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 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, its prudent to predict interest rates are not headed lower. When interest rates begin to normalize (ie. 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 act as 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. Its more palatable to take longer-term, risk-on bets that offer higher appreciation opportunity, when you have a long runway of working years left. 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 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 with 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%+ 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 to 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, increasing valuations.
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, its 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, its a very good one. One certainly worth considering for those that are seeking retirement income and diversification, through an inflation protected hard asset with tax advantages.
*source: RealPage, Inc