We’ll define cash-on-cash (COC) return, as well as explain what it means for you as an investor, especially as distinct from the more common “rate of return” and IRR metrics. Popular with mindful investors because it deals with the here and now of how an investment is likely to perform out of the gate, as well as what it is likely to yield, regardless of when and whether the investment is sold and for what cap rate.

What is cash-on-cash return in investing?

This fundamental concept in the world of income investing is different from IRR. COC return measures the annual cash distributed to you as an investor, divided by the total cash invested. It provides a clear picture of how much money an investor can expect to receive each year based on their initial cash investment.

Formula: COC Return = Cash Distributions / Total Cash Invested

Examples:

• Depreciation tax benefit? Not included.
• Pulled cash out in Year 2 because you refinanced the property? Yes, included.

The Concept of Cash-on-Cash Return

This metric focuses specifically on the cash flow generated from an investment in a particular year – excluding any tax impact – rather than the adjusted rate of return of the investment spread out over the lifetime of it. In other words, it’s used to help you figure out the level of income to expect from an investment.

For example, if an investor puts in $100,000 and receives an annual cash flow of $10,000, the cash-on-cash return would be 10%. $10k / $100k = 10%.

How Cash-on-Cash Return Differs from Other Returns

While there are various returns used to assess the profitability of an investment, cash-on-cash return differs in its specific focus on cash flow. Unlike other returns, such as Project IRR (Internal Rate of Return) or gross rental yield, cash-on-cash return takes into account the amount of cash invested rather than the total value of the investment.

IRR, for instance, tells you what the expected rate of return is over the life of an investment. On the other hand, gross rental yield measures the rental income generated by the property relative to its market value. These returns provide valuable insights, but they do not solely focus on the cash flow generated by the investment, especially in a particular year.

Calculating Cash-on-Cash Return

Now that we understand what cash-on-cash return is, let’s delve into how it is calculated.

1. Determine the net annual cash flow generated by the investment.
2. Divide the net annual cash flow by the total cash invested.
3. Multiply the result by 100 to express it as a percentage.

Calculating cash-on-cash return is an essential step in evaluating the profitability of an investment. By understanding the formula and applying it correctly, investors can gain valuable insights into the potential returns of their investment.

Example Calculation

Let’s consider a practical example to illustrate how cash-on-cash return is calculated. Suppose an investor purchases a rental property for $200,000 and expects to generate a net annual cash flow of $10,000. By applying the cash-on-cash return formula, we can calculate the return as follows:

1. Net Annual Cash Flow: $10,000
2. Total Cash Invested: $200,000
3. Cash-on-Cash Return: ($10,000 / $200,000) x 100 = 5%

Benchmarks: What’s a Good Return?

Many investors we speak with prefer to see a pro forma cash-on-cash return of at least 3-7% in Year 1 of an investment, and at least an 8% Preferred Return throughout an investment

When To Use COC Return vs IRR

Use Cash On Cash return when you’re investing for near-term income, rather than longer-term appreciation.

Think about a fund manager that boasts a track record of delivering 20% IRR to investors, net of fees, across its historical portfolio. Putting aside the fact that past performance doesn’t guarantee future results, this fund manager may specialize in buying properties in markets that appreciate over the long term (say, 7-12 years), while offering little if any cash flow in the meantime.

Does it fit your life and investment goals to sit around indefinitely, waiting and hoping that the fund manager delivers again on their historical track record, but not actually getting to experience liquidity or even income for your investment?

For many investors: yes, that’s fine. They’re focused on the long term, and they don’t need or want to touch that money until the investment is sold for a tidy profit. But for others, such as Lean FIRE investors? It wouldn’t work: the COC return in the early years of the investment wouldn’t be sufficient to pay for your expenses while you’re waiting for a sale of the property.

Some real estate syndications try to get around this by refinancing their investment in the early or middle part of the investment hold period. That really helps, as long as interest rates don’t rise much, and can deliver valuable cash back to the investor while keeping all of the initial investment in the deal.

Limitations and Risks of Relying on Cash-on-Cash Return

While COC return is a useful metric, it’s important to remember that it doe provide a limited perspective on an investment’s potential. This metric solely focuses on the cash flow generated from an investment and does not consider other crucial factors, such as taxes. Taxes can significantly impact the overall profitability of an investment, and failing to consider them may lead to inaccurate assessments of its true financial performance.

As we’ve touched on, another factor that cash-on-cash return overlooks is the potential for appreciation. Real estate investments, for example, often experience value appreciation over time, especially when combined with leverage, which can result in additional returns beyond the cash flow generated. Ignoring this aspect may lead to underestimating the long-term profitability of an investment, especially in growth markets such as the coasts and major cities.

