I’m 68 and selling vacant real estate that is worth about $750,000. Is it better to reinvest the money by doing a 1031 exchange for income producing real estate or invest in the stock market? I’m already taking Social Security and only have about $100,000 in other liquid assets. I don’t have much other income, maybe $5,000 a month.
– John
Broadly speaking, I think the choice between investing a given sum of money in rental property or stocks and other securities is often driven by personal preference. In your case, however, I would consider leaning toward investing in the stock market (specifically, a more diverse mix of liquid assets) with at least a good portion of your proceeds. Here’s how and why I arrived at that opinion. (But if you’d like to have a more in-depth conversion about your investment strategy, consider connecting with a financial advisor.)
Rental Properties vs. Securities
To start, it’s important to think about the nature of investing in either of the two choices you mentioned.
Real estate can be fairly “hands on” and is not as passive as many people often assume. Of course, that varies depending on whether or not you hire a property manager. Doing so increases your cost and reduces your net income. The price of a property manager varies across location and property types, but it’s usually somewhere in the neighborhood of 10% of collected rent. Even if you hire a property manager, there will still be decisions that you have to be involved with from time to time.
Depending on your approach, investing in stocks and other financial securities could be quite passive. There are more involved stock-picking strategies, but many people are successful and happy with far less involvement.
This may or may not be a concern to you, and you may already know what’s required of you when owning rental properties. But if you’re new to investing in rental properties I would highly recommend that you speak with rental property investors to get a better sense of whether it’s a right approach for you. It’s not uncommon for people to develop a disdain for owning rental properties – not for financial reasons, but for the added responsibility and disruptions they may cause. (A financial advisor can help you evaluate different investments and strategies, and even manage your portfolio for you.)
Tradeoffs between Rental Properties and Securities
Let’s review some of the differences between rental property investments and financial securities, like stocks and bonds. Apart from deciding if you even like the idea of owning real estate, comparing the two based on the following criteria might help you decide which option suits you better.
Liquidity
Rental properties are relatively illiquid compared to stock market investments. That might not sound like a big deal if you intend to hold the property for the long-term income it produces, but it does pose some risk. If something comes up you won’t be able to quickly and easily access the value of your property. If you hold that money in an investment account, you would be able to sell your stocks quickly and withdraw money when needed.
Diversification
Another issue to consider is how diversified you’ll be if you invest that money in rental properties. You certainly won’t be able to achieve the same amount of diversification you could with stocks and bonds.
The fewer the properties you own, the less diversification you’ll have. Your income will be subject to more risk. As a hypothetical example, let’s say you’re able to buy three properties with the $750,000. If and when one of them goes unrented, your income will fall by one third. I don’t want to suggest this is necessarily catastrophic, but it can be problematic and stressful particularly for a retiree.
(A financial advisor can help build an investment portfolio that accounts for your liquidity needs.)
Cash Flow Timing
A major draw of rental properties is that they can provide a consistent stream of income as long as they remain occupied. That is a significant benefit, but you can do the same thing with investments and a well-planned withdrawal strategy.
Withdrawals from investment accounts are also more flexible than rent checks. You can increase them if your investments perform exceptionally well, or pull back some if you need to.
Returns
Comparing returns is important too, of course, but it’s a little tricky to compare the two in this context assuming your plan is to generate retirement income.
Since you are retired, it’s likely appropriate to use a 60/40 portfolio as a baseline for investment returns. As measured by J.P. Morgan, a 60/40 portfolio produced just above a 9% average annual return from 1950 to 2023. There’s no guarantee it will do the same going forward, but this gives you an idea of what it has done in the past.
To compare stock market returns to what you can expect from a rental property (or multiple rentals), you’ll want to calculate the cash-on-cash return of the rental property. This is the annual income you expect to collect in rent, as a percentage of the total amount of money you invest in the property.
You can then compare your expected cash-on-cash return from the rental to what you can reasonably expect to earn in the stock market each year. While this isn’t an apples to apples comparison, it’s probably the most useful way to compare the two options.
Taxation
There are tax differences to consider as well. You’ll want to consult a tax professional for details of your specific situation. As you mention, you may be able to defer capital gains tax on your property with a 1031 exchange. In short, A 1031 allows you to defer the tax on the gain from the sale of an investment property if the proceeds are used to purchase another investment property. This would reduce taxes on the transaction itself. However, you also want to think about taxes going forward.
Some equity investments are more tax efficient than others, since qualified dividends and long-term capital gains are taxed at lower rates than ordinary income.
While you’ll owe ordinary income taxes on the rental income you earn from the property, tax breaks associated with rental properties may allow you to reduce or completely offset this tax liability. That’s because the IRS allows you to deduct depreciation, interest, taxes, advertising, maintenance, utilities and insurance. Real estate investors often point to the tax benefits of owning rental properties as one of the primary reasons they prefer real estate over the stock market.
Because of these differences, it’s important to look at the expected after-tax return or yield when comparing the two. (If tax efficiency is a priority, speak with a financial advisor about ways to structure your portfolio in a more tax-efficient manner.)
Bottom Line
I am not against owning rental property. Many people have done quite well with it. Either route could be a viable option depending on your preferences, but I think you need to consider how it relates to your situation and goals. Placing the bulk of your money in a broad mix of transactable securities with a good withdrawal plan may provide you with more income flexibility and investment diversification. You’ll also avoid the potential headaches associated with owning rental properties.
Tips for Finding a Financial Advisor
- Financial advisors can specialize in a range of services and areas of expertise. If you’re interested in investing real estate or rental properties, try to connect with an advisor who’s a real estate investor themselves or has some experience advising clients within this asset class. You can directly ask about an advisor’s specialties or simply do a little research on your own by examining their website and SEC-filed documentation. Both should offer some insight into the services that an advisor offers and potential specialization.
- Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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