Break up with your bond portfolio

September 2, 2020

For years, investors turned to bonds as a cornerstone of their income strategy. Long-term bonds offer low-volatility income and equity diversification. But the evolution of bond markets has eroded returns, and investors are no longer adequately compensated for increased risk. It's time to rethink traditional allocations and reconsider SFR as part of a well-balanced portfolio.

Returns no longer justify the risk

For years, investors turned to bonds as a cornerstone of their income strategy. Long-term bonds offer low-volatility income and equity diversification. However, the evolution of bond markets has eroded returns and investors are no longer adequately compensated for increased risk. Investors increasingly look for opportunities to reallocate capital away from bonds toward strategies that offer more attractive balance of risk and reward. Real assets are the best candidates due to market size and attractive returns. Of the real asset classes, Single Family Residential is the largest ($162T globally) and has the most attractive attributes. Within the space, Single Family Rentals “SFR” most closely match the requirements of bond investors, and have a number of advantages. Institutional investors have 3% market penetration in the U.S SFR market due a dated perception that SFR is hard to source and operate. However, in the years following the great recession, those presumptions were shown to be unwarranted as a number of operators gained scale and efficiency. There are still only a few platforms that can absorb significant institutional inflows, but the space is evolving quickly and over the next five years a number of platforms will likely emerge to meet growing demand from institutional investors, particularly those looking to redirect capital away from dated bond strategies.

Historically, investors successfully used a combination of strategy and insurance to both preserve and accumulate capital. While it's still possible to reduce exposure to most risks, it has become increasingly costly. For example, while investing in TIPS does reduce inflation risk, it also reduces real returns to zero, effectively preserving but not accumulating capital. For today’s investors, the evolution of the credit market and decades of disinflation has made it increasingly difficult, if not impossible to both preserve and accumulate capital with traditional bond investment strategies.

Data Tools - St. Louis Fed." https://research.stlouisfed.org/datatools.html. Accessed 13 Feb. 2020

Traditional saving-investment dynamics explain some of the decline, as the impact of an aging population and a shrinking tolerance for risk creates sustained downward pressure on credit markets. However other causes include shifting monetary policies and more frequent economic stimulus from central banks around the world. That said, the downward pressure on interest rates has been prevalent for much longer than the past 40 years. In a much historical context, interest rates have been steadily declining for hundreds of years.

"Visualizing the 700-Year Fall of Interest Rates - Visual Capitalist." 4 Feb. 2020, https://www.visualcapitalist.com/700-year-decline-of-interest-rates/. Accessed 13 Feb. 2020.

Regardless of the theoretical cause, it is empirically evident that real interest rates are declining and it seems increasingly unlikely that central banks around the world will take steps to reverse course any time in the near future. The low rate environment is here to stay and that is bad news for institutional investors searching for capital preservation, accumulation, and low equity correlation. In the current environment, only high risk strategies can achieve the desired capital accumulation, but increased volatility increases both equity correlation and harms the wealth preservation objective.

Risk Return Tradeoffs in Credit Investments

As such, the case for bonds, even for yield-driven investors, is increasingly tough and the case is even more challenging when there are attractive alternatives that currently underrepresented by institutional investors

Real-assets: a better alternative

Real-assets offer a number of compelling attributes that match and in some cases exceed the historical attractiveness of bonds. However, not all real-assets are created equal and identifying the appropriate category and specific assets within that category is a more involved process than investing in bonds. Conservative bond investors could easily back a pool of bonds that includes commercial properties in both tier I and tier III markets without a large increase in risk as equity holders owners sit in first lost positions large enough to protect senior debt holders the majority of the time. By moving down the capital stack, debt capital markets are effectively able to create homogenous investment units, even while the underlying assets and borrowers are highly heterogeneous. This homogeneity allows for very hands off, long duration investment strategies. As investors move up the capital stack homogeneity decreases, and increased levels of underwriting and diligence are often warranted. Therefore it is critical that an asset class returns are scalable with a minimal return deviation. Of the real-assets, commercial real-estate best fits the criteria and is the most viable alternative institutional investors.

As an alternative to Bond allocations, commercial real-estate investment opportunities must be low risk, which mostly limits investors to Core and Core+ assets in tier I cities. These opportunities also tend to be capable of absorbing large single transaction capital allocations which means institutional investors are often drawn to the same large transactions where capital is highly competitive and returns/cap rates are significantly bid down. Low cap rates do not necessarily mean less diligence is required. Return deviations, even with Core and Core+ investments in Tier I cities, can be very high. Low velocity, low tenant properties require extensive diligence around tenant credit risk (CBD Office) and high velocity, high volume assets require increased market and demographic diligence (Multifamily).

Large deviation of returns in multi-family are due to a lack of diversification, specifically a lack of geographic diversification. At a market level, returns to Core Multi-Family or Core CBD are highly consistent. However, large allocations into a single asset exposes returns to highly complex socio-economic movements over time. To access stable and tightly bound return characteristics, investors need to properly diversify between cities as well as within cities. Unfortunately this is often unrealistic as there are limited opportunities and low liquidity in commercial real estate markets. However, there is an often overlooked alternative to traditional commercial real-estate is capable of absorbing endless amounts of capital while still allowing for proper geographic diversification.

Single-family residential: the most attractive capital reallocation strategy

Among real assets, Single family residential, and particularly single family rentals “SFR” offers the most attractive risk adjusted opportunity. While residential exposure through MBS products are backed by the credit worthiness of individuals, single family rentals (like multifamily) are backed the credit worthiness of the entire rental market. But compared to multi-family, Single family actually has a number of advantages, stemming from both the uniqueness of the asset class and still being virtually untouched by institutional capital (~ 2% ownership). The opportunity for alpha was historically driven by the fragmented nature of the asset class and the perception that SFR is hard to source and operate at scale. But these assumptions have been repeatedly disproven over the last ten years. It is increasingly evident that SFR offers investment attributes that institutional investors crave and is arguably the best risk-adjusted investment opportunity in the world.

At Elara, we are building a technology-driven, institutional quality property management service to help investors identify and manage single-family residential investment opportunities. If you are interested in reallocating capital to single-family residential, or own a portfolio of properties and need to level up you property management, get in touch to discuss how Elara can help.

About Elara

Elara is a full-service, technology-powered property management solution that handles acquisitions, renovations, ongoing management, and strategic disposition of residential rentals. With a combination of data-driven decision-making and world-class operating experience, we deliver efficiency and quality at scale to help you get more out of every home. Schedule a meeting with our team.