Cash-on-Cash Return in Different Types of Investments

Cash-on-cash return can be applied to various types of investments, but let’s focus on its relevance in real estate and stock market investing.

Use in Real Estate Investing

In real estate investing, cash-on-cash return is a widely used metric for evaluating the profitability of rental properties. It helps investors determine the potential income generated from rental properties and assess their investment viability.

Use in Stock Market Investing

In the stock market, COC is not as commonly used as in real estate investing. However, it can still be a useful metric for investors looking to evaluate the income generated from dividend-paying stocks. By comparing the cash-on-cash return of different stocks, investors can identify those that yield higher income relative to the initial investment. Keep in mind, however, that you probably won’t be able to use leverage to increase COC return in this scenario, because the dividend yield of the vast majority of stocks will not outpace the margin loan percentage at which you can finance a stock purchase.

Overall, understanding COCR is essential for investors who are interested in income, particularly in the early years of an investment. Figuring out the Year 1 and Year 2 COC return of a 5-10 year investment can dramatically help with understanding how it will “feel” and what impact it will have on you in the near term, to make this investment.

To say that the real estate market has been turbulent this year is an understatement.  Runaway demand for homes early in the year crashed into a wall of unprecedented interest rate hikes built by a Federal Reserve determined to control inflation.  The collateral damage includes both home buyers and sellers, many of whom have traumatic war stories to tell.  I have my own war story to tell in today’s post.  But never fear, I’ll augment those meager anecdotes with some data and observations about the wider national real estate market.

My Real Estate War Story

In April I decided to pack up my house and move to something smaller and less maintenance intense.  I chose to buy a new house first and sell my old house second because I wanted to avoid the hassle of showing a house while still living in it.  It turns out that my fear of a small hassle forced me into the worst possible market timing.

The first house I unsuccessfully bid on in April had eight other offers in two days and was sold for $50,000 above the asking price.  The second house I bid on quickly had four other offers, and I barely beat out the competition by offering $40,000 over what appeared to be an already bloated asking price.  In both cases, my real estate agent advised me to avoid any offer contingencies, even a basic inspection.

I knew that the Fed was eager to raise interest rates, so I endured the four weeks until closing on my new house and moved within a week after that.  So, a mere five weeks had passed when I put my newly painted and scrubbed old house on the market.  It might as well have been a century.  The seller’s fairytale market that I witnessed in April mocked me as I entered a seller’s hellscape in late May.

Instead of multiple offers in a few days, my listing had zero offers for two months.  About a month into the process, I decided to reduce the asking price by $25,000.  One offer finally came.  It was $50,000 under the already reduced asking price.  After negotiation, we agreed on a price that was $35,000 under the asking price, which I regarded as a small victory.  Amazingly, I ended up selling the house for less than the recently updated County tax assessor’s appraised value!¹

My Perspective

Beyond my recent nightmare, all signs suggest that my local real estate market is turning the corner into something new and different.  Realtor for-sale signs are sitting on front lawns for noticeably longer.  Friends complain that rapidly increasing interest rates have put those once affordable-looking mortgage payments out of reach.  And homeowners in my area are starting to see their Zillow estimates drop by a few percent.

On the supply side, new housing developments are going up all around my neighborhood.  Typically, my morning walk consists of walking away from my new house for a half hour or so and then back again (a one-way distance of about 1.5 miles).  Within that walk radius, I estimate no less than 150 new houses going up.  And that doesn’t count the hundreds that have already gone up in the last few years.  Here are a couple of photos from one of my walking routes.

 

In my view, local demand is slowing while supply is still accelerating, which seems like a bad combination.

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We recently decided to sell one of our rental properties, and I started estimating our likely return on the investment.  This made me think about my past posts on the merits of real estate investing as a way to diversify a mindful stock portfolio.

Like most Mindfully Investing posts, I tried to make my past assessments of real estate investing applicable to a wide range of situations.  For example, I mostly used national average or median data on housing prices and rental income rates.  But because real estate investing is susceptible to many situational quirks, these national averages can’t portray all possible (or even likely) outcomes for any given investor in any particular city or region.  Further, because statistics examines the distribution of many samples, few individual investors can be expected to achieve the average or median outcome.

So, I was curious to what extent my returns for this rental property were consistent with my previous generic conclusions about real estate investing.  Can this one example reveal something that my generic assessments might have missed?

