Stocks or real estate: where should I invest as a business owner?

In this week’s blog, I want to talk about investment strategies for business owners. Specifically, I want to review the benefits of investing in stocks and real estate.

Is one a stronger strategy than the other? Or is a combination of both a better approach?

By now, you know that Dri Financial Group specializes in wealth management for business owners so, what we’re about to review will be a compilation of insights designed for those who either own a business or are an incorporated professional.

Let’s dive in.

Long time readers of this blog know that I believe that financial independence is crucial for living your best life.

In my book Live Well, Stay Rich, Never Retire, I say, “When buried under a mountain of financial concerns and stresses, we cannot be the best person we hope to be.”

Financial independence clears the mind and allows us to focus on becoming a better person: a more attentive parent, a more loving spouse, a more caring friend, or a wiser business owner.

For me, the result of having built a successful business is not to accumulate as much money as possible. It’s to accumulate enough money that I can stop worrying about money and start focusing on who I want to become.

How much money do I need to be financially independent? Based on my research, I consider myself financially independent once my investment income equals my lifestyle expenses.

For example, if my lifestyle requirements are $100,000 per year and I assume my investments will generate 4% of passive income, then I am financially independent when I have saved $2.5M. My historical research indicates that a 4% withdrawal rate on a portfolio of $2.5M will produce the required income for 30+ years.

So when you have attained a portfolio of $2.5M, does that mean you should retire?

NO WAY. The next step is to develop ways for your business to become what Dan Sullivan calls a “self-managing company.”

As the owner, this is when you can focus your time only on the business projects within your unique abilities and delegate everything else to people with unique abilities in other areas.

In this article, I will compare two main investment vehicles—real estate and stocks—that may be used to generate all or some of the passive income required to replace your business income.

Let me restate my investment goal: to accumulate income producing assets that generate a reliable stream of growing income until my passive income can comfortably replace my business income. At that point, I consider myself financially independent.

So to reach that point, let’s consider the following comparisons between real estate and stock ownership as tools to achieve financial independence as a business owner.

1) Generating profit from business ownership vs owning a rental property.

Many real estate investors consider stock investing as owning a piece of paper (a stock certificate) compared to owning a real tangible building that you can touch with your hands.

However, real estate investors must understand that stock ownership is actually ownership in an underlying business.

For example, if I own shares in Metro, I am a part owner of the business and my investment increases in value when the business does well, and vice versa. As a shareholder, I am able to vote on major business issues, but the day-to-day running of the company is delegated to the management team that reports to the board of directors.

In both cases, investors own either a rental property or part of a publicly traded business.

This argument is a TIE.

2) Generating passive income.

With a history of increasing dividends annually (or almost annually), and my investment models help identify which stocks to buy and when a stock should be sold. By following the model’s buy, sell and trim up/down signals, I reduce my time commitment with my stocks.

Remember, the day-to-day management of the business is not my responsibility. But I do monitor the business’s progress each quarter by reviewing quarterly financial statements.

A rental property requires managing day-to-day issues, such as tenant complaints, maintenance, rental issues, bylaws, insurance risks, and more. Unless a real estate investor hires a property manager, the daily management is usually the responsibility of the busy business owner. If we assume that the business owner’s time is very tight, then they may have trouble allocating sufficient time to the property management role.

This argument goes to STOCKS.

3) Generating income and capital.

Many people fail to appreciate that a gain from a stock or a rental property comes from two separate components: the income portion and capital gains portion.

For example, when you invest in a rental property, you receive rental income (after expenses) plus a potential property increase (generally, price increases equal to the rate of inflation). When you invest in a dividend stock, you receive dividend income plus a potential stock appreciation (generally, increases by the same rate as the dividend increase).

Both investment vehicles offer both parts of the total gain, but from my experience, a real estate investor has more influence over rental increases than over dividend increases. Rental increases may be connected to building improvements or improving the tenant profile, and both may be influenced by the owner. In contrast, dividend increases are voted on and approved by the board of directors of the company and, generally, the board takes its cues from the CFO, not the investors.

This argument goes to REAL ESTATE.

4) Tax advantages.

When stocks or rental real estate change in value, the gain/loss is deferred until the investment is sold and, once sold, it generally qualifies as a capital gain/loss (some exceptions apply). So the tax treatment on the capital gain/loss is the same for both investment vehicles.

Real estate investors will claim that net rental income may be offset by depreciation (capital cost allowance (CCA) for tax purposes), thereby generating a lower taxable income after claiming the CCA. But a stock investor will state that dividend income is favourably treated in the tax act because of the dividend tax credit (which offsets the investor’s tax by the tax paid at the corporate level on the same income).

When you sell the property, you may be required to recapture your previously claimed CCA as income. The recapture happens when the sale proceeds exceed the undepreciated capital cost.

