Investing in Rental Property vs. Index Fund: Which is Better?

Beginning investors often get stumped trying to determine the absolute best choice among the many and confusing investment opportunities available. Prudent and profitable investing, however, comes from carefully looking at all angles of an investment choice and balancing that choice with other commitments, according to an overall financial plan.

Let's try to analyze, for example, which might be the better investment choice when comparing a rental property vs. index fund.

Neither is a "safe" investment

The risk is inherent in both of these investments, and we're not just talking about fractional losses. You can lose all of your principal investment in both.
A stock broker will tell you mutual funds, which are pools of stocks, bonds or other securities, have the best return. A real estate broker says the same thing about the property. They both can present convincing arguments using different examples, time frames, and assumptions, and both would be telling the truth.

The bottom line is that both investments offer advantages and disadvantages and, over the long term, have produced impressive returns. But generalizing can be deceptive. Real estate appreciation varies between types of housing and market location. Despite the usual good track record for rental properties, condos are often terrible real estate investments. And, not all mutual funds are alike -- they have different specializations and appreciation histories. TSM index funds do quite well, while the S&P 500 tracking fund and other index funds are not nearly as reliable.

Both can be rewarding investments

You can also make a lot of money with both of these investments, especially if you are willing to keep the faith over the long haul.

But if you look at the growth of all stocks by using the S&P 500 and the appreciation of all real estate by using the S&P Case-Shiller Home Price Index, you can make the case that stocks resulted in nearly double the returns of real estate in recent years. Still, in the same time period, there are examples of short-term gains in which real estate rose more than stocks and others in which stocks rose more than real estate. The returns are based on the cost of the stock or real estate during a particular time period and not on the amount invested at that time.

Perhaps you would be best advised to invest in both. Diversification of investments is your best hedge against catastrophic loss as well as your strongest shot at long-term gains.
And if you just don't have the time for the high maintenance of real estate investments, consider investing in real estate investment trusts (REITS) along with a diversity of other mutual funds.

Leveraging your investments

There are other considerations in comparing these investments, such as the amount of leverage offered which seems to favor real estate over mutual funds.

When you buy a mutual fund, you buy $1 worth of mutual fund for every $1 invested. When you buy real estate, you leverage your investment. For every $1 invested in real estate, you buy about $5 worth of property. In buying real estate you put down about 20 percent of the property's price and get a mortgage for the other 80 percent.

If you invest $100,000 in a mutual fund and it doubles in value in 10 years, you will have made $100,000. This amounts to an annualized return of 10 percent a year. If you invest that same $100,000 in a property costing $500,000 and it appreciates at an annualized rate of about 5 percent, in 10 years the property will be worth $750,000. Your profit, before sales commissions and mortgage interest, is $250,000 -- more than double what you would have made in a mutual fund.

Liquidity of  investments

Another consideration in comparing these investments is their liquidity which clearly favors mutual funds.
You can sell a mutual fund in less than a day. It might take a few more days to get the funds back into your checking account. You cannot do that with real estate. Even if the real estate market is hot, count on over a month, and probably two, to see your cash. If the market is normal or slow, it could be six months. Liquidity is a distinct advantage of mutual funds.

Investment management

Both these investments also differ in the amount of time involved in managing them.

A mutual fund will not call you in the middle of the night to say its toilet is not working. If you don't have a property manager for your rental real estate, a tenant will. Even if you have a property manager, expect to be discussing the toilet problem with him the next day. Real estate is management-intensive -- it demands time and energy. You might think about your mutual funds every once in a while, but you don't have to.

Investment liability

There is also a clear choice when it comes to the liability involved.

No one is going to trip and fall over your mutual fund. You will not need liability insurance. On the other hand, a million things could go wrong with your property. You alone will be responsible for most of them. If the roof leaks, you have to fix it. If someone slips on the ice encrusting your entry stairs, count on a lawsuit. Worried about the furnace? You had better fix it.

Planning investments

Your investments should be one component of an overall financial plan. A good plan means having a clear picture of what's happening with all your finances. With that knowledge, you're able to coordinate your investments to make sure you get the most from them.

The foundation of a good financial plan is establishing a solid financial base: Provide for an adequate emergency fund, sufficient insurance coverage, and a realistic budget. Also, take full advantage of benefits and retirement plans that your employer offers.

Then, set goals for your investments. If your goals are long-term, you might choose more aggressive, higher-risk investments. If your goals are short term, you might choose lower-risk, conservative investments. Or, take a balanced approach between the two.

Generally speaking, the younger you are, the more willing you should be to take on risk. Your time horizon, or how long before you need cash in your investments, goes hand in hand with your age. If your time horizon is 25 years or more, you can consider yourself near the top of the risk profile for investing.

If you can afford both, there's no reason a rental property vs. index fund investment has to be an exclusive choice -- real estate and index funds can both fit into your plan. And your finances will be better balanced for it.