Can real estate substitute for bonds in asset allocation?

[ILikeStarTrek]

I've read various articles which basically tend to give a similar rule of thumb, which says that for retirement assets, one should have about 60% stocks, 35% bonds, 5% cash. I'm not asking about tweaks to this formula if someone thinks that one or two of these percentages should be 5% higher or lower; but just at a rule-of-thumb level, this is what I perceive to be the majority recommendation.

The general idea I've seen behind this is, stocks have a higher rate of return than bonds over time, so one wants a higher percentage of one's assets in stocks. However, because of the sequence-of-return risk of a stock market crash early in one's retirement, one should have some bonds which will give a guaranteed yield. This protects one's assets from going down too much in a stock market crash, since (again as a rule of thumb) bonds don't tend to fall at the same time as stocks, so it's a way of diversifying one's assets.

However, I believe that most typical retirees have most or all their income-producing assets in monetary funds (stocks/bonds/cash). In my case, I have over 50% of my overall income producing assets in real estate rentals.

The following numbers are round numbers which tend to describe my situation. Let's say I have $1 million in monetary assets and $1.1 million net value in real estate rental assets. Using a 3% withdrawal rate on the monetary assets, let's say I plan to start drawing out $30k/yr from that, and my real estate rentals are reliably bringing in $35k/yr income (with an inflation rate growth in both net value and rental rates). For an overall retirement income of $65k/yr.

My question is, do I still need a 60/35/5% split to diversify my $1 million in monetary assets? Or do my real estate rentals give me all the diversification I need for asset and income protection? If stocks fall in value, it affects less than half of my overall retirement assets and income. If I were to diversify my monetary funds using the 60/35/5 split, then $600k would be in stocks, which would actually be less than 30% of my overall retirement assets. I don't see why I would need to do that. It seems to me that I already have enough asset diversification and I should keep most of my monetary funds in stocks to get the higher long-term rate of return.

I'm thinking I want to keep a 90/10% or 95/5% split for stocks/cash. I don't see why I need any bonds since it seems like the guaranteed yields it is supposed to bring is for me being substituted by reliable real estate rental income.

I look forward to seeing what the financial gurus (or others, even if you don't consider yourself a guru ) on this site have to say in considering my situation.

 

[Curmudgeon]

If we have another 2008-like event, it seems likely that both stock value and RE value would tank. Would you be able to live on just the income, without having to sell at the bottom?

Not a guru, and no answers, just questions

 

[pb4uski]

I think it really depends on the nature of the real estate... but at the end of the day real estate is not a bond... it is definitely more risky than bonds but in many instances less risky than stocks.

My Mom's commerical property is a great example... we have a long-term tenant that is a Fortune 1000 company, has been a tenant for ~30 years and pays on time all the time. The property makes a great return... but... they could change their minds and bail on the lease anytime after a couple years from now... even if they bailed now and refused to pay their remaining lease payments we would need to sue them to collect. Also, there is concentration risk with most real estate... if that area has an economic downturn then you're screwed at least for a while (like Detroit and others).

With an investment grade bond, there is a high likelihood that you will get your interest when due and your par value at maturity.... real estate cahs flows have nowhere near the same degree of certainty.

 

[Luck_Club]

Like everything it depends. I own rentals and consider them less risky then bonds, and at today's rates certainly have a higher yield.

With that being said. I consider bonds the same as stocks, "marketable securities". In this class of investment, you can watch your asset value rise and fall with changes in the market. Your yield can be changed on Dividend paying stocks, but not bonds. However, with Bonds you get the added benefit of potentially having them called where they return your capital, and you have the "problem" of finding a new place to give you a return.

In my book the Rentals are steady cash flow, which can't be called, though you can miss a monthly interest payment or two from time to time.

 

[W2R]

[...]real estate is not a bond[...].

I think that says it all. Read a few books on asset allocation and decide if you want to allocate any assets to real estate, and if so, how much.

 

[Texas Proud]

NO...

 

[HadEnuff]

If I need $, and don't want to sell equities at that particular time (for example, if they have just suffered a major correction), I can sell my bonds a lot easier than selling real estate.

Which is to say, real estate is not an easily liquidated asset.

 

[traineeinvestor]

As others have said, real estate is not a bond - they have different risk/return profiles.

