One of the most common things I hear when I speak to other Millennials about retirement is their desire to build passive income. I think part of this derives from the FIRE Movement - which I’ve detailed here before. And more times than not, they want to achieve this by building a portfolio of rental properties. I certainly understand the idea behind it as receiving $15,000 annually on a property worth $250,000 is pretty realistic (at least in the Nashville area). That is essentially a 6% dividend - good luck finding that in the stock market. And if you can eventually build it into 4 properties at $1,000,000 and $60,000 of rental income per year - that looks really attractive. For reference - the ETF ticker SPY which tracks the S&P 500 has a dividend yield of 1.74% as of this writing. When you take into account the ability to leverage your real estate equity in the form of a down payment and mortgage - the idea of building a real estate empire seems attainable. But is it the best allocation of your funds if your desire is passive income in retirement?

The Fixed Variables

This sort of analysis can get complicated very quickly; for the sake of painting a picture, I will simplify where I can. For my analysis, I’m going to be making some assumptions to make this as apples to apples as I possibly can. For each investment, I’m going to assume:

• 30-year investment horizon for each investment.

• I’m going to assume any income after taxes is not reinvested into anything else.

  • If the goal is passive income, this likely would be spent maintaining your lifestyle.

  • In this analysis, it’s just going to build up in a checking account that doesn’t generate any interest.

• I’m also not going to take into account inflation for this purpose as it just adds another layer of complexity that isn’t required to illustrate which investment offers a higher return.

Rental Property Assumptions

For numbers purposes, I’m going to assume the following for the rental property - which based on historical numbers will get us pretty close. As always, past performance does not guarantee future results. And especially with real estate, so much depends on the locality. So this is all very general.

• Buying a $250,000 property with existing cash.

• Rental income of 6% per year of the property value.

  • Year 1 will have $15,000 of rental income.

• Expenses related to the property will be 1.5% per year.

  • Year 1 will have $3,750 in expenses.

    • On an average annual basis, this will be close between property taxes, insurance, and repairs and maintenance.

• Depreciation on a 27.5-year schedule with 80% building and 20% land.

• Yearly property appreciation of 4%.

• Income tax rate of 25%.

The charts show what the property valuation is as well as a breakdown of your net cash after taxes.

Stock Market Assumptions

Now let’s look at the stock market. Like real estate, I’m going to look at historical information to guide us - with the caveat that past performance does not guarantee future results.

• Investing $250,000 cash in the S&P 500.

• Dividend income of 2% per year of investment value.

  • Year 1 will have $5,000 of dividend income.

• The only expense will be an investment advisor.

  • We are going to assume I am managing the investments with a 0.75% AUM fee compared to a more industry standard of 1.0% AUM fee.

    • Year 1 will have $1,875 in expenses.

      • Unlike real estate expenses, my investment management fee is no longer tax-deductible.

• Yearly investment growth of 8%.

• Income tax rate of 25%.

The charts show what the investment account valuation is as well as a breakdown of your net cash after taxes.

The Results

The stock market plus the cash value is $2,728,070 compared to real estate plus the cash value of $1,334,066. Your ROI (Return on Investment) in the stock market is 10.91 to real estates 5.34.

Now you may be saying, “But real estate will have a net income of $26,314 in year 30 and the stock market will only have $17,470”. To that I say you are correct; however, I would much rather have the value of my investments be $2.73M to 1.33M. If I really wanted rental income, I could invest 811k of the 2.73M stock portfolio (selling roughly 1M to generate the funds needed after 20% capital gains) in real estate to get the same amount of rental income - and still have 1.7M leftover!

While real estate will indeed generate more income in year 30, and passive income in retirement is the goal of this analysis - let’s look at actual withdrawal rates. For our purposes, we are going to use the Rule of 25x. The stock investment can pull $109k whereas real estate can only pull 53k. The stock investment doubles the amount you can pull from real estate.

Other Factors

This is where things start to get very complicated, and I won’t go much further into the analysis. But I’ll say that it is generally not advantageous for real estate.

• If you ended up selling the real estate property, you end up having to recapture any depreciation you took on the property (in this analysis, I did take depreciation) and pay the recapture at your income tax rate rather than LTCG (25% vs 20%). You would be paying LTCG on whatever the difference is.

  • There is no depreciation recapture with stocks.

• You’d also be paying a ~6% realtor commission (assuming you didn’t have your own license).

  • There is not a selling commission with stocks if an advisor who has a similar fee structure as mine is working with you.

• Real estate is also not as liquid, so it may take a long time to find a buyer.

  • Stocks are generally very liquid and you can find a buyer in minutes with today’s technology.

• Leveraging your equity with real estate can be one of it’s greatest strengths but also one of it’s greatest weaknesses if you are not disciplined.

  • This is how Dave Ramsey ended up declaring bankruptcy.

  • Certain investment accounts offer leverage as well; and I generally stay away from using that if I can given the volatility the stock market can have in the short term.

    • You play with fire (not FIRE), and you’ll eventually get burned.

• If you already own your home, there is a good change your net worth already has a high percentage of real estate allocated to it. In order to diversify, you shouldn’t be creating additional exposure to real estate, but in other investment areas.

• If you don’t sell your real estate, to access any of your equity in the event rent didn’t cover your personal needs, you would need to have a HELOC or Reverse Mortgage in place - generating an interest expense. This puts you in a precarious position in the event you miss your payments - your property could end up getting foreclosed on so you lose everything.

  • There is the ability of some investment accounts to leverage your portfolio. Many times, if you miss a payment or are too leveraged, you have the ability to either deposit more funds into your account or sell positions to cover your shortfall - this is called a margin call.

• And finally, if your investments in the stock market are inside a retirement account like an IRA or 401(k), then things tip even further away from real estate as your returns and income grow tax-deferred. And if they are designated as Roth contributions - your money grows and is withdrawn tax-free.

Final Thoughts

With all of this information, it’s clear which scenario is usually the most advantageous for disciplined investors. I include the word disciplined, because if you are the type who makes investment mistakes - the stock market may not be a good place for you. You may be better served with real estate. Real estate does offer savvy investors some great opportunities if they can be there at the right place and time. Passive income can be built with real estate as the main mechanism - I just don’t think it’s the best way for most people.

The rental income aspect of real estate is very enticing - but most of the time people miss the expenses associated with real estate (property taxes, insurance, repairs & maintenance, commissions, time finding tenants, time maintaining the property, and months where there is no tenant). When you take these factors into consideration, the numbers just don’t make nearly as much sense as investing in the stock market when you have a long term investment horizon.

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About The Author

Shaun Melby, CFP® provides fee-only financial planning and investment management services in Nashville, TN through his company Melby Wealth Management. Shaun has over 15 years of experience as a financial advisor in Nashville. Shaun created Melby Money to educate the public about finances.