Investors looking for an alternative to stocks often turn their attention to bonds or real estate. Both asset classes are important pieces of a diversified portfolio, and both come with advantages and disadvantages.
Here’s a breakdown that will help you better understand the pros and cons of both types of investments.
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What is a fixed-income bond?
A bond is an instrument that promises to pay a fixed rate of interest. Bond investors lend money to the bond issuer for a defined period of time.
Common examples of bonds include government-issued debt from the federal government – the U.S. Treasury is a major borrower -- and from state and local governments.
Treasury bonds are a widely-held form of fixed-income debt backed by the federal government.
Municipal bonds are another category of fixed-income debt. These bonds are issued by state and local governments, often to finance infrastructure projects or to raise money for other public purposes.
Universities and hospitals also can issue municipal bonds to finance capital projects. Bond investors act as the lender of choice for many government finance offices. Government bonds tend to pay very low yields.
Fixed-income investors looking for a bit more return can opt for corporate bonds, used by private companies to finance operations. Mortgage-backed securities are another type of fixed-income investment.
Because of the predictable nature of repayment schedules, bonds often are referred to as fixed-income securities. Bond investors receive a contract that lists the predetermined interest rate and spells out the repayment deadline, a point in time also known as the maturity date.
This is a stark difference from a stock investment – there’s no explicit guarantee that a stock issuer will continue paying dividends, and the value of the investment rises and falls based on the performance of the underlying company.
What is a real estate investment?
An investment in commercial real estate involves buying a physical property, or a stake in one or many pieces of real estate. The investor hopes to profit through a combination of rental income and price appreciation.
There are many ways to invest in real estate. An investor can directly buy an office building, a retail property, a warehouse, or a multifamily project. Investors also can take a smaller stake in a single property via crowdfunding.
Or, an investor can purchase shares of a real estate investment trust, which pools together a number of properties and divvies up the portfolio among investors.
Risks of Bonds
Buying a bond essentially means buying a debt. The organization that issues the bond borrows the investor’s money with the promise to repay it with a fixed interest rate over time.
For government bonds, default risk is remote, but inflation risk poses more of a threat. The rate of return on government bonds often lags the rate of inflation. In that scenario, the investor’s inflation-adjusted rate of return turns negative.
This risk becomes especially acute in cases where the bond matures decades into the future. There’s also the possibility that the underlying value of the fixed-income security could decline as a result of moves in interest rates.
Bond investors also face reinvestment risk – in other words, it’s possible the only option to reinvest any proceeds will be at a lower rate compared to the rate that generated the original proceeds.
In this case, the investor could face a reduction in cash flow from the bond portfolio.
For corporate bond investors, that lender-borrower relationship raises the risk of default.
Companies sometimes fall into financial difficulty and are unable to repay their debt, which leaves the investor at the risk of not being repaid. Corporate bonds are graded by rating agencies – the greater the risk of default, the higher the interest rate paid by the bond issuer.
Corporate bonds carry a variety of specialized risks. One is the uncertainty created by the distinction between subordinated and unsubordinated bonds. If an insolvent issuer files for federal bankruptcy protection, its bonds are ranked in order of priority.
Senior debt, which is paid first, may have a higher credit rating and higher credit quality than junior, or subordinated, debt.
Another nuance involves secured versus unsecured bonds. Secured bonds generally have lower credit risk and lower coupon payments compared to unsecured bonds issued by the same corporate issuer.
Benefits of bonds
Bonds aren’t flashy – an asset allocation weighted toward fixed-income securities is considered conservative -- but they do have a number of distinct advantages:
- Guaranteed payment: Bonds issued by the U.S. Treasury are as close to a sure thing as investors can get. Principal and interest are guaranteed by the full faith and credit of the U.S. government. Corporate bonds issued by financially stable companies also offer peace of mind.
- Predictable income: Bonds pay a fixed interest rate on a regular schedule, so investors have visibility into their future income streams.
