Bonds vs. real estate: Which is the better investment vehicle for passive income?
Title says it all. Pardon my ignorance as I'm an equity guy so my knowledge is highly limited in bonds vs. real estate. Which is the better passive investment vehicle?
From my understanding the yields are quite low in both, but is it better to own a couple houses or own that capital in a mix of investment-grade / high-yield bonds? Which can you reasonably get a better return out of for low risk? What are the benefits / drawbacks to both?
ask your m0m
I don't think houses are a good investment. The baby boomers will be dying soon, so there will be a lot of houses with nobody to fill them (as all the millenial liberal arts majors rent where they live), which will drive down the price. Assuming you can find tenants who haven't gotten screwed out of a job and who can actually pay rent, you should be investing in multi-family real estate. [not investment advice, just my opinion]
That's a really great point. Think the hedge against this is buying in / very close to major cities as well, no?
Your point on multi-family makes a ton of sense, but the key issue is you'd need to invest a lot more capital. Paired with high illiquidity in RE, this makes me extremely nervous. How do you get past this hurdle?
Very different investments. Lots of bonds / bond funds will retain steady capital while producing yield. Some will focus on total return and appreciate. The housing market appreciates generally speaking over a long period of time. The dividend is based on the rental market and costs.
On paper they can look quite similar. In reality, and this is key, one is liquid (generally speaking) and the other is not. Add to illiquidity for housing, you have other random costs above and beyond mortgage, insurance and taxes. Things like repairs, HOA costs, regular upkeep (lawn service). Some people enjoy doing all that themselves. Others pay for service providers. That cuts in to your yield.
Think about your time horizon, risk tolerance (how much would it hurt if property sat vacant for 6 months, a year?) Generally speaking, the folks that I know who do quite a bit of RE investing plan on keeping the properties for a long time. Like 10-20 years. Good friend has 10 rental units in beach areas. Kept them rented until covid came. Now it's tough. But he'll survive and get back to thriving soon. He plans to own them into retirement. Perhaps sell a few at some point but likely keep most for his kids. They are starting to buy some themselves. He is predisposed to RE vs. the market. That's generally the male up of those who do well with RE.
Think about who you are and what you really want to accomplish.
+1SB. Good points and thanks for answering! Let me follow up with a quick scenario to help narrow this out:
I look at residential RE (home buying, not REITs) / bonds as basically the steady counterbalance to my public equity holdings. Essentially by age 40 or so I'd like to have 80% equity / 20% RE or Bonds (not sure which). Essentially the main goal is stability. While equity is very rewarding in LT, it can be very volatile in ST and so I'm looking for this other vehicle as a hedge against mkt / career risk. As a stress test, I'd want to know in a Great Depression scenario this 20% of the portfolio would basically be returned to me at value or with a minor 5% haircut at most (say in case of principal payback from company bankruptcy or that demand would remain for the rental real estate).
I don't want it to just be cash as inflation erodes that away. To be clear, I work in public equities and do own / will own mostly individual equities, so the counterbalance of 20% I want to be very solid. That said, the return profile I'm looking for is ~5% after-tax / post-expenses to get safely (don't want to take on excess risk). On the RE side, to your point I would definitely pay for service providers as I don't have the interest in doing that stuff myself. Time horizon is 15+yrs, I'm a very LT investor.
To sum up, what would you recommend for someone looking for a safe 5% after-tax / post-expenses yield w/ low volatility? As a side point, what's the value of a REIT vs. bonds? I get that REITs offer liquidity vs. buying individual homes, but as an asset class why would you buy a REIT fund vs. a bond fund?
If I wanted to discuss this all in great detail with someone highly trusted / can point me in the right direction, where would I go? I honestly don't know who I'd even consult to really explore RE / bonds. Would love to chat with someone for 2-3hrs who is proven and whose brains I can pick.
Very grateful for your time in advance in educating this poor sod
This doesn't really help you but either would be fine. Assuming you finance the RE, your leverage will create a greater ROI than bonds (as I don't imagine you'd be purchasing bond derivatives).
My personal opinion is, for your purposes - and that is key, to go the bond route. Your just looking for a counterweight. No heavy lifting. So many unknowns in RE.
Personal example as I own commercial property. Yes it's different but it's still quite similar as it's mom and pop stuff. Have owned several properties for 20 yrs or so. For 10 yrs I would have said "home run". Good tenants covering costs, appreciation, etc. Then downturn came, then pandemic.
Been trying to unload one for over a yr. Vacant. Carry cost sucks. Eating in to the total long term return, but more importantly, effecting cash flow today. Long story short, I would have preferred to have been in a decent low risk fund for the duration (as it was also a small piece of my total). Expect the unexpected in RE.
great post
one thing i think it's missing is leverage... especially with primary residence you can get an absurd amount of leverage in RE
dunno how it looks for secondary properties, i only own the one right now
RE has tons of tax advantages and if you're in a position to actively manage, you can make a lot of money.
As a true passive investment it's not worth it. Bonds throw off a guaranteed yield, more or less, and you don't do anything but clip coupons. To make RE profitable you can't sub out every little job or your margins will be razor thin - be prepared to make it a full time job or don't do it at all
That's my concern. My parents actually have a few single-family properties. Hasn't taken a ton of their time since they're not buying fixer uppers fortunately, but there have been 1-2 tenants from hell....
After acquisition & finding initial tenant, I don't mind putting in another 5hrs per month into it (on avg, obviously very lumpy) but don't want to spend more than that. Would spend many hours on acquisition though, to me that's the most exciting part of RE
What's your take on property managers? How much do they cut into your yield by?
Depends. I've seen property managers take anywhere between 3.50% and 8.00%, with the norm being somewhere in the 4-6% range. Of gross income.
