Why Real Estate Investing Beats the Stock Market
The average investor has a better chance of getting ahead financially through real estate than they do in the stock market. How so?
Arbitrage sounds like a scary term, but you’re likely doing it every day.
For example, when you shop online for a new outfit, you’ll likely find this outfit for sale on multiple websites. Are you going to buy it at the highest priced website or the lowest priced website?
Of course, the lowest priced site.
You are seeking arbitrage opportunities with clothing by looking where you can get the same product for the cheapest price.
In a perfect market, the product would be priced the same across the board at all retail stores, but luckily for us markets aren’t perfect and arbitrage opportunities exist!
This is also the case in real estate investing.
Think of the cash flow (net income) from a rental property as equivalent to your clothing item from above.
In other words, cash flow is the product we are buying.
If two properties deliver $5,000 per year in net income, you’re going to buy the house priced at $50,000 rather than the one priced down the road at $80,000.
You are taking advantage of an arbitrage situation where you acquire the same cash flow for the cheaper price.
The stock market, however, is very efficient. There are lots of trades happening every second so it’s rare to find an arbitrage opportunity.
You can assume the investments are priced correctly according to all the information the market has at the current moment in time.
As new information comes out, the stock price changes rapidly to reflect this new information and remains efficient.
This is why real estate is better. You can find inefficiencies in the market where homes are undervalued and buy them giving you instant profit.
For example, I bought my first rental property at the age of 20 for $30,000 and the home was worth $105,000.
That’s a $75,000 difference!
It was in distressed condition which is why we were able to purchase it far below it’s value but it didn’t cost much to fix it up and restore it’s value to market price of $105,000 so the profit reward was very nice.
This is why a lot of real estate investors gravitate towards fixing and flipping houses. In just a few months work you can double your investment in a property by selling it for a lot more than you bought it after fixing it up.
So how does arbitrage apply to rental property?
We mentioned earlier how you could find two properties that produce the same net income but are priced differently allowing you to pay for the less expensive home.
In this case though, we will look at how you can split up a set amount of money to take advantage of rents that don’t scale with the price of a home. This is another arbitrage opportunity that real estate offers. It will make sense shortly!
Let’s say we have $300,000 to spend. We could buy $300,000 of stocks that pay a 2% dividend. We could buy a house that is $300,000 and rent it out. Or we could buy 6 houses for $50,000 each and rent them all out.
My answer: split up the money and buy the 6 rental properties
If you have $300,000, then it doesn’t make sense to spend it all on one property when instead you could split it up and buy multiple rental properties to acquire a larger total cash flow than what the $300,000 home is going to provide you by itself. Arbitrage baby.
How does this work mathematically?
Let’s say your $300,000 home could be rented for $2,000 per month. You’d earn $24,000 per year in rental income before subtracting expenses for taxes, insurance, property management, and maintenance.
For math simplicity, let’s assume 40% of your rent covers expenses leaving 60% net income. You’d be left with roughly $14,000 net income from this one property.
Instead of buying one $300,000 house, you buy 6 houses priced at $50,000 each. These $50,000 houses can be rented for $800 per month.
Do the math now and see how much cash flow you just bought!
6 houses rented at $800 each would earn you $4,800 per month in rental income compared to your $300,000 house that rents for $2,000 per month. You’re making nearly 2.5X the rental income by splitting your money up into smaller properties.
You just spent the same amount of money on real estate but you took advantage of arbitrage and bought a larger stream of cash flow.
How is this possible?
Rents don’t scale with the price of a home which creates arbitrage for an investor. If rents did scale, then the $300,000 house should rent for $4,800 and not $2,000.
But it doesn’t work like this in real estate because someone could buy their own $300,000 house and have monthly mortgage payments far less than the $4,800 they’d be paying in rent.
To finish off the math, your $4,800 x 12 results in $57,600 in rental income each year. Then you would subtract 40% in expenses leaving you with $34,560 net income compared to $14,000.
Oh, and if you’d have put your $300,000 into stocks you would earn a 2% dividend each which would only be $6,000.
Someone looking to earn passive income will take the rental income of $34,500 any day over the $6,000 stocks would pay them annually.
Overall, real estate has arbitrage opportunity that you won’t find in the stock market which in turn allows you to grow your wealth faster.
Real estate investing can be rewarding if you understand the math and make wise financial decisions with your money. There is always a highest and best use of money. It’s your job to find it.
- How to Create a Business Plan for Real Estate Investing
- 20 Reasons You Should Own Real Estate
- The Ultimate Guide to Finding Investment Property to Purchase
- The Ultimate Guide to Financing Real Estate Investments
- The Ultimate Beginner’s Course to Real Estate Investing
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