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Break up with your bond portfolio
April 1, 2022
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
Investors are increasingly looking for opportunities to reallocate capital away from bonds toward strategies that offer a more attractive balance of risk and reward. Real assets are the best candidates due to market size and strong returns. Of the real asset classes, Single Family Residential is the largest ($162T globally) and has the most compelling attributes. Within the space, Single Family Rentals “SFR” most closely match the requirements of bond investors, and they 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.
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. 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. If we take a wide-angle lens to the past, we see that interest rates have been steadily declining for hundreds of years.
Regardless of the theoretical cause, it is empirically evident that real interest rates declined during the last decade (although we are bearing witness to the reversal of that trend). The low rate environment was bad news for institutional investors searching for capital preservation, accumulation, and low equity correlation. In that environment, only high-risk strategies could achieve the desired capital accumulation, but increased volatility increases both equity correlation and harms the wealth preservation objective.
As such, the case for bonds, even for yield-driven investors, proved increasingly tough (and is unlikely to be sustainably revived by this current period of adjustment). The case is even more challenging - and will remain so - when there are attractive alternatives that are currently under-penetrated 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. But not all real-assets are created equal, and identifying the appropriate category, as well as specific assets within a 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 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. It is critical that the returns of a given asset class are scalable with minimal return deviation. Of the real-assets, commercial real estate best fits the criteria and is the most viable alternative for institutional investors.
But 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 multifamily are due to a lack of diversification, specifically a lack of geographic diversification. At a market level, returns to Core Multifamily 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. Fortunately, there is an oft-overlooked alternative to traditional commercial real estate that 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 multifamily, single-family actually has a number of advantages, stemming from both the uniqueness of the asset class and the relatively low penetration from institutional capital (~3% 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 Picket, we are building a technology-driven, institutional-quality acquisitions and management platform to help investors identify, manage, and optimize single-family residential investments. If you are interested in reallocating capital to single-family residential, or own a portfolio of properties and need to level-up your property management operations, let's discuss how Picket can help.