This argument is TIE (with perhaps a slight advantage to stocks because of the dividend tax credit).

5) The ability to use leverage.

Real estate investors often boast about the leverage that is available from rental properties. But leverage exists with both real estate and stocks.

For example, a bank may lend up to 70% of the value of the property (some exceptions exist), with the investor contributing the remaining 30%.

A real estate investor will point out that their investment didn’t make 30% ($300,000/$1M), but rather their cash on cash return was actually 100% ($300,000 invested and $600,000 was returned when the property was sold). I would agree with their statement.

I would advise real estate investors that the same example of leverage also applies to dividend paying stocks.

So, go back to the chart, and change “rental property” to the name of the stock you have selected and change net rental income to net dividend income.

Leverage works for both investment vehicles.

This argument is a TIE.

6) Liquidity.

Stock investors often indicate that most stocks may be sold as needed (including a partial sale), but real estate can take months to sell and cannot be sold in portions: the entire building must be sold or not.

From my experience, the ability to sell quickly is not an investment advantage and causes stock investors to be influenced by their emotions, biases and market sentiment. This often leads to selling at the bottom of cycles or buying at the top of cycles.

I appreciate liquidity in my investment portfolio, so I don’t recommend that the entire portfolio is invested in illiquid investments such as real estate.

This argument goes to STOCKS.

7) Dividend yields compared to rental yields.

If you live in Toronto and are thinking of buying a rental building in the GTA, be prepared to find heavy competition from other potential buyers, causing selling prices to usually exceed the asking price and creating low cash on cash yields.

For example, in the current market, if a real estate investor bought a $1M rental property in the GTA, the net rental income (before interest cost) could be as low as $20,000 to $25,000 per year, hence the yield is approximately 2%-2.5%. Real estate investors may find a higher net rental yield if they search outside the Toronto area. The areas around Hamilton, Kitchener, St. Catharines or Kingston may offer yields closer to 3-5%.

However, the further from home, the more likely the investor will not be able to personally manage the property, and the need for a property manager lowers the yield.

Today, a stock investor has many opportunities to buy companies that yield a +5% dividend. For example, as I write this blog, Enbridge pays a 8.7% dividend, Power Financial pays 6.8%, Bank of Nova Scotia pays 6.4%, Canadian Utilities pays 5.6%, and AT&T pays 7.6% (just to name a few).[1]

In addition, active stock investors with a positive cash flow may capitalize on market drops (such as March 2020) and add to existing positions, thereby increasing the average dividend yield.

This argument goes to STOCKS.

Overall, my analysis shows three ties, two wins for real estate and two wins for stocks.

Obviously, the study does not cover every possible difference between the two, but I suggest investors consider including real estate and dividend stocks to form a diversified investment portfolio.

In my investment plan, I have both rental income and dividend paying stocks. Together, they generate approximately 4% annual income and will eventually replace my salary and become my main source of income.

If you have any questions about dividend stocks or wish to discuss whether you should enter the rental market, please give me a call or email me anytime: richard.dri@scotiawealth.com.

So with all things considered, what investment strategy is your favourite? Stocks or real estate?

[1] Current yields indicated are as of November 19,2020

Never Retire Profile

Judi Dench

Unless you follow British theatre and television—such as the two wildly successful series A Fine Romance and As Time Goes By—you may have first come across Dame Judi Dench when she debuted her role as M, the Head of MI6, in 1995’s GoldenEye. Or it may have been in 1999, when Dench won an Academy Award for her supporting role in Shakespeare in Love. Already 61-years-old when she appeared in the Bond franchise, Dench had by that time become Officer of the Order of the British Empire (OBE) and Dame Commander of the Order of the British Empire (DBE). Since then, she has appeared in dozens more stage and film productions, continued to be a patron of over 180 charities, and even makes it onto “best dressed” lists. Recently, Dench has said, “It drives me absolutely spare when people say, ‘Are you going to retire? Isn’t it time you put your feet up?’”

The process of finding a financial advisor can be overwhelming. It is our job to make that process simpler and easier. Dri Financial Group’s proprietary Wealth Navigator Process is designed with you in mind. Its structured framework helps you make an informed decision and feel confident in our team and management practices before we get started.

We offer you a range of services from creating bespoke financial plans and providing investment advice to helping you take advantage of our investment models. If you would like more information on the Wealth Navigator Process or our team, call me any time at 416.355.6370 or email me at richard.dri@scotiawealth.com.
—
Beyond helping you manage your finances, we take pride in motivating, educating and helping you expand your financial literacy. We are here to answer any questions you have and to help you feel in control of your financial destiny.

If you are ready to dive deeper into your financial literacy journey, we have a wide range of free tools and educational resources available.