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Real Estate vs. Stocks: Which Is the Better Investment?

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The theoretical principles of real estate investments and market-traded financial assets are extremely similar, yet they seem to attract fundamentally different investors. Real estate arguably attracts a pragmatic and entrepreneurial investor, while stock market investors seem to be more theoretical and managerial.

Having received a formal education in Finance, I was once a believer in the almighty stock market; I am now somewhat of an apostate. My general skepticism of investments in the stock market has been ridiculed by friends in the financial industry. I am called neurotic because I find it difficult to invest my hard-earned money in assets which are sometimes intangible, complex and managed by people I don't know -- and a simpleton for preferring plain ol' real estate to any sophisticated Wall Street concoction. However, as will be demonstrated in the following comparison of the Toronto Stock Exchange and the Montreal real estate market, there is something to be said for this simple, yet timeless investment.

Comparing real estate returns with market returns poses certain challenges. Total returns of a financial asset are comprised of capital gains and dividends, but the latter is difficult to estimate in the real estate market. Dividends of a stock are analogous to the Net Operating Income (NOI) of a property (after reserves). Unfortunately, the rental market is quite opaque and the average "dividend rates" of residential real estate have not been recorded throughout the years.

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Drawing from my experience as a real estate broker and erring on the side of caution, I will estimate the average annual dividend rate to have been a constant three per cent during the years of comparison. This is to say that the average $300,000 single-family home would have an NOI of about $9,000 per year -- perhaps being rented for $1,100/month (heating and electricity excluded), with other expenses (taxes, insurance, maintenance, vacancies, management fees etc.) plus contributions to a reserve fund representing roughly 32 per cent of gross rental income. It is a conservative estimate, but its degree of accuracy is not of great importance, as discrepancies in capital gains are much more substantial in this comparison.

I will refrain from presenting esoteric statistics. Instead, I will present a dollar-and-cents example that fellow simpletons can understand -- and certainly relate to. Imagine two people, Mr. Jones and Mr. Smith, who both inherited $100,000 at the end of the year 1999. Mr. Jones, an educated man and an avid reader of The Wall Street Journal, decides to invest in an Exchange Traded Fund (ETF), which attempts to mimic the dynamics of the Toronto Stock Exchange (i.e. iShares XIU). Mr. Smith, a common working-class man, decides to buy a $100,000 house on the island of Montreal and lease it on a yearly basis. At the end of 2012, Mr. Jones' ETF shares are worth approximately $144,000. In addition, Mr. Jones had been saving the dividends he received over the years in a bank account yielding two per cent interest; he now has roughly $36,000. Ultimately, his $100,000 investment has grown to about $180,000 dollars -- not too bad.

On the other hand, Mr. Smith just met with his local real estate broker, Jonathan Saveriano, who appraised his house at $257,000 (note: the median price of a single family home on the island of Montreal has gone up by about 157 per cent since 2000). Throughout the last twelve years, he had been saving his "dividends" in the same manner as Mr. Jones; he now has roughly $138,000. Mr. Smith's initial investment has grown to a staggering $395,000 dollars.

The returns of residential real estate in Montreal have without a doubt been much higher than those of the TSX since 2000, but that would not imply anything with regards to investment quality without a measure of risk. For those of you who are not familiar with the theoretical basis of finance, one must always take risk into account when measuring the performance of a portfolio as riskier investments should yield higher returns. Surprisingly, the standard deviation of annual real estate returns was much lower than that of the ETF -- 6.5 per cent compared to 18 per cent (roughly).

Given that the returns were higher and the risk was lower, we can conclusively say that Montreal real estate was a better investment than the TSX during this period. However, I make no claims as to whether these trends will continue or not, nor as to the extent which these results can be generalized to the entire Canadian real estate market or the market of other major Canadian cities. That being said, although I am not privy to statistics on the Vancouver and Toronto markets, I would be absolutely stunned if the same basic conclusion was not derived.

The Montreal real estate market has been under scrutiny for decades, but it has remained resilient in the recent tumultuous economic times and has surpassed all expectations. The market is by no means bullet-proof, but the incessant fear-mongering from skeptics diverts attention away from how good of an investment it has been historically.

As a result of the empirical evidence presented in this article, it can be said with confidence that the residential real estate market on the island of Montreal has outperformed the TSX since the year 2000. Real estate seems to have defied the principles of finance and economics -- perhaps because it is a little more than just a financial product or a commodity -- and that is what some seem to have a hard time understanding.

As once explained by Pa Bailey in the film "It's a Wonderful Life", home ownership is, "...a fundamental urge. It's deep in the race for a man to want his own roof and walls and fireplace." Unlike most other goods or services that financial assets are based on, real estate responds to an innate desire -- the desire to have a piece of this earth one can call his own. This basic yearning has been, in my opinion, the driving force of the real estate market, and the reason I continue to believe in it.

This article was originally published in the Prince Arthur Herald