Generic Conclusions

I concluded from my previous generic assessments of traditional real estate investing that:

• A main home or a vacation property that is never rented out is a much worse investment than stocks.
• However, investing in a carefully selected and operated rental property can yield long-term returns similar to stocks.
• Investing in rental properties requires more work than stock investing, but real estate prices and rents are driven more by local conditions that may help to partially counterbalance national stock market gyrations.

You can read the original post to see how I arrived at these conclusions using national average data.

Specific Parameters

How relevant are these average conclusions to my specific rental property?  First, I should give you some more details.*  The property is a two-bedroom condo in a pleasant suburban-feeling neighborhood close to downtown Tacoma, Washington.  It has a nice view of Puget Sound.  (Although the view is not quite as nice as the photo above, which was taken at a vacation condo we rented in Mexico a few years ago.)  In the last few years, Tacoma real estate prices have been steadily climbing due to the astounding growth of tech companies like Amazon in nearby Seattle.  Workers in Seattle are increasingly willing to extend their commute times to find lower housing prices.

We bought the Tacoma condo for $225,000 in March of 2016, and we’re listing it today for $325,000.  That’s a $100,000 price increase in just three and a half years, not counting selling costs.  We rented out the condo for $1250 a month, which is pretty low for this area.  We didn’t seek higher rent because we had a reliable tenant all lined up when we bought the condo.   I’ve written in the past about the huge hassles that careless renters can cause.  So, we were willing to swap some rental income in return for less effort and greater peace of mind.

Once you take out expenses like homeowners association fees, property taxes, insurance, maintenance, etc., I estimate our net rental income was about $450 per month or $5400 per year.  This works out to an additional $18,450 of income over the life of the rental on top of the $100,000 in price appreciation.

Specific Conclusions

Overall, I’m pretty happy with the investment, assuming that the condo sells near the asking price.  But for this post, the real question is whether the condo outperformed investing the same $225,000 in the stock market.  Here’s a graph showing the cumulative condo total return (blue line) as compared to investing in the entire U.S. stock market (as represented by the Exchange Traded Fund VTI shown by the orange line) and a stock fund that specializes in Real Estate Investment Trusts (VNQ, shown by the gray line).

Note that the last data point for the condo includes the expected selling costs, which eats into the final return in the last month.  Here’s a table of statistics for the same three scenarios.

Stock	Annualized Return	Volatility (St. Dev.)	Max Drawdown	Final Balance
VTI	13.8%	12.0%	-14.2%	$342,809
VNQ	5.8%	13.4%	-14.9%	$270,082
Tacoma Condo	11.0%	Not Calculated	0%	$324,412

The annualized return for the stock market was almost 3% better than the Tacoma condo, although they both performed very well by historical standards considering that the average annualized return for the stock market since 1871 has been about 9%.  I’ve discussed before that investing in Real Estate Investment Trusts (REITs) like VNQ is often viewed as a no-hassle way to diversify into real estate.  But in this case, national trends in real estate (at least as represented by this one fund) didn’t keep pace with the relatively hot Tacoma housing market.

Some readers might wonder how much the condo’s total return would have improved if we had asked for more rent.  After all, our rental income of $450 per month works out to a relatively meager rental rate of 2.4%**.  Many real estate investors won’t touch an investment that has less than a 4% rental rate, and 6% is the preferred target.  At a rental rate closer to 4%, the condo’s annualized return would have been about 12.0%, which is still almost 2% less than the stock market return in this same period.  (Rental rates above 4% are impossible in this particular locale.  So, I view 12% as the maximum realistic total return for this condo over this particular period.)

My previous generic conclusions noted that in most cases over half the total return generated from rental properties comes from rental income.  But for this condo, more than 80% of the return in this period was from price appreciation and less than 20% was from rental income.  If the condo hadn’t been in such a hot market, the total return could have easily been much worse than investing in the stock market.  Put another way, we got pretty lucky both in terms of the time and place we decided to invest in real estate.

Generic vs. Specific

Our experience with this rental condo fits pretty well with most of the generic mindful conclusions about real estate investing.  Specifically, rental property is the best way to generate real estate returns that rival stock returns.  If we had not rented the condo out, our annualized rate of return would have been closer to 9%, which is still pretty darn good considering that it’s right in line with the long-term average stock market return.  Regardless, the rental income would have helped buoy our total returns if the real estate market had been weaker.

However, our experience differed pretty significantly from generic findings that rental rates drive total returns.  The generic view suggests that a rental property with a 2.4% rental rate is likely to be a poor long-term investment as compared to the stock market.  But this turned out to be exactly wrong in our case, almost solely due to the specifics of our real estate market.

