Forget Bonds, Buy Real Estate

With interest rates cratering due to an ongoing and escalating global trade war and expectations for slowing global growth, investors around the world are placing more capital in safe havens like the U.S., driving bond yields lower. The Federal Reserve recently dropped interest rates as well; which is good for paying for our growing national debt, but hurts retirees and those looking to live on fixed income. Read this article here where some investment strategists are now over-weighting real estate as a result and reducing bond allocations.  Yield hungry investors should take a closer look at real estate.

Historically, when interest rates are cut the article cites, real estate outperforms over time. As a syndicate involved in over twenty multifamily deals across the country, investors have been receiving cash on cash returns in the 7 to 8% range consistently and with a preferred return in that same range. We see investors get paid up to 8% before the general partner in the deal receives their profit split. The preferred returns are cumulative, so that in any one year, if we had a downturn, it catches up later when there is a capital event like a refinance or eventual sale. So, the safety comes from a preferred position.

To gain an even higher yield and a more secure position, I recently participated in a multifamily real estate deal in Austin that offered a two-class option for investors versus the traditional hybrid model of one class for all investors that are more the norm. This offering earmarked 25% of the equity raise to income investors seeking higher yields. The return expectation is 10% cash on cash annually for up to 5 to 7 years. It’s a preferred equity position (Class A) over the growth investor (Class B) giving up some cash flow in the deal for an opportunity to get 25% higher growth.  Read my last blog here on that strategy.

It also, unlike bonds, is an equity position so all the tax benefits flow through to the limited partner Class A holders, almost like a pre-tax 12% to 13% return.  It's really a powerful investment approach because of the preferred position, double digit returns, tax benefits and risk. Let's talk about risk since most bond holders add bonds for safety and some income.

When you look at the risk, the data supports an overwhelming secure, confidence of achieving that 10% preferred return. Going back to our example, noting that in the 2009 market crash, vacancy in Austin was no higher than 10%. In a typical healthy market, it hovers closer to 5% like it is now. Our model stress tested vacancy as high as 20% (2x the 2009 crash) and showed ample room to support the 10% yield (4.5% cash flow at 20% vacancy and all we needed was a 2.5% cash flow to pay out 10%). This model only works if Class A equity is confined to no more than 25% of the equity stack (raise).

Additionally, Class A has a preferred return of 10% and sits ahead of Class B (growth) investor and Class C general partner in receiving their payout first. If we ever distributed less than that in any given year, the 10% is cumulative and would be caught up later when times get back to normal or at a capital event like a refinance or sale. 

Lastly on apartments, the downside market protection is proven. In 2009, less than .5% of all MF owners were seriously delinquent in paying their debt on the property while single family homes were 4.5% (insert chart). That’s a pretty powerful reason to be in this niche and took look for yield while getting the safety you are wanting from bonds.

So, for those who only know of traditional bonds, consider looking at real estate for income and safety in the right deals ­– preferred equity positions or hybrid debt with equity kickers backed by secure, income producing real estate. Consider strong local markets where jobs and population are moving to above national averages. Find operators who are experienced and conservative in their underwriting / assumptions and focused only on one niche, like MF apartments that have a history of performing well in downturns.