FWIW, we have more than half our nest egg in real estate and very little in bonds. Over the longer term, I view real estate as being less risky than bonds - preferring to accept the risks of market volatility/cash flow disruption/lack of liquidity/difficulty in rebalancing in order to get the potential for protection against inflation/ability to gear and avoiding the risk of total loss on default which comes with non-government bonds (and some government bonds).

 

[Senator]

I have a decent sized real estate portfolio, and I do not have any bonds. My cash flow is good, and even if it drops by 50%+, I can live on it. I also have free healthcare and a small pension, if I need it. Even my dividends from my stocks are nearly enough to live on.

I invested in mortgage bonds by paying off my own mortgages. Those were at 5.375%+. I get that interest money every month, without fail, by not having to pay my mortgage. No matter what the stock or bond market does. The interest I receive can never be cut, or the bond called, either.

Real estate is risky, but once you have a known quantity, it is relatively safe. The initial investment is where the risk is. Commercial real estate has it's own risks, and is more risky than residential real estate. Since you already have your rentals, the risk is minimal. You have the most risk with a bad tenant, and once you know how to screen out the bad ones, it's not very risky.

The real estate value may go up or down, but rents are consistent. And you can always increase demand by lowering rents. I could cut my rents 50% and still be cash flow positive.

Keep a solid set of US Stock indexes. I have IVV,. IVW, QQQ, IWM, DVY, HDV.

 

[97guns]

Doesn’t really matter what you invest in... if you buy it right you mitigate your downside/risk l when the asset increases. Case in point, I paid $80k for my rental properties and today they are $280k, I can withstand a pretty decent downturn

 

[Another Reader]

I have a lot of rentals and very little invested in bonds. Some treasuries and whatever is in Wellington, but that's not a large part of the paper asset portfolio. Some cash and CD's, mostly short term right now.

My conclusion is the same as Senator's. I have held most of these properties a long time. The rent checks mostly showed up in 2008 to 2012, and rents actually went up over that time. I have paid off and will continue to pay off mortgages.

I am less concerned about what a long term asset is worth on any day than the income it produces. I have to decumulate the inherited IRA, but I pay down the mortgages more than the total of the RMD's plus the smoothing increment I also take.

ETA: I don't like bonds because of the magnifying effect of interest rates on asset values. I think they tend to be mispriced relative to their risk. I would rather take swings in value on a piece of a profitable business that a stock represents than on an IOU.

 

[harley]

I wouldn't say that real estate is a replacement for bonds, but it's certainly another asset class that can be used to offset the volatility of equities. I've got a fairly large allocation of RE, and a small bond allocation. My equity allocation is about the same as the RE. So it all depends on what you're comfortable with. Some people on this forum love RE, others hate it. You're choice.

 

[ILikeStarTrek]

Thanks everyone for the feedback. Very good comments. Here are a few that I want to especially respond to.

If we have another 2008-like event, it seems likely that both stock value and RE value would tank. Would you be able to live on just the income, without having to sell at the bottom

As long as the event isn't any worse than 2008, I believe I would be fine. In 2008, real estate residential rentals were fine, it was people who were trying to sell their real estate who were in big trouble. For the money part of my portfolio, if I do a 90/10 stock/cash split, that gives me a 3-year time frame where I can use my cash without having to sell any stocks. For the 2008 crash, the stock market had very nearly recovered in three years and I would have been okay; but if there is a more extended downturn lasting 5+ years, then I would start to feel it.

My Mom's commercial property is a great example... [the tenant] could change their minds and bail on the lease anytime after a couple years from now.... Also, there is concentration risk with most real estate... if that area has an economic downturn then you're screwed at least for a while (like Detroit and others). .... real estate cash flows have nowhere near the same degree of certainty [as bonds].

Those are good points to consider. My properties are residential, so not dependent like commercial on keeping the same tenant. There is always a risk of needing to evict a non-paying tenant, and I have had a few of those in the past few years, but I have multiple properties and the probability of having to evict everyone at the same time is pretty remote. By now, I have a good idea of what my rental income is going to average, and if anything I expect my rental income to grow a fair amount since my rents are actually low for the respective neighborhoods. I live in an area that so far has a good general growth over the past 20+ years and looks to keep going. Still, as you pointed out, my real estate doesn't have the certainty of a guaranteed yield.