Also, because the stock market and the Tacoma real estate market both climbed steadily in the last 3.5 years, it’s hard to see some of the other potential advantages of diversifying with real estate.  However, the graph above shows that even in this relatively tranquil period, temporary declines in the stock market (for example in late 2018) had no negative impact on local condo prices.  And the fact that the condo had no temporary drawdowns means that we experienced much less negative volatility (the kind investors worry about) as compared to stocks.  The same things cannot be said about investing in REIT stocks, which I’ve noted before are often highly correlated with broader stock market movements.  In this period, REIT stocks also suffered a slightly worse maximum drawdown than the entire stock market.

Conclusions

Let’s be careful not to read too much into this specific example.  After all, the investment spanned less than four years and represents only one real estate market.  The VNQ fund performance strongly suggests that many real estate markets throughout the country failed to generate returns anything like the Puget Sound area.  In the next four years, the stock market may tank while the housing pressures in our area continue to mount, causing local condo returns to trounce stocks.  Or the exact opposite could happen.

I’ve noted in the past that uncertainty about the future is probably the simplest and most mindful reason to diversify.  We don’t know in advance whether stocks or rental properties in any given area will perform better.  But we know they both have the potential to perform well even while the other one is performing poorly.  The hassles inherent with owning real estate, particularly without an ideal renter like we had in Tacoma, continue to tip the balance for us toward converting this investment into stocks, even though this concentrates our risks from stocks a little bit more.

This experience reinforces in my mind that investing in real estate is much more idiosyncratic than stock index fund investing.  The greatest strength and greatest weakness of real estate investing is the wide range of market conditions you’ll encounter across cities, regions, and over time.  These peculiarities can provide opportunities to reap risk-adjusted or total real estate returns similar to or potentially even better than from stocks.  However, these opportunities can easily morph into poor risk-adjusted or total returns in unexpected ways that are relatively unique to where and when you happen to be investing in real estate.

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* This is not an advertisement.  If it were, it would be a pretty poor one, because I won’t give you enough details to track down the exact property online.  If by some crazy coincidence you happen to be looking for a two-bedroom condo in Tacoma, shoot me a message via my About page.

** I talk more about rental rates here.  It’s calculated as the annual income ($450 per month times 12 months equals $5400 per year) divided by the purchase price of the property ($225,000).

My last post discussed investing in real estate, one of the so called “alternative investments”.  You can invest in real estate many ways, which I lump into two main categories:

• Real Estate Investment Trusts (REITs), which I covered in my last post
• Traditional real estate, which I’ll cover in this post.

“Traditional real estate” investing is buying a property with a physical address, or part of such a property, or a part of many such properties.  Here are a few obvious examples of the dozens of ways to make (or lose) money on traditional real estate:

• Main home (buying outright, buying with a loan, rent-to-own, etc.)
• Vacation property
• Long-term rental property
• Short-term rental property (such as AirBnB)
• Real-estate investment groups
• Timeshares
• Flipping houses
• Crowdfunded real estate (such as Fundrise or Realty Mogul)
• Commercial/industrial property

For this post, I’m going to focus on the most common real estate investments: a main home, vacation property, and long-term rentals.

Is Home Ownership an Investment?

As I noted in my last post, home ownership fits the common sense definition of an investment.  But it’s probably unwise to decide whether to buy a home based purely on the math of investing.  Home ownership is a decision supercharged with emotion and sentimentality.  We bought our home almost 15 years ago, and the market price has hardly gone up in that time, which makes it a bad investment.  However, we’ve reaped so many non-financial benefits from owning a quiet rural house with a lovely garden, fruit trees, a big yard for our kiddo, and easy access to the local ski area.  For many people, their home brings a sense of enjoyment and security that’s priceless.  But I argued in my last post that once you’ve decided to buy a home, it makes the most sense to consider it part of your long-term investing portfolio, along with all your other investments.

The Good and Bad of Leverage

Many people see an inherent advantage in traditional real estate investing because local banks will often loan most of a property’s purchase price, which is called using “leverage”.  Leverage can theoretically boost the returns from a given capital outlay.  For example, if you buy a $100,000 rental property outright, and it generates a $4,000 annual income stream after expenses, you’re getting a 4% annual return on your capital.  However, you might be able to buy the same property with a $20,000 down payment and an $80,000 loan from the bank.  Your net income will be smaller, because you have to make loan payments back to the bank.  But even if the net income is only $2,000, that represents a 10% annual return on your original $20,000 capital outlay.  Pretty cool!

