment choices, evaluate your savings goals, and help to diversify your investments. I would also look to great advice from Fool.com. I pay about $99 a year to get great stock analysis from people that are smarter than me. It is cheaper than a broker, and on average, a well informed person can make as good as or better decisions about investing their own money.
My only advice is to think long term, stay within your means, understand your own risks, and make sure that you continue to have a stable source of revenue, and continue to improve your financial education.
Another item to have in your financial arsenal is access to rapidly liquidable assets. As another friend, Carla, said in response to the same ‘tweet’, “you can’t eat real estate”.