Real estate vs. index funds: which investment powerhouse reigns supreme for building long-term wealth and financial freedom?
Overview of Index Funds
Index funds are a type of mutual fund or exchange-traded fund (ETF) that aim to replicate the performance of a specific stock market index, like the S&P 500, NASDAQ, or Dow Jones Industrial Average.
The fund manager of an index fund purchases the same securities in the same proportion as the index being tracked, meaning that the fund’s returns should closely match the index’s returns.
This passive investment approach contrasts with actively managed funds, where fund managers try to outperform the stock market by buying and selling securities based on their analysis and predictions.
According to a recent article, not one actively managed fund consistently outperformed the stock market over the last 5 years.
Index funds are known for their low fees compared to actively managed funds because they follow a predetermined index and thus require less management and research.
In general, index funds are a popular and efficient way for investors to gain exposure to the stock market with low fees and implicit diversification.
Overview of Real Estate
Real estate investing involves the purchase, ownership, management, rental or sale of real estate for profit. This can include various types of properties, such as residential homes, commercial buildings, and land.
There are several strategies for real estate investing, including:
- Flipping: Buying a property with the intention of renovating and reselling it quickly for a profit.
- Rental properties: Owning and renting out a property to generate rental income.
- REITs: Investing in Real Estate Investment Trusts, which are companies that own and manage income-generating properties.
- Real estate wholesaling: Contracting to buy a property and then selling the contract to another buyer at a higher price.
- Real estate crowdfunding: Investing in real estate projects with a group of other investors through an online platform.
Successful real estate investing requires knowledge of the local market, a good understanding of financing options, and the ability to manage properties and tenants effectively. It also involves careful analysis and due diligence before making any investment decisions.
Advantages of Real Estate
Real estate investing can be a profitable way to build wealth, generate passive income, and diversify your investment portfolio. There are several advantages of real estate investing, including:
Passive Income
Real estate can be a great way to generate passive income. Passive income refers to income that you earn without having to actively work for it on a regular basis.
Owning rental properties is a common way to generate passive income from real estate. When you rent out a property, you receive monthly rent payments from your tenants. This income can be used to cover the property’s expenses, such as mortgage payments, taxes, and maintenance, while also generating a profit.
You Can Build Equity
Building equity in physical real estate is the difference between your property’s value and what you owe on your mortgage. Home equity is a way essentially a “forced savings” and a long-term wealth-building strategy.
While many people can argue that you can make more significant returns investing in the stock market, the “forced savings” of homeownership is still the largest financial asset for middle-income households, according to the Brookings Institute.
And while this article is more directed toward investment properties and not primary residences, the overarching concept still applies.
Disadvantages of Real Estate
While there are several benefits to investing in real estate, there are also risks and challenges, such as market fluctuations, property management issues, and unexpected expenses.
Maintenance
Owning physical real estate means there will be unavoidable maintenance costs. If you are unable or unwilling to manage the property yourself, you may need to hire a property management company. Property management companies charge 8% – 12%of your monthly rental income, which certainly isn’t chump change.
It’s important to note that a property management company doesn’t include the cost of repairs but more the management.
Tenant and Liability Risk
When you own rental property, there is always a risk that something catastrophic happens, and you could be sued due to negligence or perhaps you have an ambulance-chasing tenant.
According to a recent article, rental property insurance is about 25% more expensive than traditional homeowners insurance, which costs approximately $1,445, so you can expect to pay about $1,800 for rental property insurance, which eats into your investment property cash flow.
Advantages of Index Funds
Index funds are popular and efficient to gain exposure to the stock market. There are several advantages of index funds, including diversification, transparency, accessibility, low costs, and accessibility.
Diversification
Investing in an index fund that tracks a major market index, an investor can own a diversified portfolio of stocks that represent a broad cross-section of the market. This reduces the risk of investing in individual stocks and can help investors achieve their long-term financial goals.
Low costs
One of the most significant advantages of index funds are its low costs. An index fund like Vanguard’s VOO has an annual fee of just .03%, nearly XX lower than a actively managed funds and cheaper than real estate management fees.
Accessibility
Accessing index funds has become easier in recent years due to the growth of online investing platforms and brokerage firms.
