Stocks or real estate: Which is more profitable?

Liquidity: Shares vs. Real Estate

Real estate is considered a rather illiquid asset. Before a property is sold, it is usually advertised extensively, viewings must be conducted, extensive documents are reviewed, a notary public is retained, and finally a meeting is held to sign the purchase agreement. This process can take several weeks to months. There are further negative points for the sale of the property with a holding period of less than ten years. Namely, here the so-called speculation tax is incurred, which is calculated according to the individual tax rate. If the financing of the real estate is still running, there is an early repayment penalty for the bank. In addition, a very high capital sum is usually tied up in a property, which is then no longer freely available for the time being. Before any real estate purchase, therefore, it should be very well considered how much capital is actually to be invested, so that the money is not needed elsewhere in the medium to long term.

The situation is usually different with shares. Shares that are freely traded on the stock exchange are usually considered liquid investments, as they can be sold at any time during trading hours. The liquidity of the stock depends on the number of shares in circulation, but also on the market participants who are willing to buy or sell the stock. Shares of small companies that are not represented in the well-known indices are considered to be rather illiquid. In this case, it can take quite some time until a buyer is found at a reasonable price. Overall, it can be said that with stock investments it is rather possible to get the invested capital back in the short term. However, this is only recommended to a limited extent, as shares are subject to greater price fluctuations in the short term due to their higher liquidity and can therefore also lose some value quickly. Therefore, only invest money that you do not need in near future, so that you are not forced to sell your asset at a bad time, just because the invested amount is needed elsewhere.

The risk with shares and real estates

While we are on the subject of price fluctuations, we have already arrived at the subject of risk. The volatility of a share describes the extent of price fluctuation and thus represents a risk indicator. The higher the volatility, the higher the risk of the share. The volatility of shares varies greatly depending on the industry, the size of the company or even the country of origin. Overall, it is advisable to broadly diversify as far as possible when it comes to shares. The best way to do this is with a broadly diversified index fund. Here, for example, the volatility of the MSCI World (shares from industrialized countries) in a 5-year period is about 16.5 percent (source: justETF Research; as of July 31, 2021). In comparison, gold is at 12.9 percent and European government bonds at 3.8 percent.

With real estate, volatility is much harder to estimate. Real estate is much more diverse. On the one hand, by the nature per se (size of the property, building fabric, architecture, equipment), but also by the locality (micro and macro location). For this reason, the classification of the property into risk classes (Core, Core-Plus, Value Add and Opportunity) is of crucial importance. Core and Core-Plus properties are considered less risky than Value Add or Opportunity properties. Real estate risks include the change in value risk as well as the rental default risk. These should not be underestimated, especially for properties in poor locations. Therefore, the saying "location, location, location" cannot be dismissed. Furthermore, as an investor you should always have sufficient reserves so that you can compensate for any loss of rent and so that your property does not have to be foreclosed on, in the event of vacancy.

For these reasons, especially when building up the real estate portfolio, only Core and Core-Plus properties should be recommended, which have a lower risk of rent default and thus secure a more constant rental income. Of course, the rent default risk can also be absorbed by a diversified real estate portfolio. However, building a real estate portfolio can be more difficult for private investors than building a broadly diversified equity portfolio because of the capital required.

ROI opportunities with stocks and real estate

If we look at the current returns on real estate and stocks, the answer here seems to be more pro-stocks for the time being. In many German cities, only rental yields under four percent per year are being achieved. In the top 7 cities Hamburg, Berlin, Munich etc. on average it is even only below three percent. If we look at the return of the MSCI All Country World All Cap Index, on the other hand, the average return over the last ten years is 12.26 percent (source: finanzen.net; as of 06.06.2022).

But this is only a short time frame in the overall view of the two asset classes. A study by Moritz Schularick, economics professor at the University of Bonn, and other researchers, when comparing the returns of stocks and real estate over a period of 150 years, comes to the conclusion that real estate achieved a historical return of 7.8 percent per year, while stocks only achieved a return of 6.9 percent per year (source: Òscar Jordá, Moritz Schularick and Alan M. Taylor, 2017: "Macrofinancial History and the New Business Cycle Facts).

This does not yet take into account the form of financing. Typically, real estate is leveraged to a large extent, which can leverage the return on equity. This leverage is known as the leverage effect. Of course, shares can also be bought with borrowed capital, but this is rather uncommon among private investors and is associated with an increased risk.

Real estates are substantially more costly than stocks

Let's now look at the effort that the investor has to put into the respective investment object. First of all, there is the expense of acquiring the investment. Of course, a good stock analysis costs time, but this cannot be compared to the effort required for a real estate purchase. In a real estate purchase, as already described above with regard to liquidity, exposés have to be evaluated, documents have to be checked, viewings have to be carried out, etc. But with a good real estate agent at your side, this process can be made much more efficient and thus shorter.

However, it is also important to consider the time and effort required after the purchase of the property. For example, letting, the annual maintenance costs and repairs are among the tasks of the property owners. Here, however, external service providers can be commissioned for support. In the case of stocks, the maximum task is rebalancing, i.e. the rebalancing of the portfolio to restore the original asset allocation. The cost of this is even lower for index funds than for individual shares. Only if trading takes place, i.e. regular short-term trading, must more time be invested in the technical analysis of the shares. With the classic buy & hold strategy, the effort required to hold the shares tends towards zero.

An individual investment decision

We have seen that there are sometimes significant differences between stocks and real estate. For example, they have different risks, generate different returns, and are limited in their availability to different degrees. Ultimately, each investor must decide for himself or herself which aspects are most important to him or her. Do I want to have flexible access to my money? Can I bear the strong price fluctuations on the stock market? Do I trust myself with the effort of managing the property on my own or should I rather seek support in this regard? Where am I now in my life? If I have just started my own business, I probably won't get a real estate loan for a while. Likewise, if I'm close to retirement, maybe neither stocks nor real estate are the best choice.