Real estate is like a bond plus an investment: more growth potential

Selling bonds to buy real estate is a much simpler decision than that sale of shares in order to purchase real estate. Real estate works like a bond plus investment because bonds have more similarities to real estate than stocks.

The word “plus” is added to bonds to describe the property as a type of bond that has more upside potential and less downside potential. Although nothing is guaranteed, hence the word potential.

This post is for people who are:

  • It seeks to better understand the dynamics between real estate versus bond investments
  • Considers selling bonds to buy real estate or vice versa
  • Trying right build their net worth based on their risk tolerance
  • Finding ways to achieve financial independence sooner with more risk than bonds

Why real estate behaves like a bond plus an investment

Real estate and bonds behave similarly.

When interest rates fall, bond values ​​and real estate values ​​tend to rise. When interest rates rise, bond values ​​and real estate values ​​tend to fall.

So if you sell bonds after interest rates rise to buy real estate, you could be trading one loser for another. You are likely to lose money in bonds if you own a bond fund or sell a bond before maturity in a rising interest rate environment.

Conversely, if you sell bonds after interest rates fall to buy real estate, you can trade one winner for an even bigger winner. As a result, the shift in asset classes is not as large as if you moved from equities to real estate.

Correlation in real estate and bonds also does bond ownership less necessary for diversification if the investor already owns a property in his portfolio.

Real Estate Like Bond Plus In Upside Scenario

In a bull market, you are likely to get a higher percentage and greater absolute return on real estate than on bonds. This is where the “plus” in “bond plus” comes in.

Due to leverage, real estate tends to have a higher cash-on-cash return. In addition, due to the usually higher absolute dollar value of holding real estate compared to bonds, the absolute amount of return on real estate tends to be higher as well.

If we are talking about primary housing investment, another plus real estate has over bonds is that the home owner can use the home. while a bond investor cannot exercise his bonds. Bonds have no utility.

You can put REITs and Homes together in the chart below of 20-year annualized returns by asset class. REITs a private real estate funds are for investing. The houses are for living. Although Homes only shows a return of 3.7%, with leverage the cash-on-cash returns are much higher.

Returns by Asset Class - Comparing Real Estate and Bonds

Real Estate Like Bond Plus Behind The Scenes

Real estate can also outperform bonds in a downturn scenario.

For example, when interest rates rise aggressively in 2022 and 2023, bond funds take a hit. IEF, the iShares 7-10 Year Treasury Bond ETF, is down 15% in 2022.

Meanwhile, real estate outperformed as the median home price in America fell only ~8% in 2022. Therefore, compared to the long-term government bond fund, the median price of real estate has outperformed.

Compared to the Bloomberg US Aggregate Bond Index, which fell 13% in 2022, it also outperformed the median home price.

If you compare the median house price to riskier corporate bond funds, the median house price outperformed even more.

Real estate investors can more easily take steps to protect against downside risk

In 2023, the median home price in America is actually up a few percentage points, while bond funds are down. Why? The vast majority of homeowners refinanced when rates were lower and are therefore unwilling to sell. Lower supply supports higher prices. Meanwhile, the Fed continued to raise rates.

Real estate investors can better protect themselves from downside risk by doing so take action. These actions commonly include refinancing, finding higher paying tenants, and remodeling.

Bond investors, on the other hand, can’t do much to hedge against downside risk other than go short. Bond investors, like stock investors, are largely passive investors who cannot influence positive change.

Properties provide more benefits during the most extreme hardships

Investors buy government bonds and highly rated municipal bonds for safety. At the same time, many investors buy real estate for safety because it is a real asset with utility. Residential real estate values ​​don’t usually drop overnight.

Here are two examples of extreme hardship that explain why real estate is an advantage over bonds for peace of mind.

Example 1: There is hyperinflation 1000% per year. The value of government bonds will collapse, while real estate values ​​probably won’t. Instead, real estate values ​​are likely to become hyper-inflated as well, because it’s a good thing, after all. People work and earn money to buy real estate, not the other way around.

Example 2: Your country is going to war. Government bonds can also collapse due to capital flight. There is a fear that a new regime will take over and your country’s currency will be worthless. However, as long as your home isn’t bombed, it offers more value than bonds because it provides shelter. While the value of your home will likely drop as well, at least it allows you to live life.

It helps to understand financial concepts more easily think in extremes.

Bond type is important for relative performance

Although real estate can often outperform bonds in a rising interest rate environment or recession, this is not always the case.

