Can you ever have too much of a good thing?
Yes – doughnut holes. Once you have more than 10, you run out of fingers to put them on. Somehow they don’t taste as good after that…
What about cash flow? Can you ever have too much money flowing into your bank account?
This is what dividend stock investors are chasing. Allow me to set the record straight – there is a better way.
The Appeal of Dividend Paying Stocks
First, what is a dividend stock? It is one that actually pays it’s shareholders a fraction of the profits each year. What a novel concept!
Let’s imagine a company – Beagle Inc. Their shares cost $100 each and you buy one.
Beagle is a great company that turns a profit every year. However, they aren’t in an industry where reinvesting the profits back into the company will produce even better results in the long run. So rather than scaling up, they decide to pay a portion of the profits as a dividend to the share holders. Typically this runs in the 2 to 3 percent range per year.
So at the end of the year, your 1 share of Beagle Inc pays you $2.
Not bad! Most dividend investors will reinvest this back into the company or dividend index fund (yes, you can group together tons of companies that pay dividends) to purchase another fraction of a share (in this case 1/50th).
The following year you own 1.02 shares and earn a larger dividend payout. Fast forward a couple decades and with the power of compound interest, you receive larger and larger payments.
Over time investors hope that the stock price rises, the dividend payments slowly increase, and you can start a snowball effect by constantly reinvesting the dividends in new shares.
What’s not to love?
It Could Be Better…
Companies that pay dividends are not going to experience hyper growth. They are usually well established with predictable profit margins. If they saw the opportunity to reinvest their profits to take on a new market, they would.
Therefore, much of the growth of the stock price and dividend payments will be due to inflation. Meaning, if a company like AT&T experiences profit growth, it likely isn’t because they launched some new-fangled product. It’s because as inflation happens, they slowly keep raising prices.
So you have an investment that keeps up with inflation, pays a bit of a cash flow that you can reinvest, and allows you to start a snowball effect of compound interest. Sounds like investing in rental properties!
Rental properties have four advantages though that make them more appealing than dividend stocks.
1. Better Dividends
Most dividend paying stocks will pay out 2 or 3 percent of the share price per year. Of course there are outliers, but they are riskier. You used to be able to get around 5% a year, but that was likely due to times with higher inflation.
How does that compare to rental property investing? Pretty pathetic.
I’ve been earning about 9% cash return per year on my rental properties. This might be a little higher than longer term projections, but it shouldn’t be hard to get above 6% per year.
This is due in large part to #2 and #3.
2. Better Financing
You don’t have to buy a rental property with all cash! You only have to put down 20% of the value of the property and a bank will loan you the rest at a very attractive interest rate. Well, choosing a rental property that can generate good revenue can be a difficult task. This might be the reason why many of the real estate investors tend to hire agents (similar to realtors Lynchburg) who can filter the search process and find good rental properties for them to buy.
That said, what about Stocks? Almost everyone pays the full price up front. You can technically buy on margin, but even then you need 50% and at any point they can decide they want their money back.
With rental properties you lock in that financing for 30 years.
Most investors don’t understand the power of leverage. A stable rental property in a boring, low-cost city with plenty of jobs will keep up with inflation. Combine that with smart leverage and instead of your investment just keeping up with inflation, you are raking in the big bucks.
3. Better Taxes
Dividend income you have to pay taxes on, even if you immediately reinvest it in more shares. By default this is treated as ordinary income, which means substantial taxes.
However the IRS treats certain dividend investments as qualified dividends. If it’s a US company and you’ve own the shares for at least 60 days, you can usually pay the capital gains rate on those dividends. For me that would mean 15% federal. For the ultra-richies it is 20%.
That’s a pretty nice tax advantage for dividends. But can rental properties top it?
Well, ya! Unfortunately, there isn’t just one number that I can quote you it varies. You get to deduct “phantom expenses” like depreciation. This means you didn’t actually have to pay anything out of your pocket that year, but still get to act as you did on your tax returns. However, make sure to have a separate account for these transactions, so you would be aware of the tax or dividend returns you are getting. If unsure, you can take a look at this list of Best Business Checking Account – Our Top 6 Picks for 2022. It would likely give you an idea about the types of business accounts available for enterprises and you can pick the one best suited for your requirements. This way, you could also find a way to save your taxes.
Moreover, with depreciation alone, most of your cash flow will be tax free! I go into this more in Behind the Numbers – How I Calculated the Return on My Rental Properties.
4. More Control
When you buy a share of stock, you joins millions of other shareholders. Occasionally there might be a shareholder vote, but I think it is safe to say you have zero control.
What if the company decides to go invest heavily in some new market or pay the CEO a $100M bonus? Your only option is to sell your shares.
As a direct investor in rental properties, you run the show. You can reinvest the cash flow, just as you would with dividends, but there are also many more knobs and levers you can use.
One powerful strategy is the cash out refinance – over the years as you build up equity, you can refinance your loan to access the equity tax-free. That’s right, you can receive tens of thousands of dollars, pay zero dollars in tax, and reinvest it in another property (or any other way for that matter). Wow.
You can also “trade up” – selling your property, paying zero in taxes with a 1031 exchange and buying a duplex, four-plex, or apartment building. This is certainly something 1031 exchange brokers can help with!
Maybe remodeling the kitchen would allow you to charge higher rents… think something like that would be possible in dividend investing?
Rentals vs. Dividends
Both are chasing the same thing – cash flow. Yield. Dividends. Whatever you want to call it.
Both allow for the snowball effect of compound interest, which over the course of decades is extremely powerful.
