I have stated multiple times that real estate is my favorite asset class to build wealth. Therefore, choosing between real estate or bonds is a fairly straightforward decision. Real estate all the way.
However, as I fill out the chapters for my new book with Penguin Random House, I thought it would be a useful exercise to determine which type of investment is best for whom and when. After all, I own both real estate and bonds and so do many of you.
Both asset classes have performed well for decades. Further, we’ve got real estate tycoons and we have bond tycoons. Therefore, you can get rich in real estate or bonds. A lot of it depends on your interest.
Real Estate Or Bonds: Which Is The Better Investment
Today, real estate is all the rage. Home prices are rising thanks to low mortgage rates, a strong economic recovery, and a supportive government. With billions of people spending more time at home, the intrinsic value of real estate has gone up as well.
Bonds, on the other hand, are one of the most looked down upon asset classes given interest rates are so low.
But the funny thing is, ever since I started writing about investing bonds in 2009, I’ve received the same negative feedback about bonds.
Yet, any objective investor realizes bonds have performed well over the past 20 years. Some bond funds have even beaten the S&P 500 over the past decade or two as well.
Bonds outperformed stocks during the 2000 Dotcom meltdown, the 2008-2009 global financial crisis, the 2018 correction, and the March 2020 coronavirus-induced meltdown. Therefore, don’t count out bonds just yet.
Could it be that people tend to dislike what they don’t really understand? The bond market is ~80% larger than the stock market.
Why Invest In Bonds?
Historically, bonds have been the #1 public investment alternative to stocks. Bonds tend to outperform when stocks are doing poorly and underperform when stocks are doing well. Therefore, you may want to invest in bonds to dampen portfolio volatility.
Another reason why you may want to invest in bonds is due to capital appreciation. As you can see from the chart above, the long-term bond fund, VWESX, has performed very well since 2000.
Yet another common reason to invest in bonds is for the income they generate. Most bonds pay a coupon payment semi-annually. The interest rate you get is determined by dividing the annual coupon payment by the price of the bond. As the bond increases in value, the interest rate declines and vice versa.
In some cases, such as with US Treasury bonds and municipal bonds, the coupon payments may not be taxed on the federal or state level or both. Hence, some types of bonds produce highly tax-efficient income.
The Different Types Of Bonds
Not all bonds are created equal. The least risky to most risky types of bonds are: Treasury bonds, Agency bonds, Municipal bonds, and Corporate bonds. Then there are bond mutual funds and ETFs, which invest in various types of bonds.
Municipal bonds are rated differently. The higher the rating, generally the lower the risk and the lower the coupon payment. The lower the rating, generally the higher the risk and the higher the coupon payment.
In terms of corporate bonds, you have regular corporate bonds issued by companies like Apple Inc or Coca Cola. They pay a higher coupon than municipal and Treasury bonds, but are taxed and generally riskier.
Today, for example, Apple issued $6.5 billion in corporate bonds. The four-part offering includes $2.3B of 1.400% notes due 2028, $1B of 1.700% notes due 2031, $1.8B of 2.7% notes due 2051 and $1.4B of 2.850% notes due 2061.
The 40-year security yields 0.92 percentage points above Treasuries. It is highly unlikely a company with $100+ billion in cash will ever default on its bond obligations.
Then there are junk bonds or high yield bonds. These are corporate bonds from companies that have a higher chance of defaulting. They offer higher interest rates to compensate for the risk.
Certificates of deposit are like bonds issued by your bank. You essentially loan the bank your money for a certain period of time for a guaranteed fixed rate of return. CDs are guaranteed up to $250,000 per individual.
Related: Real Estate Or Stocks?
Why Invest In Bonds Over Real Estate
Now that we know some reasons why you might want to invest in bonds, the next question is why to invest in bonds over real estate. Here are some reasons why:
1) You don’t have enough money to come up with a down payment to buy real estate
2) You’re looking for a lower-risk way to invest your down payment to buy a house or rental property
3) You like the 100% passive nature of investing in bonds and dislike managing tenants and dealing with maintenance issues
4) You’re in a high-income tax bracket and appreciate tax-free income from municipal bonds or federal tax-free income from US Treasury bonds
5) Bonds provide for an easier and clearer way to diversify your public investment portfolio
6) You’ve already got a sizable real estate portfolio
7) You’re bullish on a corporation, but don’t want to buy the company’s equity
8) You believe interest rates are heading down and bonds provide a more direct way to capitalize on lower rates than real estate
9) You dislike paying annual property taxes
10) You’re getting close to retirement and don’t want to risk losing a lot of money
Why Invest In Real Estate?
