Today I have a guest post from occasional contributor and experienced real estate investor Brian Davis. He makes a compelling argument that challenges many of our notions about the role bonds play in an investment portfolio and whether that role can be better served by real estate investments.

You may not agree with all of his points. I don’t!

But that’s the point of personal finance and the value of featuring other’s ideas. There is no single “right way” to do things and there is a lot of value to be gained from people approaching problems from different perspectives and utilizing different tactics.

Take it away Brian….

(Disclosure: Brian and his company Spark Rental have no financial relationship with Can I Retire Yet?. This post does contain a link to Spark Rental’s Co-Investing Club from which he will profit if you sign up. This blog derives no financial benefit if you sign up and I encourage you to apply your own due diligence as you should before making any investment.)

Are Bonds Really Safe?

People love to talk about how “safe” bonds are. And sure, there’s virtually no risk of the US government defaulting on Treasury bonds. But default isn’t the only type of risk. 

Bonds are subject to inflation risk, as anyone who bought a US Treasury bond paying 1.3% in 2021 can tell you. When inflation peaked at 9.1%, that investor would have effectively lost 7.8% on their money. An investment that loses 7.8% in a year doesn’t sound risk-free to me — and that says nothing of interest rate risk to bond prices. 

Sure, interest rates and bond yields have risen over the last year. But times have changed since the days when Treasury bonds paid 15% interest, and conventional wisdom among investors hasn’t caught up with the 21st Century. 

So a few years ago I started wondering: Can real estate serve the same role as bonds in my portfolio, while performing better? 

Why Investors Buy Bonds

Before we talk too much trash about bonds, let’s recap their advantages, and why people buy them in the first place. 

First, government bonds and blue chip corporate bonds come with a low risk of default. You’re lending money to borrowers with outstanding credit, who will almost certainly pay you back. If you don’t plan on selling the bonds you buy, you can sit back and collect interest until they mature, confident that you’ll get your principal back. 

Which raises the second upside — bonds provide stable, predictable passive income. Income that retirees count on to pay their bills each month. That predictability helps reduce uncertainty in your retirement planning. 

Finally, bonds share a low correlation with stock markets. You want diversified investments so that a crash in one asset class doesn’t sink your whole retirement portfolio and bankrupt you later in life.

Drawbacks of Bonds

For all those benefits, bonds come with their fair share of drawbacks. 

I understand the appeal of buying safe, stable Treasury bonds paying double-digit interest. But interest rates remained low for decades, only just recently surging to tackle high inflation after bottoming out during the pandemic. 

Speaking of inflation, it takes a bite out of your real bond returns. To calculate your real return on a bond, you have to subtract inflation from the nominal return. And when you do so, you sometimes end up with negative returns. 

Sure, you can buy I-bonds or TIPS, and they protect you against inflation. But after adjusting for inflation, they don’t pay well, so in periods with low inflation they provide paltry returns. 

Another risk of bonds comes from interest rate changes. When interest rates rise, existing bonds lose value, since they don’t pay as much interest as newer bonds. So if you want to sell bonds before they mature to cash out, you get less money for them. 

So yes, high-quality bonds come with low default risk, but they still come with inflation risk and rate-change risk. That doesn’t make them as “risk-free” as many retirees believe them to be.

Can Real Estate Offer the Upsides Without the Drawbacks?

I believe it can — with some caveats. 

To begin with, there are many ways to invest in real estate. Each comes with its own pros and cons, risks and average returns. With a balanced, diversified real estate portfolio, you can reduce your risk of any one investment crashing and burning, and keep your overall risk manageable without settling for anemic returns. 

It also helps if you have experience. Professional real estate investors know how to invest for high returns and low risk. For novice investors, the risks in direct property investing are much higher.  

All real estate investments (other than public REITs) share little correlation with the stock market. So on that front, real estate can fill the same role as bonds in your portfolio.

Most real estate investments also generate income well. The yield and consistency vary by the type of investment, but I’d argue real estate generates better income than bonds do.

But to compare risk and returns versus bonds, you have to break down different types of real estate investments.

Real Estate Investments that Can Replace Bonds

As you consider moving some of your money out of bonds, here are a few options on the table.

Real Estate Syndications

Real estate syndications let you invest in fractional ownership of a single large property, such as an apartment complex or an office building. 

These often come with high returns, such as internal rates of return (IRR) between 15-30%. But some of that comes after the property sells, which usually doesn’t happen for 3-7 years. 