- A broad choice of maturities: Treasury securities are issued with a wide range of timeframes, helping investors find bonds that meet their goals.
- Liquidity: Treasury bonds are an especially liquid type of fixed-income investment; investors can sell Treasury bonds before maturity. Corporate bonds also trade on secondary markets, meaning you’re not locked into holding the debt until maturity.
- Tax breaks: Income from Treasury bonds is federally taxable, but the interest on Treasuries is exempt from both state and local taxes. Municipal bonds can carry a variety of tax exemptions.
- Diversification: Corporate bonds don’t move in lockstep with stocks, so fixed-income securities create diversification benefits in a portfolio. The broad array of corporate bonds allows investors to tailor risk by issuer, industry, maturity, credit rating, and interest payment schedule.
Real estate risks
Values of commercial real estate generally rise. However, there are no guarantees that the property you purchase will enjoy uninterrupted cash flow and appreciation. Here are some common risks taken by investors in commercial real estate:
- Economic uncertainty: While real estate values historically rise, the path of the real estate market is unpredictable. Your investment could lose value, either temporarily or for long stretches of time.
Supply and demand for real estate, the overall economy, local labor conditions, population trends, consumer pandemics, natural disasters, pandemics, interest rates, government policies, and unforeseen events all play a role in real estate trends, including prices and rental rates.
Economic shocks can come quickly, as when governments locked down at the beginning of the coronavirus pandemic. You can mitigate the risk of getting caught on the wrong side of a trend through thorough research, careful due diligence, and vigilant monitoring of your real estate holdings.
- Sudden shifts in consumer behavior: Market trends can shift slowly, as was the case in a retail sector roiled by e-commerce. Or they can happen swiftly, as when white-collar employers in 2020 began allowing employees to work from their home offices, a change that dampened demand for office space.
- Location risk: The old saw – that the three most important things in real estate are location, location, location – holds true. Location is the most important factor in determining the success of any investment property.
Location drives everything else – demand from tenants and future buyers, rental rates, and the potential for value appreciation. Locations could become less desirable for a variety of reasons – perhaps a departure of a large employer, or a shift in population trends.
- Negative cash flow: An investment property’s cash flow is the money that's left after paying all expenses, including insurance, taxes, and debt service. If the expenses outpace income, the landlord has negative cash flow. That’s also known as losing money.
Typical culprits for negative cash flow include high vacancy rates, hefty maintenance costs, high financing costs, and below-market rental rates.
- High vacancy rates: Investors buy rental properties with the goal of filling most or all of the space with tenants paying market rates. However, vacancies can mount for a variety of reasons.
Perhaps rental rates aren’t in line with market rents. Maybe the property isn’t being marketed aggressively. Perhaps the building is in need of maintenance, or it’s in a property sector or location with little demand from tenants. Or maybe one large tenant experiences financial trouble or moves out.
- Problem tenants: To avoid vacancy, landlords price rental rates aggressively or offer generous tenant improvement allowances. However, that practice can create another risk: problem tenants. A bad tenant might be one that doesn’t pay rent promptly or at all.
Some tenants can make constant demands on landlords for maintenance o concessions. While most tenants meet their obligations, in some cases tenants can make life difficult, or even hire an attorney and go to the court system to express their displeasure.
- Surprise repairs: Fully occupied commercial properties experience wear and tear, leading to such routine maintenance demands as repairs of HVAC systems, elevators, and bathrooms.
Roofs need to be replaced, parking lots resurfaced. Landlords can find themselves on the hook for structural repairs, or for remediation for mold or asbestos. Renovation bills easily can stretch into the tens of thousands of dollars or even hundreds of thousands of dollars.
Investors can mitigate these risks during due diligence by engaging a property inspector, contractor, mold inspector, and pest control specialist to scrutinize the property thoroughly.
