The investment debate concerning real estate vs bonds isn’t exactly a fair fight these days.
As of 5/2/14, the US 10 year Treasury is yielding 2.6%, whereas average real estate cap rates (essentially an unlevered yield) range from 4.5% to 7.5% depending on the market and asset type.
As these are average cap rates, some real estate markets and product types off investors even higher returns – the markets we’re buying in consistently offer 8-11% unlevered yields.
Many would argue that real estate’s current return premium is justified due to the increased risk profile of real estate. Let’s explore that assertion.
Bonds – Risk Free / Return Fee Returns
Academics and investment professionals deem the current paltry US treasury yield as the “risk free” rate. Of course, this isn’t entirely accurate. While the Government can raise taxes and print money to pay its bills, it’s not an absolute certainty that the Government will never default on its debt holdings (its bonds).
While I believe it’s highly unlikely to occur anytime soon, empires do fall and usually it’s due to balance sheet problems. 16th Century Spain, pre-revolutionary France and the Ottoman Empire were all crushed by debt. Spain was arguable the world’s first superpower, with an unrivaled Armada and an unwieldy, expensive empire that defaulted on its debt no less than 14 times in roughly 150 years.
Furthermore, in today’s artificially low interest rate environment, long duration bonds (especially bond funds) actually appear quite risky. Interest rates only have one way to go from their current basement levels. When interest rates eventually revert to their historical mean, bond prices will decline. While direct bondholders can avoid principal losses by holding their bonds through maturity, it’s unlikely those dollars will have the same purchasing power as when those bonds were purchased.
Inflation via Printing Press – Implicit, “Sneaky” Default
In case you weren’t aware, the US government is addicted to debt.
Our National debt is now over $17.5 trillion. How do we dig ourselves out of this wealth sucking black hole? Every American family knows the most conservative approach to reducing debt is through austerity measures that curtail discretionary spending.
In other words, tighten the belt and stop blowing cash on stuff you don’t need. However, it appears that US politicians have neither the fortitude nor the politically capital to address necessary but difficult entitlement reforms.
Perhaps avoiding spending cuts was the right move (austerity measures have prolonged the recovery in many countries), only time will tell. But if we’re going to ignore the balance sheet, the only other alternative is to slowly devalue our currency. This is precisely what the Fed is doing by purchasing massive amounts of new bond issuances (quantitative easing) and keeping the federal funds rate at near 0% for an unprecedented period of time. These measures have all but assured future inflation.
The devaluing of US currency will combat the government’s massive debt problem by reducing the real value of US nominal debt, which is a clever way to default on current debt obligations as the Government can pay back bond holders with “cheaper” money. This is just a subtle way to renege on our national debt as it avoids the panic associated with the following newspaper headline, “US Defaults on Debt For First Time in History, Confidence and Stock Market Collapses”.
So, in summary, bonds currently offer investors:
- Meager yields (likely negative real returns)
- Heightened probability of principal loss (if interest rates rise and bonds are not held to maturity);
- Zero inflation protection (excluding TIPS, which currently offer near zero yield);
- A chance to lend even more money to your Uncle with the crazy addition to credit cards, you know… Uncle Sam. I’m not a rehab expert, but continuing to bail him out with additional loans so he can pay the interest on his debt (hello Ponzi scheme) isn’t going to encourage him to change his profligate ways.
Alternatively, you can invest directly in real estate, which offers investors significantly higher returns and a strong inflation hedge.
Real Estate’s Inflationary Advantages
According to a recent study commissioned by TIAA-CREF, commercial real estate returns have beaten inflation over 5 year holding periods with 84% probability1. The study also confirmed that, over the short term, commercial real estate returns are moderately correlated (.38) with inflation while the 10 year Treasury is negatively correlated (-.29) with inflation.
Therefore, while not perfectly correlated, real estate helps hedge an investor’s portfolio against inflation.
The following structural advantages enable real estate to outperform other asset classes during inflationary periods:
- Rents increase with along with inflation. Operating expenses increase as well, but if a property holds its operating margin, net income will increase.
- Fixed debt payments do not increase with inflation. It’s good to be a net borrower when inflation rears its ugly head.
- Increased construction costs increase real estate replacement (development) costs, which reduces new competition and supports higher valuations.
- Many investors that do not own real estate are nonetheless aware of its ability to mitigate the effects of inflation. Consequently, when inflation starts to take hold, new buyers help support real estate valuations.
On the negative side, inflation should lead to higher interest rates, which (while not perfectly correlated) will likely lead to higher cap rates. However, as mentioned, the property’s higher NOI could offset or even over-compensate for this impact.
Couple these advantages with real estate’s forced principal pay down and incredible tax benefits (depreciation, interest deduction, 1031 exchanges) and its pretty much throw in the towel time for bonds. While bonds will always have a place in diversified investment portfolios.
I believe investors that need capital appreciation and current income from their portfolios should allocate more funds to direct real estate over bonds.
Personally, my investment portfolio will always be overweight direct real holdings and underweight fixed income, as I trust my ability to make sound real estate investments over the Federal Reserve’s ability to control inflation.