Still, in the meantime investors typically collect cash flow in the form of dividends, often at yields between 6-10% range. And all the while, you get the full tax benefits of real estate investments, plus accelerated depreciation. 

That checks two of the three boxes that bonds fill, for ongoing income and low correlation to the stock market. But what about risk? 

It depends on the experience of the syndicator: the real estate investor that puts together and manages the deal. If you only work with syndicators who have completed dozens of deals and never lost their investors’ money, your risk remains low. 

(Editor’s note: “Low” risk means different things to different people. Risk and reward are a trade-off. As a rule, don’t expect any free lunches!)

That said, real estate syndications do come with two challenges. First, many syndications only allow accredited investors to participate: wealthy investors with a net worth over $1 million or annual incomes over $200,000 ($300,000 for married couples). Others, classified as 506(b) syndications, do allow non-accredited investors.

Second, syndications typically require a minimum investment of $50-100K. You can get around that by investing as part of a real estate investment club. For example, SparkRental’s real estate investment club lets members pool their money with $5K per person, rather than a daunting $50-100K. 

Crowdfunded Equity Investments

In real estate crowdfunding investments, you have two options: equity and debt. Equity involves buying fractional ownership of a property (or pool of properties), debt means loans secured by real property. 

Equity investments require you to leave your money invested long-term, because real estate is inherently illiquid. Plan on leaving your money tied up for at least five years in these. 

These investments come with plenty of advantages. You can earn strong dividend income — Fundrise paid out 8.02% in dividends over the last year to Income Portfolio investors, for example. That means you don’t have to sell off investments to generate income, similar to bonds.

Equity investments also offer some protection against inflation. The value of real estate goes up during periods of inflation, and you directly benefit from that as a fractional owner. 

Because your investment is backed by real property, it can’t disappear or declare bankruptcy like a stock. In the worst case scenario, it temporarily dips in value alongside property values, even while paying out dividend income. But real estate market corrections are uncommon, and almost never deeper than 5-10%. Compare that to stock market corrections and crashes, which happen all the time. 

Note that real estate crowdfunding investments are regulated by the SEC. So while it’s possible that a crowdfunding company could declare bankruptcy, your investment in the underlying real estate is verified by federal regulators. In that doomsday scenario, the company would simply sell off the properties to recover investors’ money.

Even so, crowdfunded equity investments should only make a portion of your portfolio.

Crowdfunded Secured Loans

The other broad real estate crowdfunding investment is debt secured by real estate. 

As a general rule, it generates better income yields than equity investments. But you only earn one type of return, interest, rather than earning both cash flow from dividends and equity appreciation. 

Like bonds, you typically earn a fixed interest rate. That leaves your returns vulnerable to inflation, but secured loans against real estate tend to pay far better than bonds, so inflation eats less of your return. 

For example, I earn between 9.5-10% interest on loans through Groundfloor. Am I still peeved about the high inflation rate from 2021-2023, slashing those real returns down to 1-6%? Sure, but not as upset as I’d be if I lost 7.8% on a Treasury bond that only paid 1.3% interest. 

As for default risk, I only invest a small amount ($10-30) in each loan, with my money spread across hundreds of loans. A certain low percentage of these loans will default, and Groundfloor will have to foreclose to recover my money. But they only lend 60-75% of the value of the property, so even if they have to foreclose, they can still recover my principal in most cases. 

That low LTV (loan-to-value ratio) also leaves plenty of room for a housing market correction.

Note that these are short-term loans to professional real estate investors. When each borrower repays their loan, I get my money back plus interest, and I can reinvest it to keep compounding my returns, or cash out my returns, my principal, or both.  

So, these loans come with low default risk, strong passive income, and low correlation to the stock market — fulfilling the role of bonds beautifully.

(Editor’s note: DO NOT underestimate the risk of crowdfunded platforms! PeerStreet, Inc recently filed Chapter 11 Bankruptcy.  PeerStreet had “sophisticated investors” including Michael Burry of “Big Short” fame and venture capital giant Andreesen Horowitz.

Crowdfunding real estate platforms did not exist prior to 2012 in the aftermath of the 2008-2009 real estate market implosion. Since their inception, real estate, especially residential real estate, has boomed. This includes doing very well through the COVID pandemic and interest rates hikes over the past year.

I’m curious how these platforms will hold up when they are actually tested in a real estate downturn. I personally have exactly $0 invested in them for this reason.)

