The world is changing. Over the last few months, we’ve seen Zoom sessions replace happy hours, sweatpants replace work clothes, and the Federal Reserve move interest rates to zero. Now more than ever, investors need to be creative about finding supplemental income outside of what bonds used to provide.
This article will look at one potential alternative to bonds- private real estate – and will examine the pros and cons the asset class has to offer.
The problem with the old approach to fixed income
Younger investors are usually more tolerant of risk because they have decades to build up their portfolio, but as they near retirement age, investors lose their appetites for risk and tend to shift focus toward preserving and living off of their investments. In order to minimize risk and maximize stability, wealth managers have traditionally advised clients to shift their portfolios to bonds.
In the past, bonds provided strong ballast in portfolios to enhance investment income in a safe nature. As we near retirement, our risk tolerance decreases and our focus transitions from growing our wealth to preserving and living off our wealth.
The old rule-of-thumb is you can normally spin off about 4% from your investments without dipping too much into your principal. As an example, a one-million-dollar portfolio can generate about $40,000 per year in investment income without depleting the initial one million dollars. Generating 4% off a conservative account used to be relatively simple. The income off of bonds would make up most of the 4% needed.
Consider this option
The 10-Year Treasury bond is one of the safest bets in investing. It’s issued by the government and backed by the full faith and credit of the United States. While these treasury bonds aren’t the flashiest investments, they are very safe. They set the tone for the rest of the bond market that you may be familiar with; corporate bonds, high yield, etc. are all priced based off these bedrocks of the bond market.
While these treasury bonds have been the ballast of portfolios for sixty years, the chaos of the moment has reduced their utility. Since 1962 the 10-year Treasury yielded 6.08% on average compared to the current yield of 0.65% as of April 27th, 2020. No, that is not a typo, the current yield on the 10-year treasury is trading at over a 900% discount from the average yield.
With yields this low, investment managers are being forced to find riskier alternatives to make up the difference in portfolios. Equities, high yield, real assets, and alternative investments all have their place however you must assume more risk to receive the higher levels of return.
Why private placement real estate makes sense for the right person
The relationship between risk and return is the fundamental balance in investing. The more risk investors are willing to take on, the higher level of return you should demand for the additional risk. To fill the gap, you may be tempted to turn to more volatile investments which are subject to the whims of the publicly traded markets. We just need to look to March of 2020 to see examples of publicly traded stocks losing 20-30% of their value over the course of a few days or weeks.
The volatility of the stock market may be too much for investors to stomach so we’re forced to find an investment vehicle that combines the higher returns of typically riskier strategies with the solidity of the bond market. Private real estate offers diversified real estate portfolios with much less volatility because it is not actively traded and since it isn’t on the public markets it doesn’t have a “price” attached to it which can fluctuate daily. Because of this, the price swings of private real estate are equal to or lesser than the price swings/volatility of core fixed income portfolios.
The Sharpe Ratio calculates your return based on your risk-level when factoring in volatility.
As we analyze the standard deviation of private real estate funds, it’s important to recognize WHY the volatility is so low in this investment vehicle compared to publicly traded REIT’s (Real Estate Investment Trusts).
Certain regulations limit the amount of money that investors can pull out of these investments, which locks them into a longer-term outlook. Additionally, because these types of investments are only available to sophisticated investors there is much less panic buying and selling from retail investors who tend to be less educated. Therefore, the low volatility private REIT’s tout should be taken with a grain of salt because the limited liquidity options to pull your money out during downswings in the market creates somewhat artificially low volatility numbers compared to public markets. That being said, from a behavioral side, it can be a useful tool to see this low volatility in an income-producing position in your portfolio with potential greater upside than your investment grade bond portfolio can produce!
Who should be invested in private real estate?
Private real estate isn’t for everyone, and only accredited investors can invest into them in the first place. Because of the limited liquidity available in these funds, this investment should only really be used by clients who have other sources to pull money from when needed. The illiquid nature helps with volatility but can be a huge detriment if the investor needs to sell out of their position early and therefore should be carefully considered. Retirees with ample assets and places to pull income from can look to this uncorrelated asset class to stocks and bonds as a return enhancer to their bond portfolios.
While Private REIT’s have many benefits, it’s critically important to underwrite the fund and make sure you understand their fees and structure. Not all private real estate funds are created equal and some can charge exorbitant fees. Make sure you are working with an advisor who can underwrite and understand the costs and risks associated with private real estate before implementing the strategy into your portfolio.
Have questions about this or any other investment opportunities you might want to consider? CLICK HERE for a free 45-minute consultation!
Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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