Stock return rates vs. real estate cap rates

Question

This site says that a good cap rate for a rental property is between 4 and 10 percent.

The S&P's average annual return for the past ninety years is 9.8 percent.

This begs the question: Why would you invest in residential real estate rental property if a "good" rate of return on your investment is no better than what you could make on average in the stock market? The latter income is more passive (you don't have property to manage) and your assets are more liquid (you can sell your stocks at any time).

The only reason I can think of is that the stock market is probably more volatile than real estate. Are there are other reasons why real estate could be a better investment than stocks, particularly if you are focused on long-term average returns?

Answer 1

Rental properties act more like bonds than equities - steady, fixed net income with the main risk being default risk (missed rent payments). Bonds are traditionally lower risk (meaning lower variance in returns) and so do not demand as high as a return as equities.

So to say one is "better" is comparing apples and oranges. You can compare returns for investments with similar risk, or compare risk for investments with similar returns, but it's not always clear how to compare investments with different returns and risk if they are proportional.

Answer 2

The capitalization rate is the rate at which you get money from the property. It doesn't compare to the capital gains on a stock; it's closer to the dividend rate. This is because you still have the opportunity to have a capital gain on the property in addition to the capitalization rate.

As @Jay said, real estate tends to increase in value and in its rental price. So your thirty year return will be higher on sale of the property than the capitalization rate would indicate. I.e. the capitalization rate will increase over time plus the capital gain on the property.

Capitalization rate is useful for comparing properties. It is not a comparable stat to a stock market return. In particular, the 9.8% number assumes that dividends are reinvested. Without that, the S&P 500 only returned 5.7%.

If we look at the period from 1980 to 2016, United States house prices went up about 3.5% a year. That is in addition to your 4-10% capitalization rate. But even more, you should be reinvesting your 4-10% in real estate to get a comparable number to the 9.8%. Another way of looking at this is that your initial investment in 1980 produces a 4% dividend each year and a 3.5% return. Since the two compound, that gives about a 7.6% annual return. And that's at the low end of your capitalization rate scale. In the middle, you get more like a 10.7% return.

Answer 3

They are very different sorts of investments and difficult to compare.

Any stock you buy, the company could go bankrupt and the stock is worth zero. If you buy a rental property, it should always be worth SOMETHING. (It could burn down, but you can get insurance against that.)

If you borrow money to buy a rental property, you have to subtract the mortgage payments from your profit. But eventually you'll pay the loan off. At that point the profit increases dramatically.

Real estate tends to increase in value over time. Rents tend to increase over time. The ROI on a property bought 50 years ago is likely much more than the ROI on a property bought last year. Though you might be better off to sell the property at the appreciated value and invest the money in the stock market. Again, it gets complicated and debatable.

If you can do maintenance on the rental property yourself it will cost much less than if you have to pay someone to do it, thus giving you lower expenses than some average.

Etc etc.

I had a rental property for a while and I lost money on it every year. Personally, I now put my money in the stock market and not into rental properties. But it works for some people.