Real estate is one of the best ways to build wealth for the average American. At the very least, real estate acts as a forced savings account where each amortizing mortgage payment builds home equity. Once the mortgage is paid off, you own your home free and clear.
Inflation acts as a tailwind for real estate prices and rents. Therefore, owning real estate makes you a beneficiary of inflation. Whereas renting makes you a price taker. Just like how you wouldn’t short the S&P 500 over the long-term, it’s not wise to short real estate by renting long-term.
The combination of higher rents and higher property prices can build incredible wealth over time. Inflation tends to really sneak up on you 10 years later.
Living in and owning your primary residence makes you neutral real estate. To go long real estate you must own more than one property or invest in real estate investments such as REITs, eREITs, real estate ETFs, and real estate-related stocks.
Finally, real estate can be improved upon. Whereas with a bond, you are a passive investor who has little-to-no way of making the bond perform better. Your investment is at the whim of company management, the company’s competitors, and various macroeconomic factors.
Why Invest In Real Estate Over Bonds?
Now that we know some reasons why you might want to invest in real estate, the next question is why invest in real estate over bonds. Here are some reasons why:
1) You desire to own a primary residence
2) You could potentially make greater returns in real estate, partially thanks to leverage
5) You want to invest in tax-efficient opportunities such as through an Opportunity Zone fund
6) You are bullish on a particular real estate asset, e.g., multifamily, build-to-rent, industrial
7) You can collect a higher rental yield than a bond yield, which is often the case
8) You enjoy living life and staying at your vacation property
9) You want to build a rental property portfolio to give your children something to do
10) You’re looking to do a 1031 exchange to defer paying capital gains tax
11) You like the $250,000 / $500,000 tax-free profits for singles / married couples upon sale
12) You are in a high income tax bracket and appreciate the ability to take non-cash amortization expenses to reduce rental income tax
Historical Returns For Bonds And Real Estate
From 1926 – 2016, the historical return for the aggregate bond market is about 5.4 percent compared to a historical inflation rate of 2 percent. Bonds continued to do well through 2020.
Meanwhile, the historical return for real estate depends on the type of real estate, the location, and the duration.
According to the Case-Shiller Housing Index, the average annualized rate of return for housing increased 3.7% between 1928 and 2013. Housing has continued to do well through 2021.
Residential and diversified real estate investments did a bit better, averaging 10.5%. Meanwhile, real estate investment trusts (REITS) performed the best with an average annual return of 10.5%.
My Reasons For Investing In Bonds And Real Estate
In my 20s, I invested heavily in stocks and real estate. However, before and after the dotcom bubble burst in 2000, I transferred about 20% of my stock investments into bonds. Between 2000 – 2002, the 10-year bond yield was between 5% – 6.7%, which I found attractive.
In the summer of 2001, I had also changed jobs and cities. Therefore, I was quite uncertain about my future and wanted more stability. At the same time, I wanted to get long property with the funny money I made in 1999-2000 from internet stocks.
In 2003, I bought my first property in San Francisco. After that, I viewed real estate as a bonds PLUS type of investment. Real estate served as a way to diversify my stock portfolio and career in equities. Therefore, I stopped buying bonds until 2017.
During the Global Financial Crisis in 2008-2009, roughly 20% of my public investment portfolio was in bonds. I definitely wish I had more. Although bonds still declined during that time period.
Bonds And Online Real Estate For More Simplicity
In 2017, I sold my main rental property and reinvested $550,000 of the proceeds in a California muni bond fund and various individual California municipal bonds. My main purpose of these investments was for tax-free income.
I then re-invested the remaining $600,000 of the proceeds in stocks and $550,000 in real estate crowdfunding. My main goal for these investments was capital appreciation without debt. By selling the property I wiped away a $815,000 mortgage.
At the time, I felt bad giving up a property I had bought in early 2005. It was going to be a key part of my retirement income portfolio. However, I just couldn’t take the headache of being a landlord for this property anymore. Thankfully, the reinvestments worked out.
Today, I will only be buying bonds if the 10-year bond yield gets back over 1.75%. Instead, I’m actively investing in a build-to-rent fund, a hotel in Dallas, and a diversified eREIT.
Finally, I’m also building more cash reserves. After such a big run-up in many asset prices, holding more cash feels great.
Readers, what is your preference between real estate or bonds? How do you view them similarly and differently? What are some other advantages and disadvantages of the two asset classes I may have missed?
Real Estate Or Bonds: Which Is A Better Investment? is written by Financial Samurai for www.financialsamurai.com