However, leverage is a two-edged sword, whether you use it for real estate, stocks, or anything else.  What if property values go down (like they did in 2008), or your tenants fail to pay the rent for months on end, or someone starts a meth lab in your basement?  Regardless, you’re still obligated to make regular loan payments and eventually pay the entire loan back with interest.  And even at today’s relatively low interest rates, the interest on our example $80,000 loan is a substantial additional obligation: $30,000 for a 15-year loan and $66,000 for a 30-year loan.   I’ve seen myriad potential financial problems that come with real estate investing, and leverage makes all of those problems worse.  Further, you have to find the right kind properties that can consistently generate the necessary return after the added burden of loan payments, which is easier said than done.  Although the idea of increased returns from leverage is appealing, it also increases the risks of simply losing money.

Traditional Real Estate as An Investment

I found in my last post that investing in REITs is pretty similar to investing in the overall stock market. Does traditional real estate offer better portfolio diversification opportunities?  To answer that question, let’s look at the same metrics of correlation, returns, and volatility that I evaluated in my last post about REITs.  Unfortunately, these data are not as readily available for traditional real estate.

Correlations – I searched for several different ways to examine correlations between traditional real estate and U.S. stocks, but none of the sources I found seemed reliable or broadly applicable.  One of the main problems is that correlations can vary so much, not just across different time frames, but also across different regions/cities, property types, data sources, and methods used in the correlation analyses.

Returns and Volatility – What about returns and volatility?  I used Federal Reserve Bank of St. Louis (FRED) data on median U.S. house prices dating back to 1963 to compare the historical returns for real estate to the returns for stocks and bonds.

Of course, price changes are only one source of long-term returns from traditional real estate.  Just as reinvested dividends contribute greatly to stock returns, one global study found that rental income produces at least half of the returns from real estate.  I’ve seen analyses of rental returns that assume investing rental income in stocks, bonds, or other investments or that assume a certain amount of leverage.  But these approaches conflate real estate performance with the performance of other investments or prevailing loan interest rates.  So, I conducted my own calculations assuming no leverage and that rents were saved as cash* until sufficient funds accumulated to buy another house at the concurrent median U.S. house price.  Using these assumptions, I tracked the returns from both price changes and rental income from all the properties accumulated from 1963 through 2017.  In my view, this represents a nearly pure real estate total return assessment that we can compare independently to stock and bond returns.

It’s a vast understatement to say that opinions vary on the ratio of rental income to property value that you can expect.  One common rule is that real estate investors should shoot for monthly rent that is 1% of the house price, which equates to 12% in annual rent.  Another common rule is that you should expect about 50% of the collected rent will go to expenses (not including mortgage payments) such as property taxes, insurance, maintenance, vacant periods, etc.  So, I applied these rules and estimated net rental income as 6% per year (half of 12% per year).

You’ll also see widely varied opinions about the realism of the 1% and 50% rules.  One variable, among many, is that 1% monthly rent is pretty reasonable for low-cost-of-living regions, like the rural mid-west and south, but completely unreasonable for high-cost-of-living areas in big cities and coastal states.  My experience with rental properties in coastal and more rural Washington State is that netting 6% rent per year is a pipe-dream.  Consequently, I also calculated total return based on netting 4% rent per year, which for Seattle (and I suspect many other high-cost-of-living cities) is still very optimistic.

Here are two graphs of total returns from 1963 through 2017, assuming that $10,000 was initially invested in:

• A main home or vacation property that is not rented (the “House Price” scenario)
• A rental property with 4% net rent (“House Price + 4% Rent”)
• A rental property with 6% net rent (“House Price + 6% Rent”)
• Bonds represented by 10-Year government bonds.
• U.S. stocks as represented by the S&P 500

To better show both the early and late growth trajectories of each scenario, the first graph uses a log vertical scale and the second uses a standard vertical scale.

And here are some key metrics for these same scenarios.

Scenario	Final Value	Annualized Return (CAGR)	Best Year	Worst Year	No. of Houses Acquired
House Price	$189,831	5.42%	17.37%	-9.2%	1
House Price + 4% Rent	$766,629	8.06%	16.55%	-3.5%	4
House Price + 6% Rent	$1,406,094	9.22%	20.33%	-1.5%	8
10 Year Bond	$282,884	6.23%	32.81%	-11.1%	NA
Stocks – S&P500	$2,249,405	9.93%	38.46%	-37.2%	NA

Stocks are the clear winner in terms of final value, at least in this period from 1963 through 2017.  But the difference in annualized return between stocks and real estate with 6% net rent is pretty small.  This suggests that rental houses in specific cities could beat concurrent total stock market returns.  Further, the top graph shows that from about 1972 to 1985 national real estate returns beat stock market returns, and that could conceivably happen again in the future.  And if you like the idea of becoming a real estate mogul, note that the 6% rent scenario accumulates eight rental houses over 55 years, all without borrowing any money from the bank.

