In early 2022, inflation has slashed nearly 8 percent off of every dollar you owned just one year ago.
Meanwhile, 10-year Treasury bonds have paid a paltry 1.2 percent to 2.3 percent over that period. Had you invested in one of these bonds a year ago, you’d have lost around 6.5 percent on your investment, in real dollars.
It’s enough to make you wonder: Do bonds deserve their reputation as the “safe” investment option? Or should you reconsider ways to diversify your investments?
Why investors buy bonds
People buy bonds for several reasons. To begin with, they offer a simple way to diversify away from stocks. Stocks offer many advantages, from instant liquidity to high historic returns to easy diversification across industries and regions. But stocks also come with enormous volatility, which adds risk.
Older investors nearing or in retirement typically move part of their nest egg out of stocks and into bonds. This is precisely how robo-advisers manage your account as you get older, and how target date funds change allocations as the target retirement date gets nearer. This makes some sense: High-grade bonds provide steady income with a relatively low risk of default.
Unfortunately, they also leave investors vulnerable to inflation. The risk of default isn’t the only risk that comes with bonds.
Real estate: an alternative to bonds?
Real estate offers many of the same advantages as bonds, without the same inflation risk.
First, real estate provides diversification away from stocks. Real estate prices share a low correlation with stock markets, so they help protect investors from the risk of a crash wiping value off of their entire portfolio. In fact, real estate values are historically far more stable than stock prices.
Second, real estate generates ongoing income. Beyond high-income yield, you don’t need to sell off any underlying assets to collect it, so you don’t need to sell off assets or worry about “safe withdrawal rates” and running out of money.
As for risk, real estate comes with different risks than bonds. Real estate adjusts in value based on inflation, so it doesn’t share that risk with bonds. Look no further than how rents rose nearly twice as fast as broader inflation in 2021.
Still, different types of real estate investments come with their own risks and strengths.
Ways to invest in real estate
You could go out and flip houses of course, but that hardly qualifies as a passive investment that could replace bonds in your portfolio.
Instead, consider these options for passively investing in real estate, to replace part of the bond allocation in your portfolio.
1. Publicly traded REITs
You can buy shares in publicly traded real estate investment trusts (REITs) through your regular brokerage account or IRA. That makes them simple and liquid to buy or sell.
Unfortunately, they share an uncomfortably close correlation with stock indexes for my taste. This makes sense, since they trade on public stock exchanges.
Even so, they offer high dividend yields, as by law they must distribute at least 90 percent of their profits to investors in the form of dividends. Public REITs also make it easy to diversify your real estate investments, buying shares in funds that own many properties across the world.
2. Crowdfunded REITs
In the 2010s, a new class of REIT skyrocketed in popularity. These private REITs don’t trade on stock exchanges, which removes the volatility in prices. Investors buy shares directly from the REIT company and sell shares back to them when they want to cash out.
That also removes the liquidity, however, as most crowdfunded REITs require you to hold your shares for at least five years after buying, or they hit you with a penalty when you sell back shares.
It makes sense though — real estate is an inherently illiquid investment. It costs a great deal of time and money to buy and sell.
Compare the real estate crowdfunding investments available on the market today, many of which allow non-accredited investors to participate. Just make sure you only invest money you don’t mind leaving put for at least five years.
3. Crowdfunded real estate loans
Not all real estate crowdfunding investments are structured as pooled funds like REITs.
Some let you invest money toward specific loans, secured against real property. For example, Groundfloor lets you put as little as $10 toward any given loan. If the borrower defaults, Groundfloor forecloses to get your money back.
Nor are these homeowner mortgages, paying 3.5 percent interest over the next 30 years, and lending out nearly 100 percent of the purchase price of the property. These crowdfunding platforms are hard money lenders: They only work with investors, offering short-term loans to buy and renovate a fixer-upper. To protect themselves (and you, as a participating investor), they only lend 60 percent to 80 percent of the purchase price, on average.
4. Private notes
You can also lend money directly to other real estate investors, in the form of private notes.
For example, I’ve loaned money to a real estate investing couple that I know and trust in Ohio. They pay me 10 percent interest only on my loan to them, payable each quarter.
However, you should only lend private promissory notes if you know a successful real estate investor personally, and you fully trust them to pay you back in full and on time. If they default, you have little recourse but to sue them for breach of contract and possibly foreclose on their property if you recorded a lien.
5. Rental properties
You can, of course, buy rental properties and become a landlord. It’s a classic way to bring in semi-passive income from here to eternity.
On the plus side, savvy investors can earn strong, predictable returns on their money, with minimal risk. But rental investing requires knowledge and skill, plus effort and time to buy each property. That says nothing of the ongoing work to manage each property.
The average person underestimates how much work and skill it takes to reliably earn high returns as a landlord. They also overestimate landlords’ returns, leading to a myth that landlords earn enormous returns while doing no work.
Only invest in rental properties if you’re interested in real estate investing as a side gig, because that’s the level of commitment required to succeed.
6. Real estate syndications
Real estate syndications allow you to buy into a large property as a fractional owner.
For instance, an experienced commercial real estate investor finds an apartment building to buy. She puts in 20 percent of her own money and raises the other 80 percent from silent partners like you.
You get to own a percentage of a large apartment building, without having to do any work, and without having to cough up millions of dollars by yourself.
Sadly, most real estate syndications only allow accredited investors to participate, due to Securities and Exchange Commission regulations.
Should you replace bonds with real estate?
If you like the idea of earning higher returns than bonds, without the volatility of the stock market, real estate offers another option.
That said, only consider moving a small percentage of your bond portfolio to real estate in the beginning. You can ramp up later, but get comfortable with your chosen real estate investing strategy before moving too much of your nest egg into it.
I personally don’t invest in bonds. I find the combination of low returns and high inflation risk unacceptable compared to the returns I earn on real estate. But only you can decide your own comfort level in choosing an investment portfolio.
Brian Davis is a real estate geek and co-founder of Spark Rental.