Stocks vs. Real Estate(ZT)

(http://money.cnn.com/galleries/2007/real_estate/0704/gallery.stocks_v_realestate.moneymag/index.html)

Round 1
Performance
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%.

Other studies argue that real estate's returns are much worse. Yale finance and economics professor Robert Shiller, author of Irrational Exuberance, who looked back to 1890, contends that only twice has real estate produced truly outstanding returns: after World War II, when returning troops were starting their families, and from 1998 to 2005, a period he thinks is a bubble.

Housing's rate of return, he argues, has to trend back to the mean of about 3% a year - barely above the inflation rate. If that's starting to happen now, he says, we could be facing many years of losses.

Before you decide that real estate is already down for the count, though, consider this: Equity REITs, which own stakes in commercial properties, were among the best performers in the Francis-Ibbotson study, with annual returns of 14.8%. But REITs are stocks, after all.

Round 2
Leverage
Real estate partisans reply that these academic studies leave out the asset's strongest advantage: leverage, or the use of a mortgage to amplify the return on your cash.

You know the math: You make a 20% down payment on a $500,000 house. Two years go by and the house increases in value to $550,000, or 10%. The return on your down payment - your real stake in the deal - is a stunning 50%, however.

What about stocks? Well, you can leverage them by buying on margin, but you can borrow no more than 50% of the purchase price. You could also play in the options market, but you risk losing your entire investment.

Of course, a lot of real estate fans who chased a quick buck in recent years are finding out about the other side of leverage. Suppose you put 5% down on a $250,000 condo in Las Vegas in 2005. You planned to rent the unit out for a while, then flip it. Now the condo glut there means that when you sell - if you can sell - you might get $220,000.

So you'd wind up minus your original investment and owe the bank $17,500 to boot. That's a sucker punch many people in formerly hot markets are feeling now.

Still, as a way to turn a small stake into a lot of money in a rising market (and home prices have generally gone up), you can't beat the leverage that real estate offers.

Round 3
Costs
What leverage gives you, transaction costs take away. When you buy, you shell out for mortgage processing, credit reports, title insurance, appraisals, a lawyer for the bank, a lawyer for you, local transfer taxes and other charges. You may also pay a percentage point or more of the loan up front to lower your interest rate.

All in all, closing costs can run 2% to 4% of your purchase price. Sellers have to lay out a 6% commission for their agent, prepare a place for sale and, if it's their home, pay to move. Buying and selling can total about 10% of the purchase price.

Such costs make real estate a tough game. That $550,000 house (the one that gained 10% in two years) just turned into roughly a break-even proposition. And that total doesn't include the cost of maintenance and refurbishing, mortgage interest, taxes or insurance, which may add up to more than what you'd have laid out to rent a similar property.

Expenses run even higher if you are the owner of an investment property. You have to add the cost of advertising for tenants, evicting those who mess with you and carrying empty apartments.

In their study, Francis and Ibbotson didn't deduct such costs when they calculated returns. Had they, real estate would have fared worse. Stocks, by comparison, are incredibly cheap to own and sell. At a discount brokerage such as Scottrade, you can pay anywhere from $7 for an online purchase to $27 for one that is broker assisted.

Same when you want to dump your stock. A mutual fund that tracks a broad index of stocks can cost you as little as 0.09% of assets a year.

Round 4
Taxes
Stocks can throw two decent punches in this round: First, if you (or your mutual fund) hold a stock for more than a year before selling, then you owe only a capital-gains tax that tops out at just 15%. Second, you can offset any investment losses you realized against your gains on your income tax return.

Real estate, by contrast, delivers a battery of tax benefits, especially for your home, says Ronald Hegt, a senior tax partner at Hays & Co., a New York City C.P.A. firm. You can deduct mortgage interest and property taxes yearly. And when you sell your house, the first $500,000 in profits are tax-free (for individuals, the first $250,000). You are on the hook for long-term capital gains taxes for any extra profit, but the top federal rate is only 15%.

Rental and commercial property also come with breaks. Expenses to maintain the property are deductible. And you can write off depreciation, a break for the supposed wear and tear on the property. On the flip side, there's no exclusion from taxes when you sell, and you pay 15% in capital-gains taxes on any profit. Worse, the government makes you pay taxes on the depreciation you took.

Round 5
Transparency
One share of Google common stock is the same as every other share. The price is updated constantly, and it is accessible to anyone. Each piece of real estate, on the other hand, is unique. Buying or selling at the "right" price is, at best, an educated guess. At worst, you're a sucker.

An easy round for stocks? Think about Enron, Tyco and WorldCom. All were widely followed by investment professionals, their results audited, their financial reporting regulated by the feds. And now their CEOs are in jail and investor losses total in the tens of billions. If Wall Street failed to notice anything amiss, how would you?

Real estate, on the other hand, is tangible. You can check the basement, consult a termite inspector and make sure that nobody is building a pig farm next door. Of course, if you've watched Flip This House and Flip That House, two cable-TV programs that feature people trying to get rich quick by buying and fixing up properties, you know that savvy folks often learn too late that the plumbing is shot or that vermin ate the wiring.

Still, John T. Reed, editor of "Real Estate Investor's Monthly," insists that such mistakes are avoidable - just not easily avoided. "You can verify the property taxes, the cost of utilities and everything else about the property," he says. "Those are knowable."

Round 6
Effort
Stocks are the easy winner here. Owning property - even your own house - can be a pain in the neck. Every time you turn around you have to fix, or pay to fix, the havoc wrought by a mechanical or natural disaster.

Some folks may thrill to the drama of termites and broken pipes, but that's a pretty small group. If you consider such events nuisances, you're better off sitting in a plush chair and choosing from a manageable list of big, well-know stocks (see the Sivy 70). Or choosing mutual funds that are run by a professional manager or that track an index.