Private Notes

Rather than investing through a real estate crowdfunding platform, you could instead lend money directly to a real estate investor you know and trust. Emphasis on know and trust. 

You can earn strong returns this way, completely passively. I lent money years ago to a real estate investing couple I know and trust, who pay me 10% interest like clockwork on it. 

But it requires that you actually know successful real estate investors, which many people don’t. Also, if the borrower defaults, you’d have to go through the expensive, cumbersome foreclosure process to recover your money. 

In other words, you should only lend money privately to real estate investors who you trust implicitly with your money. Consider it a more advanced option, with higher risk than your typical bond investments.

Paying Off Your Home Mortgage

Paying off your mortgage early is not just a safe investment, it’s guaranteed. Once paid off, you avoid paying interest, so you earn a guaranteed return equal to your mortgage interest rate. 

So, paying off your mortgage loan early makes for a risk-free — but also low-return — investment, lowering your living expenses. Consider using some of the money you had planned to invest in bonds to pay off your mortgage early instead if your mortgage rate is higher than the returns offered by high quality bonds.

House Hacking

Paying off your mortgage early isn’t the only way to ditch your housing payment. 

Instead, consider house hacking. It involves finding a way to generate income with your home, to cover your monthly mortgage payment. 

In the classic model, you buy a duplex to rent out one side and live in the other. You can do the same with a three- or four-unit property, all of which qualify for conventional mortgages.

But that’s not the only way to house hack. You can instead rent out rooms, or storage space, or boat or RV parking. My business partner went so far as hosting a foreign exchange student to cover her mortgage payment. Alternatively, you could add an accessory dwelling unit (ADU) to your property and rent that out. As a bonus, it doubles as an in-law suite, and typically adds value to your home.

Buy Rental Properties

I’m the first to admit: the average person shouldn’t invest in rental properties, despite the tax advantages and other upsides for retirement income.

For all their advantages, they also come with high risk for novice investors. Most people make mistakes on their first few real estate deals, and don’t earn the high returns they were expecting. Only experienced real estate investors can consistently earn high returns at low risk. 

Plus, rental properties come with a lot of work. Sure, you can outsource some of the labor by hiring a property manager, but then you need to manage the manager. People can keep on protesting against “lazy landlords” all they want, but until they actually own a few rentals of their own, they don’t know what they’re talking about. 

The bottom line: you should only replace bonds in your portfolio with rentals if you’re an experienced investor.

Watch Out for Publicly-Traded REITs

At this point, traditional investors start asking “What about publicly-traded REITs? Do those make a good alternative to bonds in my retirement portfolio?”

No, they don’t. While they do often pay high dividend yields, they don’t satisfy the other two roles of bonds in your portfolio. They come with high price volatility (like stocks), and they share a high correlation with stock markets. Neither of which should come as a surprise, given that they trade on public stock exchanges. 

Word to the wise: keep your real estate and stock investments truly separate, especially if you want real estate to replace bonds in your portfolio.

Final Thoughts

Sure, high-grade bonds come with low default risk. But they also pay low yields, while still coming with inflation risk and rate-change risk. As far as I’m concerned, the returns don’t justify the risk. 

Instead, I opt for diverse real estate investments with low to moderate risk, and pay moderate to high returns. It helps that I’m pursuing financial independence in my 40s, and have more risk tolerance than a 60-something who may not have the option of continuing to work if a disaster strikes their portfolio. Even so, the risk/return math on bonds just doesn’t add up to me. 

Chris’ $.02

I agree with Brian’s assertion that most people have an oversimplified view of investment risks in general, and they specifically don’t understand all of the risks associated with different types of bonds.

I actually agree with much of what he wrote in this post…. with one huge caveat.

Buying bonds can be done with simplicity, safety, and minimal cost or effort by almost anyone with a few hours of research and a couple clicks of a button. Real estate can not.

This is not to say it can’t or shouldn’t be done if you have the appropriate time, temperament, and skillset to be successful as a real estate investor in any or all of the forms he describes. That’s why I share viewpoints of people like Brian who have successfully navigated alternative paths to financial independence than those typically espoused by Darrow or I on this blog.

Just recognize that any comparison of the returns, risks, costs, and amount of sophistication required to invest in bonds vs. real estate is not an apples to apples, or even apples to oranges, comparison. It’s more like comparing apples to orangutans in my humble opinion.

What does your asset allocation look like? Where do bonds and real estate fit in? Let’s talk about it in the comments?

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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