You do the math. That's an enormous line item. If you have a large portfolio they can be helpful, because physically collecting checks or following up on arrears for a couple hundred apartments just isn't feasible. But if you own a handful of small buildings, maybe a dozen or two units in a reasonably contained area? You're better off doing it yourself. It's thousands of dollars a year.
Fundamentally two very different investments even though real estate can be classified as "fixed income." It comes down to your risk-reward appetite and how hands off/on you want to be. I'm not an expert on bonds, but basically you receive a fixed amount semi-annually until maturity and don't need to do anything. Real estate is A LOT more work, but can also be a lot more rewarding. With bonds, all the information is public and there are various research reports and rating reports for bonds. The bond market is also much more liquid and efficient than real estate, which means that finding undervalued bonds is more difficult unless you're playing in junk bonds. However, real estate has tons of inefficiencies because it is so illiquid and there is information asymmetry. Furthermore, every piece of real estate is unique and have subtle differences even if they are directly adjacent to each other. For example, imagine two properties sitting side-by-side of the same size and condition. One might think that they are the same value; however, one property might be on a corner lot or have parking spaces which would increase its value. Real estate illiquidity, lack of information, and uniqueness makes it challenging to value real estate (at least in the sub-50 units market), which sucks if you are a newbie, but very rewarding if you are willing to put in the effort to learn and do your homework. Whether you choose real estate or bonds also depends on where you are located (#1 Rule of real estate is location). I live in a Tier 1 market, so demand for housing is almost inelastic (although prices are much more expensive than the national average), but I am willing to pay more for real estate in my area because of the strong demand, reliable rent growth, and appreciation. Just to give you an example, I'm looking at a renovated three-family in a hot, up & coming market asking for $1.2mm with existing ~$102,000 gross rent/yr. My projected OpEx is ~$21,000/yr based on the properties I already own, which leaves me with an NOI of $81,000. At 80% LTV, 3.75% interest rate, 30 yr amortization, my annual debt service is ~$53,000/yr. My cash flow to equity is $28,000/year or a 11.67% cash-on-cash return (you would need to buy junk bonds to see this yield in the bond market) that is almost tax free after depreciation and this hasn't even accounted for future rent growth and long-run appreciation potential. Furthermore, the existing tenants just renewed their lease, which means that they were/are paying rent even through the pandemic, so I don't really need to worry about the risks of covid19 (from my experience, in bad markets where real estate values fall, the rental market tends to do better because people still need to live somewhere). If I were to lose my job, I'd still have a reliable $2,300 coming in each month to live off of.
+1 SB. Thanks for walking through that scenario, very enlightening!
Yeah to clarify, if I were to go the bond route it would be a bond fund (or multiple funds - ex. one investment grade and one high yield). No interest in selecting individual bonds as I have 0 expertise there. Whereas for real estate I'd likely buy an individual property vs. a REIT fund (although would need to build a lot of knowledge first). Have a couple clarifying questions:
On a bond funds vs. a REIT, is there one that is more compelling than the other in providing good risk-adjusted returns? Low vol is a must, but also in terms of getting at that 5-8% LT total return?
How do you figure out what a Tier 1 mkt is vs. a Tier 2 or Tier 3? More importantly, how do you figure out what a T1 mkt will be in the future? How would you place these 5 cities: Washington DC / Austin / Houston / Chicago / San Diego?
What books / resources do you recommend for someone aiming to invest in residential real estate?
Grateful for your time!
2.) By Tier 1, 2, 3 I'm really just going with what CBRE/JLL/Colliers research reports says are Tier 1 and I generally agree with them. NYC/Boston/DC/LA/SF/ is what I consider Tier 1. In all these cities, there is a severe housing shortage which has caused rents to skyrocket, triggering the government to suggest legislation such as rent control. Furthermore, it is very difficult to develop in these markets because of the very strict zoning laws and long variance process, whereas i've heard that states such as Texas or North Carolina do not have zoning laws. I do not invest in the cities you've listed but I know a little bit about them. Of the cities you listed, DC is the only one that I would consider investing in because it's supply/demand economics is very similar to the market that I am in. In my opinion, Austin/Houston has way too much supply, San Diego is mostly a retirement city, Chicago always perplexes me as to why their real estate market is not as strong as Tier 1 markets but for whatever reason, it is not. I have a friend who lives there and the landlord paid the leasing agent as opposed to the market I am in where the tenant pays for the leasing commission (this can give you a good idea about the supply/demand economics). However, there are plenty of developers and investors that make money in those markets, so it really comes down to knowing the markets. In terms of how I know where a T1 market will be in the future, I don't really think about the entire city as a whole but rather submarkets. You have to think about why these cities are so attractive San Francisco has Silicon Valley, Boston has tons of colleges, NYC has Wall Street etc etc. Unless there's a black swan event, these cities will continue to grow in population and jobs which further increases the demand for real estate. But within these markets, there are submarkets that are "cheaper" than others. The way that real estate trends spread is like concentric circles that spread out as certain submarkets become too expensive. For example, when manhattan got too expensive, demand shifted to Williamsburg, once Williamsburg becomes too expensive then it will spread further out. If you can figure out the next hot town and invest ahead of time, then you can find some pretty good deals, but knowing the market is key.
3.) I have no books to recommend to you because I hate reading books lol. As long as you have a solid understanding of finance and equity to invest, the rest you can figure out. My advice is to keep looking at real estate. Call a couple real estate agents to learn about the hot markets and look at properties. Maybe there are 2 properties that are adjacent to each other, but 1 sold more than the other. Why? The markets that I play in, if you give me the # of units, bedrooms, size of the property, condition, and address, I can basically decide whether or not the asking price is a good investment (to me) or not. I researched this market for a year before investing in anything
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