Index Fund vs Real Estate - Real World Example
You have to agree with me. Saying that I’m a real estate investor is much sexier than saying I am an index fund investor. There is something about real estate that appeals to everyone. Maybe it’s the late night flip or flop tv shows. Or the real estate billionaires we see on the cover of Forbes. We just don’t get the same visceral feeling when we talk about index fund investing. It sounds and feels, to be completely honest, boring.
But that doesn’t mean index investing should be dismissed. Both real estate investing and index fund investing are great investing strategies to grow our wealth. However, they are two very different strategies. And it is good that we understand what the key differences are so we can make the best financial decision that works for us.
Index Fund Investing - Pros
Alright to start out with, what are index funds in a nutshell and why do I advocate for them so much? Index investing in a nutshell is this. Instead of hiring an expert or spending a lot of your brain bandwidth trying to select the right stocks or actively managed mutual funds, you just invest in a good low cost index fund like the Vanguard Total Stock Market Index Fund, also known as VTSAX and you essentially forget about it. An index fund attempts to match the return of the segment of the market that it is indexing.
An S&P 500 Index Fund matches the 500 largest publicly traded companies in the United States.
A Total Stock Market Index Fund replicates all the publicly traded companies in the United States.
A Total International Index Fund replicates a broad cross-section of thousands of reputable international stocks.
With a small management fee for each fund, ranging from 0.04% to 0.11%, you can be invested in an index fund within minutes. And indexing in many expert’s opinions is really one of the best ways to invest because they have and will continue to outperform the thousands of actively managed funds over a long period of time.
Higher Diversification & Less Risk
One of the reasons why index investing is so effective is that index funds by nature are highly diversified and less risky. Diversification is the key to reducing investment risk. The fastest way to get rich overnight is to own the next Netflix. But the fastest way to lose all your money is to own the next Blockbusters. To know what companies will do well or not do well is nearly impossible.
However, you don’t need to have a magic ball in order to get healthy returns on your investment. If you buy an S&P 500 or Total Stock Market Index Fund, your investment is highly diversified and its performance will match that of the companies that the fund is indexing. Is it possible to lose all your money? Ofcourse, but that means that all the major US companies have essentially been destroyed and in that case, the value of your investment portfolio will be the least of your worries.
Low Operating Cost
Another reason why Index investing is so effective is its low operating cost. Actively managed funds are known to charge anywhere between 1 to 2 percent expense ratios. This means that between 1 to 2 percent of your investment is deducted each year to pay the fund manager to run the fund. On a $100,000 portfolio, that comes out to $1K to $2K annually.
By contrast, index funds are much cheaper given no person is actually managing the fund’s performance. There isn’t a person deciding which funds to buy or sell or when to buy or sell them. The fund simply replicates the index. As a result, most index funds have an expense ratio well under 0.1%.
VTSAX and VFIAX, Vanguard’s Total Stock Market Index Fund and Vanguard's S&P 500 Index Fund have respective expense ratios of 0.04%. On a $100,000 portfolio, this comes out to $40 annually. I’ll take a $40 expense over $2,000 any day. And the real power of low operating cost really comes to play when you incorporate compounding into the formula. These expense ratios can net you or cost you hundreds of thousands of dollars over a period of 10 to 20 years. Cost matters and the king of low cost are passively managed index funds.
No Need to Hire a Investment Manager
But my favorite reason why index funds are so effective is that there really isn’t a need to hire an investment manager to monitor our portfolio. I firmly believe that with enough right information, any one of us can effectively manage our own portfolio. When you have an investment manager, they take a huge chunk of your portfolio to manage your money for you. This is real money that is going into someone else’s pocket instead of staying and compounding in your account.
Some argue that there are really good investment managers whose performance is worth the cost. Peter Lynch, managed the Fidelity Magellian fund from 1978 to 1990 and posted an average annual return of 29%. However, such individuals are so rare that some investment scholars attribute their consistent performance to luck rather than skill.
Just like stocks, many of yesterday’s superstar managers can quickly turn to today’s underperformers. And how can you effectively identify who tomorrow’s superstar will be? This unfortunately is a futile pursuit. The bottom line is that with index funds, who’s managing the fund is not an issue. Index funds only track the index. Nothing more. Nothing less.
Index Fund Investing - Cons
However, it's not all unicorns and rainbows when it comes to index fund investing.
Lack of Control
One major downside is that you are at the mercy of the market forces. With index fund investing, you are investing in the entire market. You don’t have any control over which stocks or industries you want to invest in. If the overall market is down for the year, your portfolio will be down as well. For example, at the start of 2020, the stock market dropped by close to 10% in a matter of a few days. All driven by the fear of Coronavirus and the instability in the market.
If you were invested in index funds, your portfolio took a pretty hard hit because it reflected the overall market. You are at the mercy of the market trends.