I wouldn't say that real estate is a replacement for bonds, but it's certainly another asset class that can be used to offset the volatility of equities. I've got a fairly large allocation of RE, and a small bond allocation. My equity allocation is about the same as the RE. So it all depends on what you're comfortable with. Some people on this forum love RE, others hate it. You're choice.

I think this is a good comment. As several posters have commented, real estate is not the same as bonds. But what I'm looking for is a way to be diversified and lower the overall risk in my investments. I believe I can make a good case for saying that, 2008 crisis not withstanding, in most financial downturns real estate provides a better general diversification from the risk of a stock downturn than bonds do. And as I mentioned above, even a crisis like 2008 wouldn't hurt me in my real estate, because in 2008, one could still rent out houses even though they weren't selling.

(For what it's worth, I actually bought most of my rental houses in late 2008 & 2009. I bought them at bargain prices. I have rented them out thus far. I could sell them and make a good profit if I wanted to, but I like the cash flow I get from keeping them and I tend to view them as more solid investments in general than bonds.)

I'm definitely still monitoring this thread, and if others have further comments, I look forward to reading more.

 

[BeachOrCity]

I had a similar AA as you with lots of real estate and my stocks bonds cash mostly in stocks. Ultimately because of liquify differences between RE and bonds I decided to change my AA so my stocks bonds cash portion had an age appropriate bonds and cash component.

I asked myself a question. Would I still retire early if the stock market fell 50 percent ? The answer was no if I kept it all in stocks and yes if I moved some to bonds.

 

[Senator]

I had a similar AA as you with lots of real estate and my stocks bonds cash mostly in stocks. Ultimately because of liquify differences between RE and bonds I decided to change my AA so my stocks bonds cash portion had an age appropriate bonds and cash component.

I asked myself a question. Would I still retire early if the stock market fell 50 percent ? The answer was no if I kept it all in stocks and yes if I moved some to bonds.

How much real estate value did you have in comparison to your total portfolio?

in my case, I have pretty close to a 50/50 real estate vs stocks.

I think it also matters to how much extra your total portfolio generates over what you actually need. If you only have enough, you have to be very conservative.

 

[Luck_Club]

How much real estate value did you have in comparison to your total portfolio?

in my case, I have pretty close to a 50/50 real estate vs stocks.

I think it also matters to how much extra your total portfolio generates over what you actually need. If you only have enough, you have to be very conservative.

My Rental RE to Stocks ration is 72 RE: 28 Stocks. Excludes home.

 

[Earl E Retyre]

FWIW, I view real estate as being more similar to stocks than I do bonds.

Rationale being that I invest in equities as a hedge against high inflation risk combined with expecting a much higher return than my bonds/cds. I earn a higher return as a pay-off for taking volatility risk.

I view my real estate rentals in the same way. It is a hedge against high inflation risk combined with expecting a much higher return than my bonds/cds. I earn a high return as pay-off for taking risks such as the real estate market tanking, higher than expected maintenance costs, or delays finding new tenants.

My bonds/cds offer guaranteed income with little to no risks. My real estate offers almost guaranteed income with relatively low risk (in my opinion). So, in that way, they are similar. However, I view the hedge against inflation as the primary characteristic if I were comparing the investments.

 

[Senator]

FWIW, I view real estate as being more similar to stocks than I do bonds.

Rationale being that I invest in equities as a hedge against high inflation risk combined with expecting a much higher return than my bonds/cds. I earn a higher return as a pay-off for taking volatility risk.

I view my real estate rentals in the same way. It is a hedge against high inflation risk combined with expecting a much higher return than my bonds/cds. I earn a high return as pay-off for taking risks such as the real estate market tanking, higher than expected maintenance costs, or delays finding new tenants.

My bonds/cds offer guaranteed income with little to no risks. My real estate offers almost guaranteed income with relatively low risk (in my opinion). So, in that way, they are similar. However, I view the hedge against inflation as the primary characteristic if I were comparing the investments.

Great points. It is almost like a blend of stocks and bonds. I have talked with many investment advisers, and most do not really know how to handle real estate... They want to ignore it. Investing in your own mortgage is ignored, while investing in a fund that invests in mortgage backed securities is considered a bond. My mortgage is a safer bet to invest in than a mortgage bond, assuming I continue to manage my real estate portfolio as I have in the past.