I couldn’t generate detailed volatility statistics with the frequency of data used here, but the best- and worst-year statistics show that traditional real estate often has muted volatility as compared to stocks and even bonds.  The steady stream of rental income further dampens annual ups and downs.

The “house price” scenario is analogous to the return on your main home, and this analysis shows that the median U.S. home was a much worse investment than even government bonds, at least in this period.  The same conclusion applies to a vacation home that’s never used as a rental.  For the two rental scenarios, compounded rent contributes between 75% and 86% of the final value coming from rental income, for net rent between 4% and 6%**.

Considering the particulars of this analysis and the results for both returns and volatility, I conclude that a carefully selected and operated rental property investment is nearly as good an investment as stocks.

Qualitative Factors

For me, more qualitative factors break the tie between investing in stocks versus traditional real estate.  For example, rental income is relatively difficult to compound as compared to stocks for the following reasons:

• You have to constantly monitor and control rent expenses to achieve the net rent you projected.
• You have to save the net income consistently and find the best available cash interest rates.
• Once you’ve saved enough income, you have to quickly find a good next rental house to buy, regardless of the prevailing market conditions.  (Biding your time slows down the rate of compounding.)
• Meanwhile you have to keep up on the maintenance and steady occupancy of your ever-growing fleet of rental houses.
• You need to avoid acquiring too many poor-performing rentals.  But you can’t swap out poor performers too much, because the added process costs will further erode your returns.

And you have to do all this consistently year after year, house after house, until you have a pretty remarkable real estate empire built up.  Compare this rental gauntlet to the ease of literally just pressing the “reinvest dividends” button on your stock brokerage account and then going to bed.  Based on my experience, calling rental income “passive” is laughable, particularly if you’re trying surpass long-term stock market returns.

I’m willing to agree that many real estate investors out there may have managed to grow their money faster than investing in stocks.  But it seems likely to me that they:

• Are a small minority among traditional real estate investors.
• Work in regions of the country or local areas with high rent ratios.
• Are extremely knowledgeable and savvy about real estate investing, having learned from earlier mistakes and money lost.
• Are using leverage in very controlled and specific circumstances, which requires even more savvy.
• Enjoy running a full-time business in rental real estate, which is anything but passive.

One way to make rental property income more passive is to hire a rental property manager, who will typically take at least 10% of the rent in addition to other specific costs that can arise.  But given the virtual tie between traditional real estate and stock returns, any added rental expenses starts to tip the balance more in favor of stocks.  And in my experience, a property manager reduces, but certainly doesn’t eliminate, the hassles associated with rental properties.  You’ll still have to make fairly regular decisions, monitor the manager, potentially replace poor-performing managers, and make sure you’re actually netting the income you projected.

It’s also worth noting that the government taxes real estate returns very differently from stock returns.  You’ll find arguments for why real estate returns are both tax favorable and unfavorable as compared to stock returns, and I’m not going to try to resolve that fight.  But I think it’s fair to say that the taxes associated with property income and sales are more complicated.  I always plan to obtain the most favorable tax rates on rental income and capital gains, but unexpected surprises often upset my plans.  And many surprises are difficult or impossible to control including: changes in income tax regulations, changes in property values, changes in property taxes, changes in tenants, the amount and degree of maintenance and repairs needed in any given year, insurance claims, etc.  In contrast, the taxes on stock returns are comparatively easy to predict.

Conclusion

Traditional real estate is:

• A bad investment in the case of a main home or non-rental vacation home,
• A good investment that’s a considerable hassle in the case of do-it-yourself rental properties, or
• A decent investment with some hassles in the case of rental properties with a manager.

That’s not a ringing endorsement.

On the other hand, the mindful perspective on diversification is that we can never predict the future.  Because no one knows what will happen next, moderate amounts of diversification across relatively high-return investments, like stocks and traditional real estate, is prudent.  Investing in traditional real estate requires some work, but some types of carefully managed real estate can generate returns on par with stocks.  While assessing the chances that your real estate holdings will zig when the stock market zags is nearly impossible, traditional real estate prices and rents are much more driven by local conditions that are somewhat insulated from national stock market gyrations.  And with real estate investing, you have greater potential control over your returns by applying local knowledge, studying what makes properties in your area valuable, selecting quality tenants (within the bounds of fair housing laws), improving your do-it-yourself skills, exploiting tax laws the best you can, etc.

