Almost every day, I hear advertisements about buying gold because it is such a great investment. As I have heard these claims, I have wondered how real estate stacks up to gold as an investment.
Surprisingly, some correlations exist between buying gold and buying real estate. Both investments are considered a good hedge against inflation and fluctuations that occur when the government overspends and the Federal Reserve weakens the value of the dollar. Both have intrinsic value, meaning their price never goes to zero like some stock investments have done. Both are considered long-term buy-and-hold investments. Both require insurance to protect against risk of loss. Both claim to offer price stability, meaning their prices are less volatile than stocks.
Admittedly, over the past 40 years, gold has performed extremely well. From 1974 through 2013, gold increased in value from $158.93 an ounce to $1,356.30, an average annual increase of 5.51 percent. From 2006 through 2011, when real estate was experiencing its worst performance of the past 40 years with an average annual decline in value of -2.19 percent, gold was soaring at an average annual increase of 17.30 percent. During that period, gold increased in value 260.42 percent. Gold seems to perform better during periods of economic decline when stocks are experiencing a bear market.
However, from an appreciation perspective, over the past 40 years, real estate has more than held its own, increasing an average annual rate of 5.43 percent, which includes the great recession years of 2006 through 2011. From a pure appreciation standpoint, gold beat real estate over the period from 1974 through 2013 by an average annual appreciation of 0.08 percent, a virtual dead heat between average gold prices and average prices of new home sales.
Unlike gold, however, appreciation in value is not the end of the story for real estate; it's only the beginning. Real estate far outperforms gold in all of the following metrics: cash flow, leverage, equity buildup, tax benefits, stability and control. Although income-producing real estate requires more intense management, most projects generate annual cash flows of 5 to 10 percent of the equity invested. Gold offers no annual cash flow on the equity invested.
Leverage, Just One of the Benefits of Real Estate Investing
Real estate has the ability to leverage an investor's capital, meaning an investor who buys real estate does not have to pay all cash to purchase the asset. Investors in gold have to pay all cash when buying gold.
Banks will lend at least 75 percent of the money required to purchase a real estate investment. In using the bank's money, an investor leverages his investment by putting down a small down payment and borrowing the rest of the money to acquire the property. With positive leverage, an investor can actually supercharge his or her return because the entire property appreciates in value not just the cash invested.
Equity and Cash Flow from Real Estate
From 1994 through 2013, gold had an annual appreciation rate of 6.51 percent. During the same time period, a real estate investor who bought an average-price new home for $154,500 put down 25 percent equity of $38,625 and paid interest of 5 percent on a 30-year amortized loan would have had an annual return on the appreciation of his capital investment in the home of 7.64 percent.
Another benefit of income-producing real estate is that while the tenant is paying rent, which goes to pay the monthly mortgage payments, the debt on the property is reducing. An average new home that cost $154,500 in 1994, based on a 75 percent loan-to-value ratio, would have a mortgage of $115,875. Over the next 20 years, the principal loan balance would be paid down to $58,647. The tenant, by paying rent, would have paid down the mortgage balance by $57,228. The increase in equity from the reduction in the principal balance of the loan was paid by the tenant's rental payments. When combining a 5 percent cash flow with equity buildup and appreciation over 20 years, the overall return on this modest real estate investment would be 10.79 percent; a whopping 4.28 percent higher return than an investment in gold!
Tax Benefits of Real Estate
Besides cash flow, leverage, equity buildup and appreciation, a real estate investor also experiences favorable tax benefits while owning real estate. Although real estate actually appreciates in value, for tax purposes, the government permits an investor to depreciate the asset over either 27 ½ years or 39 years, depending on whether the property is residential or commercial. This tax break enables the investor to shelter most of his cash flow without having to recognize it as income. Additionally, when a real estate investment is sold, the gain on the sale is taxed at a 15 percent rate, depending on the investor's adjusted gross income.
Gold is taxed at 28 percent. Gain from the sale of gold is considered collectibles gain and is taxed at a higher rate than conventional long-term capital gains. The maximum tax rate on collectibles gain is 28 percent.
Real Estate is More Stable
Although gold is more stable than stocks, it is still more volatile than real estate. Over the past 40 years, gold experienced a decline in value in 15 of the past 40 years. Those declines ranged from a low of -0.05 percent to a high of 25.2 percent in one year. During several years, gold declined more than 10 percent in value. Real estate, on the other hand, experienced declines in value in only five of the last 40 years. Those declines ranged from a low of 1.74 percent to a high of 7.42 percent. Real estate is unquestionably less volatile than gold.
You Have the Control
Finally, an investor in gold or real estate has control over the asset, as long as the gold acquired is not part of an Exchange-Traded Fund (ETF) and the real estate is not part of a Real Estate Investment Trust (REIT). However, the type of control is much different. An investor in real estate can control the performance of the asset by raising or lowering the rents when economic times are good or bad. He or she can also provide sweat equity to improve the asset's value. Even location can enhance the value of a real estate investment.
This type of control is not available to an investor of gold. When gold is purchased, whether it's in the form of gold bullion bars or coins, one of the most important considerations is where to store the gold. If it is stored in a custodial vault, the investor has to worry about whether or not the custodian will go out of business. If that occurs, the investor is left with an unsecured claim against a bankrupt custodian. If the investor purchases a safe and stores the gold at home, then there is the concern of a robber stealing the gold and possibly harming the investor or their family in the process.
A few years ago, I had a client who owned $100,000 in gold. He stored the gold in a safe at his home. He wanted to invest in a commercial income-producing real estate investment with me and was required to be a co-signer on the mortgage loan. He submitted his financial statement to the bank showing that he had $100,000 in gold. The banker wanted to see the gold. The investor did not want to take the gold to the bank nor did he want the banker coming into his home to see the location of the safe. They finally compromised by having the investor take his gold to a coin dealer for verification of its value and providing certification that he was indeed the true owner of the gold. The whole process was a hassle.
In summary, gold has performed well over the past 40 years, but it does not have the same performance capability as an income-producing real estate investment. Gold may provide positive appreciation in value similar to real estate, but it can't provide cash flow, leverage and equity buildup. Nor can it compete with real estate when it comes to tax benefits, stability or control. In short, when all the additional advantages of a real estate investment are considered, gold just doesn't stack up.
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