Let’s say you bought for $1 million one-year government bonds yield 4.5% before interest rates started to rise. Nine months later, you sold the entire position to buy the property.

With a 1-year Treasury bond, you probably haven’t lost any principal because of the bonds’ huge liquidity, long enough holding period, and relatively short duration. Instead, you probably made a 3.375% return ($33,750) after nine months instead of a 4.5% return after twelve months.

Holding an individual government bond to maturity is a guaranteed return. Holding a short-term Treasury bond further increases the likelihood that you won’t lose money if you need to sell before maturity.

In the example above, the 3.375% yield will overcome an 8% decline in median property prices in 2022. So if you bought a $1 million property that dropped $80,000, your net gain would be $80,000 plus the $33,750 you they made off of your 1-year Treasury gains.

Invest based on your understanding

I don’t like to own bond funds because there is no maturity date to get back the full principal plus interest. You can certainly get more returns by buying bond funds if you time your trades properly such as the day interest rates peak and sell when interest rates fall.

A lot of bond investors do and invest in riskier junior bonds, corporate bonds, and high yield bonds to try to get higher returns. However, these types of investments are not for me. I’m happier as a buy-and-hold investor.

To invest in riskier assets for more potential growth, I would rather invest in stocks or real estate because I know these assets best. To preserve capital, I would much rather invest in individual government bonds or AA-rated municipal bonds and hold them to maturity.

Considerations for selling government bonds to buy real estate for cash

Before selling individual government bonds to pay cash for a new home, consider the following:

  • Will I lose money if I sell early? Check this by comparing the purchase price of government bonds with the bid price if you are selling. If it looks like you will sell the bond at a loss, you can decide to hold it until maturity and sell another bond instead.
  • How much risk-free interest income will you give up per month if you sell before maturity? The main reason I wrote the post is to not earn interest, How to delay closing escrow to make more money.
  • How much in federal ordinary income taxes you’ll have to pay on Treasury bond income. If you sell the government bond earlier, you will pay less ordinary income taxes because less income will be generated. Government bonds are not subject to state income tax.
  • What would the composition of your net worth and investment portfolio look like if you sold government bonds to buy a new home? Personally, I’m not a fan of any single asset class that accounts for more than 50% of one’s net worth.

Selling government bonds to buy real estate was an easy decision

Since real estate is like a bond plus an investment, I feel that over the long term my home’s value will grow faster than my Treasury yields. Part of the reason is that I believe interest rates will eventually fall and government bonds will become less attractive.

If I were to sell junk bonds or long-term government bond funds that are way down to buy real estate, that would be a much harder decision. Long-duration junior bonds and government bond funds are likely to outperform real estate if interest rates fall because they are much more volatile.

My biggest gripe with selling Treasuries to buy a house is no longer getting the ~5% risk free income. A guaranteed 5% return with inflation around 3.5% is a solid real return.

Even though I was paying cash and had no mortgage, I went from earning a lot of risk-free income to earning little. Plus I have extra property taxes and maintenance bills to pay.

Summary of Real Estate as a Bond Plus Investment

  • Bonds and real estate act similarly to changing interest rates
  • Real estate can offer higher returns than bonds in good times
  • Real estate can lose less than bonds in bad times because real estate investors can act
  • If you own real estate, there is no need to own so many bonds to diversify your portfolio
  • Selling bonds to pay cash for a house is easier than selling stocks to pay cash for a house
  • Your reserve fund should hold short-duration individual government bonds versus government bond funds or riskier types of bonds

The properties are mine popular asset class for ordinary people to build wealth. Real estate generates income, provides shelter, offers diversification, can be upgraded, usually benefits from inflation and has a positive historical return. The average net worth of American households will rise to $1.06 million in 2022, thanks in large part to real estate.

Bonds are fine and have a historical average return of about 5%. But since you can’t enjoy or upgrade your bonds, bonds simply aren’t an attractive enough investment compared to real estate.

Real estate is easier to achieve financial freedom than bonds. As a result, I will continue to own real estate through bonds for the rest of my life. The basis is to invest in real estate appropriately. If you go into too much debt to buy too much house, you could face financial problems in the future.

Questions and suggestions from readers

What are your thoughts on holding bonds if you already own real estate? Do you see real estate as a bond as well as an investment? When does owning bonds outweigh the benefits of owning real estate?

If you want to average for dollars in a weak real estate market, check out Fundrise. Fundrise primarily invests in residential and industrial properties in the Sunbelt, where valuations are lower and yields are higher. Fundrise is an affiliate partner of Financial Samurai.

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