Market gurus from Bill Gross to Warren Buffett and many other strategists with a platform to get their views out to the public are calling a top for the bond market. The message is starting to take hold.
Bank of America Merrill Lynch's monthly institutional fund manager survey showed 84% of respondents believe bond markets are overvalued, the highest reading in that survey's history. The problem is, few of these conversations or articles talking about the bond top provide any solutions for advisers to use to fill the portfolio void when bond exposure is lowered.
Here is one idea. Private core real estate can provide many of the attributes that advisers are looking for from their fixed-income investments including attractive and consistent income, capital preservation and low correlations to equities. Additionally, in today's environment, private core real estate can have a higher probability of successful performance outcomes relative to fixed income over the near to mid-term.
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Private core real estate has been used by large institutional investors for decades because historically, the asset class has delivered solid income, preserved capital and acted as an equity diversifier. Private core real estate is high-quality real estate (asset sizes typically larger than $50 million), substantially leased (generally over 90% to high-quality tenants), located in major metropolitan markets with strong job and population growth prospects (typically the top 10 to 20 metropolitan statistical areas in the country), purchased with conservative leverage (less than 25% loan to value if leverage is used at all).
INCOME IS CORNERSTONE
Income is the cornerstone of fixed-income investing. In today's low-yielding environment, investors looking for higher income returns have a choice between increasing the duration of their investments or taking on additional credit risk in their search for yield. Due to the well-leased nature and the high-quality tenant mix that is typical of private core real estate, the asset class has delivered an attractive income stream.
In addition, private core real estate yields are attractive relative to other fixed-income investments. Private core real estate is currently yielding 350+ basis points more than the 10-Year Treasury rate, which is a significantly wider spread than the historical average of 75 bps. As a reference point, the low-point spread over the last 10 years was 63 bps in June 2007. The current level of spread or “risk premium” available in the private core real estate markets suggests there is substantial relative value for the asset class vs. traditional core fixed income. Private core real estate yields are also in line with high-yield bond and emerging market debt markets, but with meaningfully lower exposure to credit, duration and currency risks. Put simply, an investor can earn similar yields by owning a Class A office building in a top-20 metro market, or a bond backed by Indonesia, Turkey, Poland, etc.
CAPITAL PRESERVATION
Investors often hold fixed-income investments to help preserve capital because of the contractual nature of the interest and principal payments associated with them. While private core real estate does have fixed-coupon and principal repayment, the durable income stream generated by the asset class because of the staggered underlying leases, along with the tangible nature of the asset (owning a building rather than a financial instrument can be attractive in times of market stress), make it an attractive option for preserving capital.
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One of the most important factors cited by fixed-income investors is the asset classes' low correlation to the broad equity markets. Private core real estate also has a low correlation to the equity markets, with an average -0.04 correlation on a rolling three-year basis, making it a valuable diversification tool when constructing portfolios.
One of the largest challenges facing fixed-income investors is the prospect of inflation and rising interest rates. There is a risk that inflation will rise, thereby lowering the purchasing power of the income received from one's fixed-income investments. Additionally, as interest rates rise, the value of fixed-income instruments in the secondary market falls as investors demand a discount from the bonds face value to increase the yield to the interest rate currently available in the market.
In this type of market environment, private core real estate is attractive because the income generated from these investments can increase over time through rental growth and the ability pass through rising costs to tenants. In fact, private core real estate has performed better than equities or fixed income historically during times of inflation.
The challenges facing the fixed-income asset class are well-documented, and, in our observation, those calling the end of the bond bull market have offered few viable alternatives. Allocating capital to private core real estate is one good option and merits consideration. The asset class has historically delivered attractive and consistent income returns, can provide benefits to multiasset portfolios because of its low correlation and the tangible nature of the asset class, and is well positioned to perform in various interest rate environments.
Casey Frazier is the chief investment officer of Versus Capital, a Denver-based asset manager focused on making institutional direct/private real estate accessible, more liquid and cost effective.