Personally, I never want so much traditional real estate in my portfolio that it feels like a full-time job, or even a half-time job.  I didn’t retire early just to spend all my time doing credit checks and repairing garbage disposals.  Even if the most advanced Modern Portfolio Theory in the world suggested that I should hold 50% in traditional real estate, that wouldn’t sway my opinion at all.  My asset allocation to real estate is mostly dictated by my lifestyle preferences.

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*I assumed the cash earned a return consistent with a high-interest bank savings account by applying the average annualized return of 3-month T-bills over the period 1963 to 2017, which was 3.38%.  To some degree this confounds real estate returns performance with cash returns performance.  But it seems to me that even the most risk-averse real estate investor would probably seek out the risk-free rate of return represented by short-term T-bills or similarly safe cash vehicles.

**If I exclude interest paid on the saved cash, rent accounts for 59% to 68% of the total return.

Mindfully Investing focuses on the three mainstream investments of stocks, bonds, and cash.  I thought it would be worthwhile to add some information on so-called “alternative investments”.  Two of the most popular alternative investments are gold, which I covered in a recent post, and real estate, which I’ll discuss in this post and my next post.

It’s funny that people think of real estate as an “alternative investment” when 64% of U.S. families own a home, but only 54% of the U.S. population owns stocks.  For philosophical reasons, many people don’t like to think of their current or future home as an investment.  Even if we ignore home ownership, real estate is still one of the most common investments.  For example, 10 of the 18 portfolios suggested by finance big-wigs and analyzed at Portfolio Charts have substantial allocations to real estate.

Real Estate as Investment

Home ownership philosophies aside, an investment is almost anything you purchase that you expect to generate income or appreciate in value.  That definition fits the money down and monthly loan payments on a home (the purchase) and the potential for capital gains when a home is later sold (appreciation).

Further, ignoring the large amount of capital tied up in your home could distort your investment plan.  I’ve described my family’s investing portfolio as 80% stocks and 20% cash, with the cash allocation shrinking as my retirement progresses.  But in reality, it’s more accurate to say our portfolio is 65% stocks, 15% cash, and 20% real estate, because we own our main home, a rental property, and a vacation condo.  These last two properties are clearly investments, because the rental pays regular income and both could produce a capital gains when we sell them.

Although many of us have no plan to move out of our main homes, failing health will eventually force many of us into assisted living or the like.  Selling a main home is certainly an option for meeting those future expenses.  Further, many people’s retirement plans explicitly include using home equity through a reverse mortgage, downsizing, or moving to a region with cheaper real estate prices.  So, I think it’s mindful for most investors to include all of their investments in their long-term retirement plans including their main home and any other real estate.

Real Estate Investing Options

Beyond a main home, you can invest in real estate dozens of different ways, which I’ll lump into two broad categories.

Real Estate Investment Trusts (REITs) – REITs are companies that own, operate, or finance income-producing real estate in a range of property sectors.  Most REITs issue publicly-traded stock that you can easily buy and sell like any other stock, including in mutual funds or Exchange Traded Funds (ETFs) that contain the stocks of many REIT companies.  And just like any other stock, you can make money on REITs through both dividend payments and price appreciation.  There are many kinds of REITs that I won’t go into here, some of which are not publicly traded.

Traditional Real Estate – Traditionally, buying real estate means buying a property with a physical address, or part of such a property, or a part of many such properties.  The property could be houses, rental properties, vacant land, farms, part of buildings like a condo, whole buildings, or drive-in theaters for that matter.  I’ll get into more details on traditional real estate and rental properties in my next post.

For the rest of this post, I’ll focus on REITs.

Should You Invest in REITs?

Because REITs are a particular type of stock, it makes sense to evaluate REIT stocks like any other stock.  The main reason to hold different types of stocks is for diversification.  The most mindful way to invest in stocks is to avoid the idiosyncratic risks associated with individual stocks and instead buy baskets of stocks in the form of funds.  Although diversifying your stock fund types is no silver bullet, it may sometimes reduce portfolio volatility or slightly increase returns as compared to less-diversified approaches.  Diversification offers greater potential benefits when the stock types involved are relatively uncorrelated or negatively correlated.

Correlation – What are the recent correlations between REIT stocks and the rest of the stock market?  This graph from Ben Carlson shows the rolling 3-year correlation between REITs and U.S. stocks since 1980.

