If an individual has capital to invest, the rational course of action is to evaluate a variety of investment opportunities and to choose the one that offers the best chance for the highest return. Often, this means comparing the pros and cons of one opportunity to those of another. And one such comparison that is commonly made is between the stock market and commercial real estate investing.
Stock Market and Commercial Real Estate – Defined
The term “stock market” is typically used to describe the publicly traded securities of large corporate entities. In many cases, the stock market is best represented by the “S&P 500” or the “Dow Jones Industrial Average,” both of which are indices that measure the price changes of a basket of large stocks. To invest in the stock market, individuals can purchase index funds, mutual funds, exchange traded funds (ETFs), sector-specific funds, or individual stocks. For the purposes of this article, the S&P 500 is used to represent the stock market.
The term “commercial real estate” is used to describe a broad class of investment properties that are purchased with the intent to earn a profit through income, appreciation, or both. There are four types of commercial real estate properties: Office, Retail, Industrial, and Multifamily, and each has its own risk/return profile and operational quirks. To invest in commercial real estate, individuals can choose from a variety of options including a direct purchase, REIT, or private equity real estate firm. For the purposes of this article, the Vanguard Real Estate Index Fund is used as a basis for comparison to the stock market.
Stock Market vs. Commercial Real Estate – Pros and Cons
Stock market investors benefit from historically high returns, liquidity, diversification, low transaction costs, and capital gains if security prices rise. However, the stock market tends to trade on both company fundamentals and macroeconomic trends that impact future return expectations, which can lead to intense price volatility at times, testing the nerves of even the most seasoned investors. In addition, “shares of stock” are an intangible asset with no physical representation, which can be detrimental during economic periods of high inflation.
Commercial real estate investors benefit from the consistent cash flow produced by rental income, capital gains, depreciation, tax efficiency, widely available debt, portfolio diversification, forced appreciation, and inflation protection. In addition, commercial property values tend to appreciate slowly over time, making them less volatile and less impacted by the short-term news cycle that can swing stock prices dramatically. However, a commercial real estate investment can be illiquid and require a full time property manager to ensure operations run smoothly.
Both the stock market and commercial real estate have their own pros and cons, which may influence an investor’s decision towards one or the other. In an effort to determine which is the better investment overall, historical return data can provide an important clue.
Stock Market vs. Commercial Real Estate – Historical Return Data
Again, for the purposes of this article, the S&P 500 is used to represent the stock market. It is a weighted average “composite” index of 500 stocks intended to reflect the overall return characteristics of the stock market as a whole. The stocks included in the index are selected by their market capitalization, liquidity, and industry. The index itself dates back to the 1920s, but the current iteration with 500 stocks dates back to 1957. Since that time, the index has averaged an annual return of 8%. The best year, 1958, returned 38.06% and the worst year, 2008, returned -38.49%, which demonstrates the potential volatility of price changes.
The Vanguard Real Estate Index Fund deploys capital into Real Estate Investment Trusts (REITs) that represent a broad swath of the commercial real estate market. For example, their top holdings include American Tower Corp, which owns and operates wireless broadcast and communications infrastructure (for example, cell phone towers), and Prologis, which owns and operates industrial real estate assets. Since its inception in 2001, the Vanguard Real Estate Index fund has produced an average annual return of 7.96% after taxes on investments have been paid, so it is roughly equivalent to the S&P 500.
Stock Market vs. Commercial Real Estate – Which is Better?
From the historical data, it appears as though stock market and commercial real estate assets have produced a roughly similar return in recent history. But these numbers can be misleading, as there are a variety of factors that go into each asset class and they are not a perfect comparison. The truth is, one is not better than the other. There is a strong argument to be made for both stock and commercial real estate as part of a broadly diversified investment portfolio of risk assets. The overall investment strategy and exact allocation of funds to each is a function of the individual’s own investment objectives and risk tolerance.
For example, if an individual prefers intangible assets, has a short- to medium-term time horizon, and is seeking high returns, liquidity, and the diversification of an index fund, a stock investment may be a better fit. But with this approach, an investor should be prepared for potentially wide price fluctuations and the payment of capital gains taxes upon sale.
Conversely, if an individual has a medium- to long-term time horizon and is seeking passive income, relative price stability, and the tax benefits afforded by depreciation deductions, a commercial rental property may be a better option. But this investor should be prepared for illiquidity, high purchase prices, and high transaction costs associated with both the purchase and sale of a property.
Before choosing to invest in the stock market, commercial real estate, or both, it is a best practice to review the options with a qualified financial advisor to ensure that the resulting choice is a good fit with the individual investor’s total return requirements, risk tolerance, time horizon, and other personal finance objectives.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