Both are largely dependent upon inflation for growth in the underlying asset, as well as for the cash flow to increase.
But with these four advantages, rental properties clearly win.
What do you think? Should dividend investors consider switching to investing in rental properties?
I like both rentals and dividend paying stocks. I think both have advantages and disadvantages; one of the advantages of dividend paying stocks is the lower barrier of entry. For a $100,000 house you would need at least 20% down to finance it, or maybe more if it’s an investment property. Compare that to a few thousand buying Johnson and Johnson. You also don’t have to worry about bad tenants, maintenance, vacancies or lawsuits…. With stocks, you just sit back and enjoy the quarterly dividends.
That said, I agree that the returns are better with real estate. I examined my tax returns for 2015, and one of my rentals loses a couple of hundred every month, while the others make over 300 a month in cash flow. The net result is positive cash flow for all my rentals, but combined with this “monthly loser” property and depreciation of all the other properties, I paid zero in tax for all my rentals. Wow. I know in the future it may not be this good, because the depreciation schedule will eventually run out, but you make a very good point in upgrading via the 1031 exchange, or getting a cash out refinance to get tax-free money out of the property.
In the end, I use both dividend paying stocks and real estate to generate passive income. I think it’s important to diversify the passive income streams.
Wow, sounds like you are doing really well with your rentals! I don’t think it makes sense to hold on to a property when the deprecation schedule runs out when you can do a 1031 exchange with a little effort.
With stocks you don’t worry about the lawsuits, but they definitely happen and hurt your returns! With rentals it is highly unlikely you will encounter lawsuits, but you do have to be more hands on.
More passive income streams is the key: https://rentalmindset.com/financial-freedom-requires-cash-flow/
I think I’m using the same turnkey provider as you in Memphis. I read one of your posts and it’s uncannily similar; the tenant moved out in the winter after a one year lease, and the rehab costs were expensive…. Nothing major, but they had a markup on little things here and there.
Needless to say, once they finally got the tenant with a 2-year lease this time and an automatic rent increase after year one, they kept the first month’s rent as a finder’s fee. I was still out for that month and a half in rent payments, not to mention the $$ I had to shell out for the rehab, because I live out of state; like on the west coast.
I’m sort of torn in the middle regarding rentals vs. dividend paying stocks. I think both have a place in the passive income portfolio. Great blog btw, I’ll continue to be a subscriber.
The short term definitely has it’s struggles with small frustrations and expenses that hurt the cash flow. But when looking at it all together (appreciation, leverage, tax savings, mortgage pay down), I am betting my money it pays off much better in the long term. Just have to weather some of these short term difficulties!
My tax advisor has been pushing me to get into rental properties for years. I’ve stayed away because of liquidity concerns as well as the management issues.
But lately I’ve been looking at diversifying our portfolio away from the stocks, bonds, and international stocks we currently hold into real estate and dividend stocks.
Do you have any experience buying real estate using funds in an IRA?
Definitely not the most liquid of investments, but that helps keep others away. Hopefully a portion of your portfolio doesn’t need to be as liquid.
I don’t have any experience with real estate in an IRA, but know it is possible. I think it would defeat the purpose of a lot of the tax breaks you normally get in real estate (like the depreciation your tax advisor wants). So I think it makes more sense to outside of the IRA.
I’m a bit torn about this. I agree that you can have some serious cash flow with the right rental property and good tenants. As I’m looking to simplify things though, increasing dividend and REIT investments doesn’t sound like a bad idea. At the same time, I like having diversified cash flows. In the end, I’ll probably keep things as is.
I think if more people sat down to calculate the 4 or 5 different components of return from rental properties, they will find it worth the effort! Most people only think about 1 component at a time, like the cash flow. Yes the cash flow might be equal to what you get in a REIT, but there are other components of rental property return. I wrote more about the return expected from each here: https://rentalmindset.com/the-impressive-returns-of-remote-rental-property-investing/
Of course, not everyone has the right temperament for it…
Thanks for reading!
Good post.
Everyone can just do both like I do. Own rentals for income, and index the market for growth!
Definitely can do both and diversify. I think rentals have more potential for growth that index funds though, so that is the majority of my holdings.
I wish people would realize that their gain when using rentals for increased income … Is in fact the renter’s loss. Investment in rentals that already exist as rentals is driving up costs for both real estate and rental costs. Especially now that people are literally selling shares in rental income properties.
People who rent have to live somewhere, and where I am that somewhere is becoming larger and larger tent cities.
Have a heart while you make money. Please.
It is important to be a responsible landlord and be responsive to tenants. Ideally you are building a partnership with them where they have a home they can stay in for years, something they wouldn’t be able to afford to buy on their own.
I’m not sure I buy the argument of driving up the price with more people investing in rentals. Yes, the asset price may go up, but the rental price would go down if anything. More options out there, tenants have the power to move.
On the asset price – I think making it easy to invest in rentals is a good thing for the middle class. They can invest in these, access cheap leverage that only the huge banks usually have access to. However, jumping from lower class to middle class is still tough.
How do you factor in property taxes and insurance into all this? I currently have a partially mortgage free house looking at selling our renting. Currently have a HELOC which will be cover by post of the rent. Anyway, property taxes and insurance are a big chunk that gets eaten away. Hope do you account for that?
Subtraction. You just have to subtract all the expenses from the amount received.
Is it a big chunk? Not really for my properties in low-cost areas. Of the income received, insurance is about 5%, taxes 8-20% (depending on the property), management 10%.