Each individual investor is unique in the sense that each has his or her own individual return requirements, preferred asset classes, investment objectives (for example, income, capital gains, or both), liquidity needs, risk tolerance, and time horizons. An investor should weigh these individual needs carefully before making an investment choice. Compounding the decision, there is a wide variety of options that play to the individual needs of the investor. And two of these options are bonds and real estate properties.
In this article, we will explain what bonds and real estate are and compare the two as investments.
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Bonds & Real Estate Definitions
In order to make a thorough comparison between bond and real estate investment options, it is first necessary to define exactly what each of them are.
What are Bonds?
A bond is an instrument of debt between an issuer and a bond holder. In other words, it is a loan made by an investor to a bond issuer. In return for the loan, the issuer agrees to repay the principal amount (the face value), plus interest over a set period of time. Unlike stocks, bond holders have no ownership interest in the issuer, so they don’t necessarily benefit from the issuer’s growth—but they also don’t see much of an impact during a contraction phase, as long as the issuer has the funds to continue making the required payments.
Types of Bonds
Generally, bond issuers fall into two categories: governments and corporations. Government bonds, sometimes called Municipal Bonds, are issued by governmental organizations that use the funds to make investments in the community for things like roads, bridges, sewer systems, and parks. Government bonds are backed by the issuer’s ability to levy a tax and use the funds to repay the issuance. Corporate bonds are issued by corporations that use the funds to invest in projects or products that will increase their revenue. For example, corporate bonds could be used to fund the building of a new factory or the launch of a new product.
Benefits of Bonds as Investments
Bond holders benefit from the stream of income produced by the bond’s interest payments and from the lack of volatility in its price movements. The interest rate paid on a bond is directly related to the “credit risk” associated with the issuer. For example, a 10-Year United States Treasury Bill pays less than 1% interest because these bonds are backed by the full faith and credit of the United States government, which is very unlikely to default on its obligations. In contrast, the interest rate for a bond issued by Tesla, a high growth company, is around 5%, which reflects the increased risk of default relative to the government. Generally, bonds are considered to be on the lower end of the risk spectrum for investing. As a result, their returns also tend to be lower, but more stable and with smaller price fluctuations.
Bond investors have a number of options from which to choose when making an investment. They could choose the individual bonds of a corporate or government issuer, or they could invest in a mutual fund or ETF that contains many different types of bonds. For the purposes of this article, the Vanguard Total Bond Market Index Fund is used as a basis for comparison.
What is Real Estate?
Real estate and rental properties are physical assets that can be used to generate rental income, price appreciation, or, ideally, both. Generally, real estate investment opportunities fall into two major categories: residential real estate and commercial real estate.
Residential Real Estate Investments
Typically, a residential real estate investment involves the purchase of a rental property that contains fewer than five units; this could be a single family home up to a quadplex. These types of investment properties typically work well for entry level real estate investors as a means of producing cash flow. However, residential real estate investments are difficult to scale and may require devoting more time to property upkeep and repairs than initially imagined. For real estate investors seeking passive income, a commercial real estate investment may be a better option.
Commercial Real Estate Investments
Commercial real estate is a class of assets that, with the exception of multifamily properties, are leased to other businesses. This can include office, retail, industrial, and multifamily properties of greater than five units. A commercial investment allows investors to achieve greater scale and to magnify the tax benefits of real estate investing, like depreciation and 1031 Exchange deferrals.
But, commercial real estate investments are significantly more complex than their residential counterparts, and typically require a full-time property manager and a well-capitalized business plan. Like residential real estate, commercial property investors can purchase an asset directly, but this investment strategy is typically only available to the most well-funded individuals. Unlike with residential real estate investments, commercial investors have a number of other options like Real Estate Investment Trusts (REITs) and Private Equity investments that can provide all of the benefits of commercial real estate ownership without the time commitment and expertise needed to manage it.
In order to make a comparison between real estate and bond investment, the Case-Schiller Home Price Index is used as a proxy for residential real estate returns and the Vanguard Real Estate Index Fund is used as a proxy for commercial real estate returns.
Bonds vs. Real Estate: Which is a Better Type of Investment?
Because the bond and real estate markets, respectively, are so diverse, it can be difficult to make an accurate comparison between the two. However, for the purposes of this article, a well-known home price index is compared with returns for two mutual funds, the capital of which is deployed into a diverse basket of bond and commercial real estate investments. To compare similar time periods, only the last 10 years are reviewed.
The S&P CoreLogic Case-Shiller US National Home Price Index indicates an average annual gain of 4.60% for home prices. Here, it is important to note that residential real estate prices are highly variable from one market to another. High-growth markets like Orlando, Denver, and Charlotte have outpaced this average while stagnant markets have underperformed.
The Vanguard Total Bond Market Index Fund has delivered an average annual return of 3.48% before taxes over the past 10 years. Again, it is important to note that this is somewhat misleading, as certain segments of the corporate bond market may have outpaced this level while other segments of the government bond market may have underperformed.
The Vanguard Real Estate Index Fund has delivered an average annual return of 8.50% for the past 10 years. Certain segments of the CRE market—such as multifamily—have been strong over this time period, while others—such as Office—have not performed as well.
Using these three indices as a guide, it is clear that commercial real estate assets have delivered better returns than bonds and residential real estate have over the previous 10 years. But this doesn’t necessarily make it a “better” investment. CRE returns should be considered within the context of each investor’s individual needs and preferences. For example, if an investor’s main priority is capital preservation and income, then the relatively low-risk nature of a bond investment may be the best fit for his or her needs. Conversely, if the investor is comfortable with greater risk and an illiquid asset, a commercial real estate investment may be a better fit.
Before committing capital to any investment, individuals should consult their financial advisor, attorney, and/or CPA to ensure there is alignment with their investment goals.
Ultimately, we are strong believers in diversification and think that there is room for all of these assets in an investment portfolio. Because of the unique properties of each asset, bonds and real estate tend to mesh well to create a well-rounded portfolio that can deliver strong total returns over time.
Interested In Learning More?
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.