Average Return
Another downside of investing in index funds is that you will always get average returns of the market. Nothing more, nothing less. No way to increase your returns through more activity. Your investment return is capped at the market’s return. For example, let’s say the S&P 500 Index returned 8% for the year. Your index fund that tracks the S&P 500 will also return 8%. If you want above average returns, you will have to take on more risk.
Too Simple
The third downside of investing in index funds is also one of its strengths, and that is simplicity. When the solution to making money in the market is so simple, you can get lazy when it comes to building your money knowledge. With index fund investing, you essentially set it and forget it because there is nothing really to do after you’ve invested the money.
This is both good and bad. It’s good because you don’t have to actively manage your portfolio and can live your life without worrying about the day to day fluctuations of the stock market. However, it could be bad because you can get lazy when it comes to building your money knowledge. You aren’t forced to expand your knowledge about the market, the economy and investing in general. And without this knowledge, you can also be at the mercy of the next fast talking investment salesman.
Real Estate Investing - Pros
Alright, enough about index fund investing. Let’s talk about real estate investing and why so many people opt to invest in this industry.
Rental Income
Number one reason why people love real estate investing is the rental income. Once you have a tenant in your property, they will start paying you every month. This is money that you can use to cover the mortgage payments and other expenses associated with owning the property.
And the beauty of this rental income is that it’s relatively passive once it's set up. Once you find a tenant and sign the lease, you don’t have to do much except collect the rent every month. With my rental property, the rental income automatically gets deposited into my rental checking account every month without me even realizing it. It’s a great, fairly passive way to make money.
Leverage
The second reason why people love real estate investing is the ability to use leverage to maximize your return on investment. What is leverage? It’s basically using other people’s money to finance your investment. For example, let’s say you want to buy a rental property for $100,000. But you don’t have $100,000 cash sitting around. Not a problem, if you have $20,000 saved up for the down payment, the remaining $80,000 can be financed through a mortgage.
This is an example of using leverage to finance your investment. You are only using $20,000 of your own money to buy a property worth $100,000. And as the property appreciates in value or you pay down the mortgage, your equity in the property will increase. Of course we have to understand that this can work against you if the market swings the other way. With rewards comes risk.
Appreciation
The third reason why people love real estate investing is the property appreciation which increases your overall net worth. Over time, your property could go up in value, and as it does, your equity in the property will increase. For example, let’s say you buy a rental property for $100,000 and it appreciates to $120,000. Your equity in the property has increased by $20,000 from appreciation alone.
Continuing the example from earlier, on a $20,000 down payment investment, you essentially doubled your money through appreciation. And as your property continues to appreciate, your equity will continue to increase.
Control
The fourth reason why people love real estate investing is the level of control it gives over your investment. As I mentioned earlier, one of the downsides of investing in index funds is the lack of control on your returns. You are at the mercy of the market. If the market is doing well, your investment makes money. However if the market isn’t doing so hot, neither will your investments.
However when it comes to real estate investing, you have a level of control far greater than index funds. If you buy well and manage your property well, there are so many different ways to increase your return on investments through what we call, ‘sweat equity.’ Literally using your sweat to increase the equity in your home.
You can increase the value of property through renovation. You can increase your rent to maximize your returns. And during times of low interest rates, you can also refinance your property to increase overall cash flow. All things that are possible with rental properties that just aren’t possible with index investing.
Real Estate Investing - Cons
However, just like everything in life, it’s not all unicorns and rainbows when it comes to real estate investing either. Let’s talk about some major downsides to real estate investing. Many reasons why my wife and I personally don’t put all our eggs into real estate.
A Lot Hands On Activity
The number one downside to real estate investing is that it requires a lot of hands-on activity to get those great returns we just talked about. It’s not a completely passive investment like index investing. You can’t just buy a rental property and automatically get deposited into your rental checking account every month without some level of work. It doesn’t work that way.
You need to find good tenants, manage the property, deal with repairs, and all sorts of other things. If you don’t want to deal with the hassle, then you will be frustrated with real estate. You need to be prepared to put in the work or hire someone who can do it for you. And when you do hire someone to do all the work for you, your returns may not be so great and may not make the effort worthwhile.
Location Dependent
The number two downside to real estate investing is that it is really location dependent, and this translates to high risk. Unlike index investing where you can be invested in companies all around the world, with real estate investing you are limited to the geographic location of your property. And as we all know, not all locations are created equal.
For example, if your rental property is located in an up-and-coming area of the city, then as a result, your property value will appreciate and your vacancy rate will be low since your place will be in high demand. However if you happen to own a property in a not so nice part of the city and where people are moving out, versus moving in, then your return on investment wouldn’t be so hot. Not to mention the headache that goes along with managing an underperforming property.
Require Large Upfront Cash
The third downside to real estate investing is that it often requires large upfront cash to get started. It may not be in millions, but definitely more than what you would need to get started in index fund investing. For example, in order to start in index funds, the most you need would be around $3,000 if you wanted to buy a Vanguard Index fund. Much less if you go with an ETF.