In this time, the correlation between REIT stocks and all U.S. stocks was mostly between about 0.2 and 0.9, with a brief excursion into barely negative territory around 2001.*  And as I like to point out, correlations often increase exactly when you hope diversification will come to your rescue.  Thus, the REIT correlation with other stocks was highest during the 2008 financial melt down, when almost all asset prices were plunging in unison.  While these correlations show that REITs have provided some sporadic and moderate diversification to a stock portfolio, they also suggest we should be skeptical of claims that REITs are “heavily non-correlated” with stocks.

Returns and Volatility – The other stock measures we typically examine are returns performance and volatility, with returns being by far the more important of the two.  This graph compares the performance since 1994 of U.S. REITs (blue line Portfolio 1), the entire U.S. stock market (red line Portfolio 2), and a 50/50 mix of REITs and U.S. stocks (gold line Portfolio 3) as provided by Portfolio Visualizer.

And here are the return and volatility metrics over this time.

Stock Type	Annualized Return (CAGR)	Volatility (St.Dev.)	Best Year	Worst Year	Maximum Drawdown
REITs	9.3%	19.3%	35.7%	-37.1%	-68.3%
US Stocks	9.3%	14.9%	35.8%	-37.0%	-50.9%
50/50 REITs and Stocks	9.3%	15.5%	33.4%	-37.0%	-59.5%

Although they took different paths along the way, both the REIT and U.S. stock portfolios ended up with the same annualized return of 9.3%.  But REITs were more volatile, including an absolutely stomach-churning maximum drawdown of more than two-thirds of the portfolio value.  And this happened right when many folks were hoping that property values would rescue them from the quick sand of the 2008 financial crisis.  The combined 50/50 portfolio had lower volatility than the REIT portfolio, but the all-stock portfolio still had the best combined metrics for this period.

I’ve always cautioned against putting too much weight in any single comparison of assets over a set time frame.  Ben Carlson likes to say you can win any argument about markets by simply changing the time frame of the analysis.  The above graph shows that REITs underperformed stocks from 1994 to 2003, outperformed from 2003 to 2007, outperformed again from 2009 to 2016, and then underperformed in the last couple of years.  But over the total time that REITs have figured prominently in the stock market, having REITs in your portfolio produced negligible long-term benefit.  Of course, the next 25 years could turn out completely different, and it’s entirely possible that adding some REITs today might help your stock portfolio weather some unexpected storms tomorrow.

Other Factors – Depending on your income bracket, one disadvantage of REITs is that their dividends are usually taxed as ordinary income, while other stock dividends are most often taxed at the relatively low rate of 15%.  However, the 2017 tax reform reduced taxation of REIT dividends in at least a couple of other important ways.  Further, the dividend yield from REIT index funds is often higher than the yield from comparable broad-market stock index funds, which means you won’t necessarily net a lower “take home” dividend from your REIT index fund.  And of course you can invest in REITs through a tax-advantaged account, where these tax differences are mostly irrelevant.

If you intend to add REITs to your stock portfolio, make sure you account for your current amount of REIT exposure first.  For example, a U.S. all-market stock fund like VTI from Vanguard already holds about 4% in REITs.  So, if your portfolio contained only VTI, and your goal was 10% REIT exposure, you would only have to add 6% in REIT funds to reach that goal.

Conclusion

REITs offer convenient exposure to real estate using low-cost index funds.  In recent history REITs haven’t acted that independently or performed that differently from the overall stock market.  To the extent you see value in diversifying across different stock sectors, REIT stocks may be a solid part of your investing plan.  But adding some REITs to your portfolio is certainly no guarantee that you’ll get consistently better performance or protection from the next market downturn.

Before you add REIT funds, be sure to correctly assess your overall exposure to real estate by including in your calculations any REIT exposure from your existing stock funds, your main home, and any other traditional real estate holdings you may have.  For many folks, their main home represents a huge investment that, by itself, often provides enough allocation to real estate.

My overall portfolio includes about 20% in traditional real estate holdings, not counting the small REIT exposure from the broad-market index funds I own.  So, I don’t feel that I need any more exposure to real estate from REIT-specific funds.

I’ll discuss the pros and cons of, and reasonable portfolio allocations to, traditional real estate in my next post.

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* Positive correlation of +1 means that two stocks (or funds) move together in lock step; they are “highly correlated”.  A correlation of 0 indicates that one stock moves randomly with regard to the other; they are “uncorrelated”.  A negative correlation of -1 means that the two stocks move exactly the opposite of each other in equal amounts; they are “negatively correlated”.