We have several clients who use cash flow as the indicator of successful wealth building. I will admit, it does feel good to “clip coupons” and deposit the checks in the bank. Investors who value this metric tend to gravitate to real estate investments because it can generate rents. Real estate is also perceived as “safe” compared to stocks with their more profound price fluctuations. However, to some degree, this perception is often based on real estate market values being hidden from view due to illiquidity, not the fact that the prices are inherently stable. Stability is further in doubt when you consider that most real estate investments are levered. Stock market prices are surely volatile and are priced by the second. However, I would bet an exercise of polling passersby as to what they would pay for your strip center across the street would have far wider and more volatile pricing than even stocks. The fact that this price variability is hidden does not make it less volatile, just less known. Borrowed money can also enhance real estate returns to make them competitive with stocks, but negates the argument that real estate is safer.

People harken back to the stock market crash of 1929 as the type of event that real estate avoids, but real estate has its own meltdown corollary that I will identify with four numbers and three letters as counterpoint: 1990 RTC. The Resolution Trust Corporation was set up to clean up the mess of the S&L meltdown 35 years ago. This was a 1929-scale event for real estate and wiped out many investors. Some will say that their real estate is “paid for” and therefore less risky. Sure, but that reduces the return to more of a fixed-interest bond-like comparison, not stocks. Now, don’t get me wrong, I like real estate, and it can certainly be said that legendary fortunes have been made in the space, but most of those have involved borrowed money.

My goal is not to convince people that investing in real estate is a bad idea. Rather, to highlight that a 15% return in real estate is typically inferior to a 9% return in stocks. There are two reasons why real estate returns and stock returns cannot be considered apples to apples. First, rents have nearly twice the tax rate of qualified stock dividends, which are tax-capped at 23.8%. Secondly, since cash flow tends to make up a larger portion of total return for real estate than it does for stocks, tax payments, which are due as you go along, have a significant negative bearing on long-term compounding. If you hold an asset for a lifetime, the one that generated the least cash flow is the best performer, all other things equal. This would argue for low-dividend-paying stocks as the best long-term compounder due primarily to tax drag on current cash flow which could have been tax-free if redirected to the balance sheet rather than distributed. This is what makes Berkshire Hathaway such a superior compounder of wealth because Warren Buffet designed it deliberately to avoid taxes on distributions.

Because of the step-up in basis rule, which can apply to both stock and real estate if held for a lifetime, current cash flow scenarios (think real estate, annuities, and bonds) tend to trail other choices. Under some circumstances, real estate transactions qualify for 1031 tax-free exchange, but investing in a rental income or a mezzanine development fund generates current cash flow with high tax friction. The repeating tax friction year after year retards long-term wealth building. Some will say that real estate also has the tax benefits of current depreciation. Yet, that must be recaptured as taxable upon sale. High current cash flow makes sense for the insurance industry, and that explains why they own vast swaths of strip centers, office buildings, and apartments. But for very wealthy people who don’t spend all the cash flow, and instead use it as mental reassurance that they are receiving something tangible, it is worth evaluating with a sharper

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