However, with real estate investing, you often need to put down a minimum of 20% if not more to buy a property. So if you wanted to buy a $250,000 condo, you would need at least $50,000 in cash just for the down payment. And we are not even taking into account all the other costs associated with buying a property such as closing costs, repairs, etc. I know for very savvy real estate investors they might be able to do it for much less and with other people’s money, but the reality is that such a strategy requires a lot of experience and social capital to pull it off.
Not Liquid
The fourth downside to real estate investing is that your money isn’t easily accessible. A fancy financial term for this is, it's not liquid. This is in contrast to index investing where you can sell your shares at any time and have the cash in your hands within a few days.
With real estate, it's not that easy. If you need to access the cash that you have invested in a property, you will likely have to sell the property which could take months. And this is highly dependent upon the real estate market at that time. In the meantime, you will still have to make mortgage payments, pay for repairs, and all other costs associated with maintaining your property.
Tae’s Real World Example
Alright, enough about high level pros of cons of index investing and real estate investing. Let’s talk about some real numbers. I will compare one of my rental property returns with my index fund returns in the past 5 years to see if one really did perform much better than another. And one caveat, I’m going to round up a lot of numbers and timing to make the comparison easier to follow. Let’s first start out with a simple index fund investment.
Tae’s Index Fund
In 2017, I invested $50,000 into VTSAX, Vanguard Total Stock Market Index Fund. My personal favorite index fund. The 5 year annual average returns for the past 5 years have been little under 9% (8.55%). This means that my $50,000 investment is worth around $75K today ($75,356,23). $50,000 starting amount and $25,356 total returns. Not bad for not having done much except spend 10 minutes 5 years ago opening up my account and investing my cash.
Tae’s Rental Property
Alright, around the same time, I also purchased a rental property with a $50,000 down payment. In order to calculate the returns I’m going to add up returns from three sources: the net rental income, the debt paydown on my mortgage and the property appreciation.
As with the net rental income, my total cash returns in the past 5 years has been around $15,000. About $300 average per month. This is what remains after all my monthly expenses are paid for from my rent. It may not seem like much, but this is because most of my rental income goes to paying down the mortgage and I had to hire a management company because the property is out of state.
With debt paydown, this comes out to around $12,000. This is how much of my total mortgage has been paid down by my tenant since I’ve owned the property. I refinanced my mortgage when the interest rates were lower last year so I’m hoping this will start to speed up in the near future.
With appreciation this is where I’ve surprisingly seen the biggest increase. Since I’ve owned the property, the home value has appreciated by close to $90,000. To be honest I wasn’t expecting much appreciation on this property given it resides in an area that normally didn’t have much appreciation in the past. We’ll have to see if this will continue to hold or if it's a fluke of the market, but it's a nice icing on the cake. Alright so when I add all these up, I get a total return of $117,000. This comes out to an average return on investment of 27% per year.
Tae’s Index Fund vs. Rental Property
Now when we look at it from this perspective, it totally blows the index fund investing out of water right?
Real Estate 5-Year Total Returns: $117K
Index Fund 5-Year Total Returns: $25K
Real estate investing is the sure way to go right? Well, I do want to caveat this example though. Though I believe the net rental income and the mortgage pay down was predictable, the home appreciation was not expected at all. In hindsight, the purchase I made back in 2017 makes me look like I’m a real estate genius, but to be honest I was really just lucky.
The net rental income and debt pay down comes out to combined around $27,000 the past 5 years, so when we compare it to the $25,000 returns on my index fund, they are actually quite comparable.
The second piece to note here is that I’m also excluding a lot of factors associated with owning a rental property. The amount of work that goes into owning and managing a property versus owning a simple index fund, the tax implication, and not to mention the liquidity aspect. I can sell my index fund tomorrow and have cash in my account within a few days. But with rental property, who knows if the zillow price is accurate? I wouldn’t know until I tried selling my property and all the transaction costs would eat into my returns.
And the paperwork. My goodness, I always underestimate the amount of paperwork that goes into buying and managing a property. From all transactions to tax and insurance paperwork. There are a lot less moving pieces you have to manage compared to if you owned a simple index fund.
Could real estate investment derive better returns than index funds? As you saw in my example, yes, ofcourse. However the bottom line is that what is better than another isn’t so simple. In the big picture, I personally believe both can play a role in our wealth building journey. They are both great assets to hold for a long period of time.
However, if I was to recommend starting with one before the other, I would recommend starting out with index funds first to set the foundation for real estate investing. I personally am planning to buy more rental properties in the near future to add to my portfolio. However I plan on doing it slowly so my investments aren’t skewed too much towards one type of asset class. And I’m also pretty lazy so I don’t want to add too much work on my plate. Again the paperwork that comes with real estate investing shouldn’t be underestimated.