Higher end real estate is much more of a risk than average priced places. Rents can fall, and higher end properties may not have the cushion necessary to accept lower rents.

In high inflation, real estate generally goes up. In fact, even low inflation, it goes up. Bond prices going down (i.e. rates going up), property taxes, may affect real estate adversely. In MN, the recent changes to building codes even caused real estate prices to go up. Figure a $20K increase for a average sized home in MN, vs. SD. That in turn brings all real estate prices up.

The problem with real estate is, even though you maybe have $10M worth of property, you cannot even buy a cup of coffee with it. It is illiquid, mostly. A bond fund is liquid.

In the mean time, I continue to re-invest my dividends in US index funds, and continue to raise my rents. Gross rents are up over $20K annually since I retired 18 months ago, and would be up over $30K if I was not in the middle of a rehab and have my one vacancy. It is a property I am likely going to sell in the spring.

 

[BeachOrCity]

How much real estate value did you have in comparison to your total portfolio?

in my case, I have pretty close to a 50/50 real estate vs stocks.

I think it also matters to how much extra your total portfolio generates over what you actually need. If you only have enough, you have to be very conservative.

I was an am about 50 percent real estate. But my real estate investments dont throw off the kind of cash yours do. This latter part is a good point.
If RE CoC meets all your espenses, stock bond allocation is less critical.

 

[BeachOrCity]

My Rental RE to Stocks ration is 72 RE: 28 Stocks. Excludes home.

If this is the case. Hope your RE cash flows REALLY well

 

[Texas Proud]

I do not know why people try and view things differently so it will fit in a box they think they need to fit...

There are 4 or 5 asset classes from most places I have seen.... here are 5...

The main asset classes are:

• Shares (also known as equities). For more information, read our guide 'What are shares and how do I buy them?'
• Bonds (also known as fixed-interest stocks). These are a form of IOU issued by governments and companies when they want to borrow money from investors. ...
• Property. ...
• Commodities. ...
• Cash.

As you can see, property is separate... just live with the fact that you have chosen a different asset allocation than most...

 

[calmloki]

Hmm. As of today we are at
37.8% residential rentals
27% property contracts and loans
16.3% stocks
8.3% Cal tax free bonds
10.6% savings

Not including home values or a little postage stamp sized worthless property at the coast or some gold

I've no idea how to view our holdings but NW keeps growing, so we'll just keep bumbling along. Will echo that during market crashes and real estate crashes our rents have just kept chunking along - much to be said for having no debt to service.

 

[Luck_Club]

If this is the case. Hope your RE cash flows REALLY well

Yes it does. Our plan 15+ years ago was to use the cash flow from the Rentals to fund our retirement. It will fully cover our costs when debt is fully retired.

 

[harley]

I do not know why people try and view things differently so it will fit in a box they think they need to fit...

There are 4 or 5 asset classes from most places I have seen.... here are 5...

The main asset classes are:

• Shares (also known as equities). For more information, read our guide 'What are shares and how do I buy them?'
• Bonds (also known as fixed-interest stocks). These are a form of IOU issued by governments and companies when they want to borrow money from investors. ...
• Property. ...
• Commodities. ...
• Cash.

As you can see, property is separate... just live with the fact that you have chosen a different asset allocation than most...

Yep.

 

[knucklehead 61]

i have a lot of rental properties that are 76% of my nw.
i only have 7 mortgages now, it will be a couple more years until the next smallest one is paid off which will increase our cashflow nearly 8k / yr.
i am raising rents on 10 of them over the next few months which will give me almost 8k more cashflow next year to blow on my antique motorcycle addiction.
if our local economy tanks & housing values go down...who cares? i don't plan to sell, but will certainly buy more foreclosures. besides, when homeowners loose their houses to the banks i can buy them for a discount & rent them back to people that will always need a place to live.
rental real estate is paying for my living expenses as well as allowing me to "blow" (read: invest) at least 50-75k / year on "toys" (read: antique harley-davidsons).
while my 75% stock portfolio at vanguard is sharply up over the last couple years, my
25% bond portfolio at vanguard is basically as flat as keira knightley's chest.
on the other hand, my real estate has pretty much doubled over the last 4 years while also providing a seven figure gross cashflow....and fantastic tax deductions to boot!