For a moment, consider the following thought exercise: Assume that an investor has $50,000 in capital that he or she needs to deploy, but this person can only invest in one of the following asset classes: stocks, bonds, or commercial real estate. In order to make such a decision, the investor must consider the relative merits of each.
In this article, we define stocks, bonds, and commercial real estate, explain the pros and cons of investing in each, and discuss historic returns.
Stocks, Bonds, and Commercial Real Estate Defined
To make the most informed investment choice possible, it is necessary to begin by defining exactly what the stock, bond, and commercial real estate asset classes are.
What are Stocks?
In order to raise capital for their business operations, many corporations elect to sell shares of stock to investors. In return for their money, investors are entitled to a small percentage of ownership in the company equivalent to the number of shares that they purchase. If the company uses the funds wisely and invests in profitable projects, the value of the shares rises over time.
Shares of stock in the largest corporations can be “publicly traded,” which means that they can be bought and sold by anyone on stock exchanges like the New York Stock Exchange or Nasdaq. The price of a publicly traded share of stock is driven by the company’s profitability, as well as by news or economic data that can affect the public’s perception of the company’s future profitability.
Stock investors can invest in the individual shares of a single company, such as Apple, or they can invest in a variety of sector-specific (for example, transportation) or index mutual funds and ETFs. For this reason, it can be difficult to cite a return for the “stock market” because this can vary widely depending on the investment choice. For the purposes of this article, the Vanguard S&P 500 Index Fund, which invests in 500 of the largest US companies, will be used as a proxy for stock market returns.
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 their required payments.
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, these funds could be used to build a new factory or launch a new product.
Bond investors also have a number of options from which to choose. They could invest in the individual bonds of a corporate or government issuer, or they could invest in a bond 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 Commercial Real Estate?
The term “Commercial Real Estate” or “CRE” refers to a class of real estate assets that are purchased with the intent to make a profit through cash flow, capital gains, or both. The basic premise behind a commercial real estate investment is that a property is purchased for a certain amount, and that purchase is financed with a combination of debt and equity. The space in the property is leased to other businesses, and the resulting rental income is used to pay operational expenses including taxes and insurance. If there is any money left over, it is distributed to equity investors at year end.
Commercial property investors also have a number of options. They can purchase a property directly, which is the equivalent of purchasing an individual bond; they can invest in a Real Estate Investment Trust (REIT), which is the equivalent of a stock or bond fund; or they can even invest with a private equity firm, which is a unique alternative investment arrangement. Like stocks and bonds, it can be difficult to identify a representative cross section of commercial real estate investments, but for comparison purposes, the Vanguard Real Estate Index Fund is used here.
Pros and Cons of Stocks, Bonds, & Commercial Real Estate Investments
Although all three of these asset classes have the potential to deliver a profitable return, they are very different investments.
Stock investors benefit from direct ownership in the company in which they have invested, which means that if the company is profitable, the value of their shares tends to rise. Publicly traded stocks have a high degree of liquidity and investors can gain a significant amount of diversification when investing in a mutual fund or index fund. Finally, a stock investment can be tremendously profitable. For example, a $100 investment in Netflix stock in 2000 would have been worth $23,171 by 2019.
However, a stock investment is not for the faint of heart. Prices can endure periods of tremendous volatility, which can lead to wide variances in annual returns, even if the long term trend is up. In addition, equity holders are last in line to receive a payout should a company go bankrupt. For these reasons, of the three options, stocks carry the highest risk/return profile.
Bond investors do not have direct ownership in the issuing entity, but they benefit from a stream of income produced by the interest payments on the face value of the bond. In addition, these investors may realize some tax benefits on certain bonds, and they enjoy the relative stability of bond prices. Finally, bond investors are ahead of equity investors in the capital stack, so if a company goes bankrupt, they have a greater chance of being repaid.
However, bond investments are subject to credit risk, meaning that they are only as good as a company’s ability to repay the debt. High-profile bankruptcies such as Enron and WorldCom offer painful reminders of this fact. Historically, bonds have offered lower risk, but also lower returns.
Commercial Real Estate Investments
In some ways, commercial real estate investors get the best of both stock and bond investments. They can benefit from the passive income and tax advantages (for example, depreciation) produced by the underlying properties (as with bonds), but they can also realize potentially significant capital gains (as with stocks). But a commercial real estate investment is also exposed to the credit risk associated with tenants making their required lease payments, and the market risk associated with interest rate fluctuations. In addition, a commercial real estate investment can be illiquid because the transaction costs are high and it can take a long time to implement a property-level investment strategy. In terms of its risk/return profile, commercial real estate as a whole tends to sit between stocks and bonds.
Historic Returns of Stocks, Bonds, & Commercial Real Estate
Again, it can be difficult to make a direct comparison between stocks, bonds, and commercial real estate as asset classes because they each offer such a wide variety of investment options. For the purpose of this article, returns from representative index funds are used as a proxy.
The Vanguard S&P 500 Index Fund, which represents the stock market in this comparison, has delivered an average annual return of 13.58% for the past 10 years. While this may seem impressive—and it is—it hides the fact that the returns have also been fairly volatile over the same time frame. In the worst year during this period, 2018, the return was -4.58% and in the best year, 2013, the return was 32.18%.
The Vanguard Total Bond Market Index Fund, which represents bond investments in this comparison, has delivered an average annual return of 3.59% for the past 10 years. And these returns have also been more stable than those seen in the stock market. In the worst year, 2013, the return was -2.15%, and in the best year, 2011, the return was 7.69%. It is also worth pointing out that the worst year for the bond fund was the same as the best year for the stock fund, highlighting the idea that stock and bond prices tend to move opposite of each other.
The Vanguard Real Estate Index Fund has delivered an average annual return of 8.50% for the past 10 years. In its worst year, 2018, the return was -5.95%, and in its best year, 2014, the return was 30.32%. Based on these returns, it can be seen that real estate investing sits somewhere between stocks and bonds from a risk/return perspective.
Based on average annual returns for the previous 10 years, it would appear that the stock market has delivered the highest returns. However, we try not to think of these options in terms of “which is best;” we prefer to think of them as “which is the best fit,” and that presents the final point of this article.
The Importance of Diversification and Product/Investor Fit
Each individual investor is unique—each is at a different place in life, and has different needs and objectives from their investment. Younger investors may have a longer time period for their investment and can afford to take more risk with their investments. Older investors may have a short-term time horizon and prioritize capital preservation and lower-risk opportunities as they approach retirement. For these reasons and more, we believe it is very important to learn about an investor’s risk tolerance, time horizon, return expectations, and liquidity needs before recommending a specific type of investment.
Further, we believe strongly in the power of portfolio diversification. This means allocating the contents of an investment portfolio among multiple asset classes to capture the unique risk/return profile of each, and to create a strong total return. For most, a broadly diversified portfolio of risk assets—one including stocks, bonds, and commercial real estate—is the very best option.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.