Financial
advisors have long touted the 60/40 portfolio as the silver bullet to managing
retirees’ portfolios. By investing 60%
of investable assets in stocks and 40% in bonds, historically, this portfolio
construction has achieved diversification, volatility reduction, and solid
appreciation. The ultimate goal, of
course, is ensuring said portfolio will provide for an enjoyable lifestyle, and
funds will not run dry prior to death.
Falling interest rates make bond prices rise and bond yields decline, as rates and
prices are inversely related. For the
last 40 years this scenario has been the reality, leading bond values to rise
as rates have plummeted.
However, just
because something has worked in the past, does not guarantee it will continue
to work in the future. Although traders can beat bond indices through duration
and credit bets, the majority of bond holders are passive investors, receiving
coupon payments while holding until maturity.
Loose monetary
policy over the last decade plus, as part of the financial crisis recovery
plan, has proven difficult to unwind without financial calamity. COVID-19 further complicated the situation,
as central bankers provided unprecedented, additional liquidity to markets,
while lowering the federal funds rate again, in an effort to stave off a major
recession or depression. This has led to
a very difficult environment for fixed-income investors, who rely on risk-off
investments to balance their retirement portfolios and pay income, i.e. bond
investors. At the time of this writing,
the 10-year treasury is yielding 1.3%, considered the “risk-free rate of
return.”
With all the
money flooding into the economy, inflation has begun to appear. And
this is not just asset price inflation, but consumer goods and services are
trending towards higher prices. Even if
the Fed calls inflation “transitory” due to supply/demand imbalances created by
the COVID-19 shutdown and subsequently, they are not forced to raise rates, it
is prudent to predict interest rates are not headed lower. When interest rates begin to normalize (i.e.
rise), bond prices will fall, while yields on new issue bonds will still have a
long way to go before they pay income worth considering for most investors.
What’s a
fixed-income investor to do? One
alternative solution is investing in private real estate offerings, otherwise
known as real estate
syndications, as a passive investor.
Bonds play four
primary roles in portfolio construction – income generation, capital
preservation, appreciation opportunity, and a hedge against an economic
slowdown. I’ll show how investing
passively in real estate syndications can meet these same objectives and
outperform bonds in our current economy.
Income
Income
generating investments that create cash flow become top of mind when paychecks cease to exist after
retiring. It is more palatable to take
longer-term, risk-on bets that offer higher appreciation opportunities, when
you have a long runway of working years left – but not after the paychecks
stop.
As noted
previously, the risk-free rate of return (the 10-year treasury) is currently
yielding just 1.3%. Corporate and
municipal bonds will pay more, but it will be a struggle to find anything
investment grade above 3% unless you look out 30 years. Junk bonds pay slightly higher, but the yield
spread between investment grade bonds and junk bonds makes the risk-reward
unattractive due to much higher credit risk.
Alternatively, real estate
syndications offer preferred returns in
the 7-9% range, typically paid monthly or quarterly. You can invest in industrial, multifamily, self-storage
facilities, mobile home
parks, hotels, retail, office, ATM machines, and an array of other classes of property. And you won’t have to wait 30 years for
maturity, as most offerings aim to return capital to their investors in 5-7
years.
With May’s
inflation data showing that the CPI rose ~5%, bonds are producing a negative
real rate of return. By holding them,
you’re losing purchasing power as time goes by.
Capital Preservation
The primary
goal of a retiree, before achieving any capital appreciation, is preservation
of principal. After all, who wants to
take heavy losses after the paychecks stop coming in, only to find themselves
forced to go back into the workforce.
Inflation is
causing the devaluation of the dollar, leading investors to look for a “store of value” for their
money. Gold has often served this role
in a portfolio. However, gold doesn’t
meet one of the primary objectives of bonds, as it pays no income.
By investing in
a real estate
syndication as a passive investor, you
now own a piece of a “hard asset” – one that has scarcity in good locations
with high demand and low supply.
Scarcity and demand ensure that your real estate investment will hold
its value and more than likely lead to appreciation.
Appreciation
Real estate has
outperformed over the last decade, offering 10%+ cash-on-cash returns and 20%+
internal rate of return (IRR) for massive annualized gains in many deals. With the benefit of leverage and tax incentives only available
to real estate, returns are amplified.
When considering the paltry income bonds pay, it’s no wonder capital has
made its way into real estate, compressing cap rates and yield spreads.
Although it
can’t be guaranteed that this level of performance will continue, real estate
is positioned well to continue to outperform.
Why? Here it is again – Inflation. Rents have been rising
faster than inflation for years, and have recently begun to accelerate again
after taking a breather in 2020. Since
commercial properties and apartments are valued based on the income they
produce, rising rents make property values rise. True rent growth (lease-over-lease) jumped
11.1% in June year-over-year in the US downtown apartment space in 2021. While this data doesn’t account for
concessions made to tenants during the COVID-19 shutdown, it is a good
indicator that rents are rising faster than inflation, thus increasing
valuations.
On the other
hand, bonds are likely to depreciate, losing investor principal in the
near-term. With interest rates at their
lowest levels in history, a reversal to the norm would send bond prices
plummeting.
Hedge Against Economic Slowdown
Bonds have
historically done well when stocks have done poorly, protecting investors by
reducing portfolio volatility through asset
diversification. In challenging environments, stocks tend to
waiver, leading the Fed to cut rates to provide a spark to the economy. Lowering interest rates has led to
appreciation of bonds, and a negative correlation with stocks. As discussed, this is unlikely to
continue.
Investing in
real estate syndications as a passive investor can fill the void left by
bonds. Private real
estate offerings are illiquid, have higher
transactions costs, and have fewer prospective buyers and sellers as compared
to public markets. While this doesn’t
sound favorable initially, it is actually one of the main reasons these types
of investments are less correlated with the stock market and perform well
during economic slowdowns.
Because the
assets held by real estate syndications are traded at a far lower frequency,
and have a less efficient market, there is very little change in their values
day-to-day in comparison to publicly traded investments, like stocks or even REITs.
One caveat to
consider prior to investing is your liquidity needs, as real estate
syndications are best for investors who don’t need access to their principal
for 5-7 years.
Conclusion
Bonds are dead,
and with them, the traditional 60/40 portfolio – at least in the short- to
medium-term for the average investor, anyways.
I personally won’t be buying any bonds until the 10-year is above 2.5%.
Retirees need to look elsewhere for a large chunk of their portfolios to fill
the void left by bonds.
While investing passively in private real estate syndications isn’t the only option, it’s a very good one. It is certainly worth considering for those who are seeking retirement income and diversification through an inflation-protected, hard asset with tax advantages.
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
