Passive income streams are a vital ingredient to achieving greater levels of financial independence and flexibility over the long run. Over many decades, investing in stocks and property have proven to be effective investment approaches for developing such passive income.
Investing in stocks (or equities) gives us the opportunity to grow passive income through a company’s dividend payments to shareholders. Many people achieve this through directly managing their own stock portfolio or through investing in dividend-paying funds such as Exchange-Traded Funds (ETFs). The level of diversification and associated costs will be different with either approach, but the principles are the same: investing in listed businesses to benefit from their growth and associated dividend payments.
Property investment allows us to benefit from renting a tangible asset to tenants, such as an apartment or house. How much you can earn annually as a percentage of value (the rental yield) varies by location and property type. For this comparison, I’ll focus my attention on residential property. Clearly there is a market for commercial property rental, but it’s likely to be less accessible to the everyday investor.
For the purposes of this comparison, I’ve focused on what I believe to be the most important areas of consideration: returns on investment, costs of investment, control and influence, risk and volatility, and liquidity. And with that, let’s get straight to it.
#1: Returns on investment
The below table summarises the typical returns that we see on property and equities. In the case of property, this is based on inflation-adjusted house price growth over the last 20 years in the UK and the average rental yield in the UK during 2018.
For equities, the dividend yield is based on the UK FTSE All-Share Index in 2019. It’s worth noting, however, that dividend levels have been settled around this level for a few years now, so this should provide a sound indication of future earnings potential.
For the growth in value of equities, 7% is widely regarded as the typical equity return over the long run, inclusive of dividends and after accounting for inflation. So the value appreciation figure in the table below is the balance of the returns to bring the total return to 7%.
So what does this data all mean in practice?
Well, as they carry higher risk, both equities and property compare favourably with holding a stash of money in the bank or investing in government bonds. In short, the data suggests a £200,000 investment would generate average annual income of £7,200 on property or £6,800 on stocks. And you’d see stronger capital appreciation on stocks than property over the long-term.
But that doesn’t really tell us the full story. Property yields can vary considerably by location. Higher prices in business districts have tended to bring down average rental yields, where prices have risen out of kilter with rental charges. Similarly, a dividend average assumes a highly diversified investment portfolio tracking an index. In reality, increased dividend returns can be attained through a bespoke investment approach, albeit at greater risk.
#2: Costs of investment
Investing in stocks and property for passive income also comes with associated costs that aren’t reflected in the above figures. Whether you’re self-managing a portfolio of stocks or investing in a managed fund, stock investment comes with fees. Of course, this cost is higher if your fund is being actively managed on your behalf by a financial provider.
Notwithstanding, the associated costs of managing property rentals is likely to be higher. Property rental comes with related costs like property tax, maintenance and insurance, and requires more hands-on management of a physical asset. In other words, if we take the average figures in the table at surface level, the yield on dividends is likely to outshoot the yield on property after these costs.
This is all assuming, of course, that we ignore the power of leverage in this equation. Now, I’m not an advocate of accumulating expensive debts. As I’ve argued before, debt can create a significant drag on net worth. But it’s worth considering for a moment that some of the cheap credit we have available can provide a significantly enhanced long-term risk-adjusted return on investment for buy-to-let property.
#3: Control and influence
Aside from accessing the full value of asset earlier, the beauty of property investment is that you call the shots as the owner. That means you decide how much to charge for rent and you decide what work to do on a property to add value as a rental or selling proposition. This power to influence returns is not something you’ll get in the world of stocks as an everyday investor.
That power of personal influence over returns comes with a bigger personal investment. Managing and finding tenants is not easy. And the stresses of renting out property are not for everyone.
But while property investment probably requires more maintenance as an investment, dividend investment doesn’t get you off the hook from this work. Fund managers need to regularly rebalance portfolios to optimise returns. You’ll need to maintain a keen eye on things to ensure your investment is performing as it should.
#4: Risk and volatility
Both property and stock investment are long-term passive income investments. If you treat them as short-term investments, unless you’re flipping property or time your entry fortunately, you risk unsatisfactory results.
Property and stocks generally exhibit a return profile strongly correlated with macroeconomic performance. That means property and stocks will benefit from an economic upturn, but it also means they generally take significant hits during economic downturns. That’s why if you’re investing for solid passive income and capital appreciation, they should be considered over a time horizon of 10-15 years.
But when it comes to pure volatility, stock returns are more volatile than property. First, in the face of an economic downturn, dividend yields move more than rental yields. Why? Because companies cut dividends when they need to support bottom line in tough economic times. Conversely, in the face of a recession, people still need places to live. And while rental demand may fall away a bit during a recession, the returns are much more stable than dividends.
Second, day-to-day value volatility is much higher for stocks. If you’re uncomfortable taking the long-term view and are instead inclined to watch your net worth jump up and down as the markets move each day, you’re unlikely to get on well with stock investment. Conversely, property values shift much more slowly as the pattern of supply and demand in the market changes.
And what about the longer-term risk to returns? Both investment approaches benefit from long-term economic growth. But property has a unique demand-side asymmetry. The population is growing with only a fixed amount of buildable land. That sustained demand provides even more support to the case for continued growth in house prices over the long run.
#5: Liquidity and accessibility
Property does not match up to the liquidity of equities, however. If your money is tied up in property, you can’t quickly access it when you need it. Stocks provide far greater liquidity. After all, so long as your stock investment isn’t tied up by some constraint (e.g. in a pension fund) you can sell them whenever you like.
There’s a strong case here. Being able to sell quickly means you can shift cash around your investment portfolio more efficiently to take advantage of opportunities. But there is a risk here too. As already mentioned, stocks should be considered a long-term investment. And unless you’re a skilled investor, in the short-term it’s hard work beating the market. So the risk of this liquidity is that it allows you to sell off quickly in fear. This can be financially precarious in a downturn and can lead to consolidating big losses.
On the other hand, selling on emotion is a lot harder with property. The process is longer and there is much less demand in a downturn. As a result, you’re more likely to be forced to hold the investment over a longer time horizon. Less selling flexibility can clearly be disadvantageous and advantageous. It means opportunities can be missed on the markets due to a lack of liquidity. But it can also act as a check on impulsivity and emotional investment.
What’s the upshot?
The consensus is that stocks, on average, offer a better overall long-term return. These returns vary based on levels of diversification, the type of investment vehicle, the location of investment and other investment-specific factors. But stock investment carries some greater risks and a lower level of personal control and influence than property investment. The general advice is therefore to invest for diversified sources of passive income.
And don’t underestimate the importance of the long-term view. Right now, things are slowing down on the market for both property and equities. Market ‘corrections’ and even recessions typically follow lengthy booms in both these investment classes. This is why a long-term view is so imperative for these passive income strategies.