- Lack of liquidity: If you own stocks or bonds, cashing out can take just seconds or minutes. That’s not the case with direct investment in real estate. Preparing a property for sale, marketing it, conducting tours, and negotiating the terms of the sale can take months. If an investor needs money quickly, there might be no choice but to sell for less than the property’s market value.
Real estate benefits
Commercial real estate investment has minted no shortage of millionaires and billionaires, so there certainly are gains to be made for those who learn the industry and make smart moves. Among the advantages of real estate investing:
- Cash flow: Cash flow is the net income from a real estate investment after the landlord pays the debt service, taxes, insurance, and other operating expenses. A well-run, fully leased commercial property will generate plenty of cash flow, an important benefit. What’s more, this cash flow can increase over time as market rents rise.
- Favorable tax treatment: As savvy real estate investors weigh any purchase, tax benefits are part of their calculation.
Real estate investors can take advantage of numerous tax breaks and deductions. In general, you can deduct the reasonable costs of owning, operating, and managing a property.
Depreciation is another tax consideration – the IRS allows commercial property owners to write down the value of commercial buildings over a period of 39 years. By counting depreciation as an expense against taxable income, real estate investors lower their tax bill.
Another perk is that real estate investors can put off capital gains taxes by buying another investment property through a 1031 exchange.
- Appreciation: Real estate investors make money through rental income, but the truly eye-popping returns come through appreciation in the value of the underlying property. Real estate values generally rise over time. With a well-timed investment, a real estate investor can make big money on the sale of a property.
- Wealth building: Investors in commercial real estate provide a service – they lease commercial space to companies that prefer not to own their places of business. This allows landlords to generate returns in two ways – through the cash flow created by those rental payments, and through any appreciation in the value of the property.
- Portfolio diversification: As an asset class, commercial property doesn’t necessarily move with other asset classes. Real estate has a low—and, in some cases, negative—correlation with stocks and bonds. Allocating real estate to a portfolio of diversified assets can mitigate overall volatility, and ultimately generate a higher return per unit of risk.
- The power of leverage: Leverage means using borrowed capital to boost returns. Most real estate investors finance with mortgages, and this allows for higher returns.
To give a simplified example, say you made a $250,000 down payment on a $1 million property, then sold the property for $2 million. That’s a 100% increase in the property’s value, but a 300% return on the investment. Because real estate serves as collateral on any financing, mortgages are readily available.
- Competitive returns: Real estate returns vary widely, depending on such factors as property sector and location. However, it’s quite possible to reap returns that exceed those of stocks.
- A hedge against inflation: As of early 2022, the pace of inflation had returned to levels not seen since the early 1980s. Real estate tends to thrive in an inflationary environment. Rising prices generally reflect strong economic growth, and a robust economy creates tailwinds for demand for real estate, and for increases in rental income.
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Which is a better investment?
This is a nearly impossible question to answer, one that depends on an investor’s time horizon and risk tolerance. For instance, a 30-year-old investor who wants to build wealth and can accept risk would be wiser to allocate funds to real estate.
A 70-year-old investor who has a comfortable nest egg might prefer the safety and stability of bonds. In terms of sheer horsepower, commercial real estate offers investors a much greater possibility of getting rich. Fixed-income securities, on the other hand, are more about wealth preservation.
Because these two asset classes are both so broad and so different from one another, it’s difficult to make an apples-to-apples comparison. Both asset classes have their place in a diversified portfolio. To determine which is better for you, explore the topic with your tax specialist and your financial advisor.
Related: Investing Enough for Retirement
Bonds and real estate are major asset classes that offer investors a way to diversify their portfolios. Both types of investments come with pros and cons. Deciding which better suits your portfolio requires analyzing your financial needs.
If wealth creation is the priority, an investment in commercial real estate is the better call. If wealth preservation and peace of mind are at the top of your priority list, fixed-income securities might be the preferred solution.
Are you interested in learning more about real estate investments? If so, contact us today!