Many popular online investment platforms, such as eToro, Webull, M1 Finance, and Robinhood, offer a wide range of index funds for investors to choose from. These platforms often have low fees and minimum investment requirements, making it easy for investors to get started with index fund investing.
In addition, many 401(k) plans and other retirement accounts now offer index fund options, making it even easier for investors to access these funds.
Disadvantages of Index Funds
Index funds, while popular for their low costs and ease of use, have some potential disadvantages. Investors should carefully consider these drawbacks before investing in index funds.
Lack of Flexibility
Because index funds are designed to track a particular index, their holdings are determined by the composition of that index, and they may not be able to adjust quickly to changes in the market or take advantage of certain opportunities.
This lack of flexibility may limit their potential returns compared to actively managed funds.
No opportunity for outperformance
Because index funds are designed to track the performance of a stock market index like the S&P500 or Nasdaq, there is no opportunity to outperform the benchmark.
So, there could be years where certain market sectors significantly outperform the overall market, thereby leaving potential gains on the table.
Tracking Error
While index funds are designed to track their benchmarks as closely as possible, they may experience some tracking error, or differences in performance between the fund and the index it tracks.
This could be due to factors such as transaction costs, management fees, and cash drag, and could lead to lower returns for investors.
How are Real Estate and Index Funds the same?
Real estate and index funds are both investment vehicles that allow investors to gain exposure to the broader market with relatively low costs and potential for diversification.
Passive Investments
Real estate and index funds are passive investments. Rental income from a real estate property can provide a stable source of cash for investors. Meanwhile, the diversified nature of index funds does not require portfolio rebalancing and can generate a consistent dividend.
Diversification
Both real estate and index funds provide investors with the opportunity to diversify their portfolios. Real estate allows investors to diversify into a different asset class, while index funds allow investors to diversify their stock market exposure.
How are Real Estate and Index Funds Different?
Despite these similarities, there are also some key differences between real estate and index funds.
Minimum Investment
If you are investing in physical real estate, there is a significant upfront investment required, whereas you can invest in index funds through an online broker like eToro with just 1 share.
According to rocket mortgage, the average duplex cost is around $300,000, factoring in closing costs and a down payment, you need at least 10% of the purchase price of the investment property to invest- in this case, $30,000.
Ongoing Management
Additionally, real estate investments require ongoing management and maintenance, whereas index funds are passively managed and require little ongoing from investors.
Liquidity
Index funds can be easily bought and sold through your brokerage without a wide bid/ask spread. Meanwhile, buying and selling real estate comes with significant transaction costs and can take at least 1 month to close.
Volatility
Because real estate is not publicly traded, it is not subject to market volatility, meanwhile, because index funds are publicly traded investments, they are subject to the volatility of the overall stock market.
Leverage
Another key difference between Real Estate and index funds is leverage. When you buy real estate, you can use borrowed money to amplify your returns. Meanwhile, you generally cannot use leverage if you are buying publicly-traded REITs.
Sure, you can use margin loans and introduce leverage when investing in REITs, but margin loans are much more expensive than a mortgage and introduce another level of risk.
The average margin loans between 8 -12% at big-name brokers, with the best rates usually only for clients with $1,000,000 or more in assets, and it can’t be amortized over 30 years like a mortgage.
Real Estate Returns vs. Index Fund Returns
Over the past 20 years, the S&P 500 has outperformed the NCREIF Property Index (NPI) in terms of average annual returns.
According to data from NCREIF and Bloomberg, the NPI has provided an average annual return of approximately 7.8% from 2002 to 2021, while the S&P 500 has provided an average annual return of approximately 9.8% over the same period.
However, it is important to note that real estate and stocks have different risk and return characteristics, and investors should consider their investment goals and risk tolerance when deciding between the two asset classes. Additionally, real estate investments may provide diversification benefits to an investor’s portfolio, as they may have low correlation with stocks and bonds.
Frequently Asked Questions
Is real estate riskier than index funds?
Real estate is generally riskier than index funds because you are investing a large amount of money in a single asset class. Meanwhile, index funds provide implicit diversification because the fund invests in stocks across different industries and sectors.
