As you may recall that a few weeks ago, I asked whether I should buy an investment property in this housing market given that I didn’t even own a primary residence yet. There were quite a few very insightful comments left by my readers and first of all, I’d like to thank you for all your kind responses.
I haven’t decided what I should do yet but I went to see an investment property with my coworker over the weekend and it got my blood pumping because he ended up putting an offer in for one of the properties we saw. Here are the details:
- 1411 sq. ft, 2 stories town home
- 3 bedrooms / 2 bathrooms
- $187 per month HOA
- $2000 per year mello roos (basically like property taxes, only non-tax deductible)
- 1.03% property taxes
- $1,500 a month rent can be expected for the property
- My coworker offered $170,000 for the house
The agent told us that there were already a few offers higher than $170,000 for that particular property, but my friend still has a chance to get it since he can pay cash for it while the others all needed a loan.
Witnessing this got me thinking much more about the investment property idea I’ve been kicking around so I did some calculations comparing the return on buying this investment property versus using the $170,000 to buy a dividend paying stock, say Altria (MO).
Since we cannot predict the future, there are some assumptions made. I listed them below
- The housing price and the stock price of Altria will stay the same. I know this is not realistic but trying to predict the appreciation of these two investments is like trying to guess the lottery so let’s keep it simple.
- I assumed that 5% of the time, the house will be vacant. My coworker told me that he knows of an agency that will help find him a tenant for 3% of the first year’s rent, so I used 5% since tenants won’t move in immediately. (I suspect the vacancy rate assumption is on the low side but let’s use it for comparison purposes)
- Since the positive cash flow generated by house cannot be put back into the house, I am adding the same amount of money into my investment of the townhome each year. In reality, I can use the proceeds to invest in something else.
- I’m not including any house maintenance and repair charges into the investment property. I’m assuming that my coworker can fix everything himself and nothing needs to be purchased.
- The investment property is actually one hour away. I’m assuming that there will not be a need to drive there and no gas expenses will need to be incurred.
- There are no taxes involved in the comparison. In reality, the rent you receive from your investment property need to be taxed each year, as do the dividends.
- The rent and dividend is going to stay the same. Again, this is not true in reality. Judging by history, Altria’s dividend increase is much better than rents, but there is always the risk in any given stock to lower their dividend.
- By assuming $1500 rent per month and 95% occupancy, I took out $2,244 of HOA per year and $1,751 per year of property taxes for a total gain of $13,105.
- I took Altria’s dividend as 6%, and had it compound quarterly since that’s what happens in reality if you reinvest the dividends
|Time Frame||Town Home||Altria (MO)|
Before I did the calculation, buying a townhome made a lot of sense since the monthly check from the investment property is much more than the 6% that I would get from Altria’s dividend. As you can see though, buying the stock turns out to be much better in the long run because of the magic of compound interest.
Buying a stock and living off its dividend also seems to fit my quest of finding passive income. Those that have investment properties know that maintaining a house is definitely not considered passive income. Repairing the property, dealing with the occasional bad tenant and needing to do all the paperwork of having an investment property make these types of investments an active one.
Taxes were not part of this calculation. As mentioned, rental income needs to be taxed each year, which would eat into the gain. On the other hand, dividends (for now) are taxed at 15%, much less than the taxes on a rental income.
Property taxes on the townhome is however tax deductable. So depending on your situation, you might get a few hundred dollars back each year for the townhome (the money can be used to pay for the repairs)
There is no question that owning an investment property gives you much more satisfaction than owning a stock because you actually see the house that you own. This factor might convince you to buy an investment property regardless of what the numbers tell you but I rather have more money in my pocket.
Owning a stock is much more versatile, which can be a good and a bad thing at the same time. It’s good because you can use the funds in case of emergencies, but if this means that you can just wake up one day and decide to sell a stock and buy another stock that you feel is hot at the moment, then all the gains can be wiped out in an instant.
Houses can be destroyed, set on fire and so forth but they are in general a safer investment than betting on any one company. I picked Altria because they have a good track record but you should never put all your eggs in one basket.
In the calculation, there was no mention of appreciation. Although much of the decision will depend on which asset increases in value quicker, there is really no way to tell what will happen in the future. Altria has historically performed much better than any investment property but if we get another housing bubble, who knows?
This calculation is based on having cash for the whole investment property. The biggest advantage of investing in real estate is the ability buy a house with little money down. Even with the increased loan standards, we can still buy a property with only 25% down. This gives us tremendous leverage. This comparison is not intended to look into this, and will be discussed in a future article.
What do you think?
Many of you have no doubt made the decision between owning a stock and buying an investment property before. What made you pick one over the other and why? What were the results? My coworker, myself, and the rest of the readers who are trying to decide between the two would really appreciate your feedback.