Real Estate Investing — Bonds
Real estate is a critical asset class to understand, and no investor — regardless of how old or rich they are can afford to ignore it.
3 Tips to Remember
- Most real estate investors stick to a niche, at least in the beginning of their investing career. That’s not a bad thing
- Each asset class has its advantages & disadvantages. (Avenue 28 will explore these in future articles.)
- A rock-solid investment does you no good if it does not help you reach your specific needs and goals. Always put your strategy first, then pick the appropriate vehicle.
This is the second part of our series about real estate investment vehicles. Part One covered public equities, discussing investing in the stock in real estate companies and REITs.
Now, we move away from public equity and into corporate debt.
Real estate companies, like those in any other industry, sometimes borrow money to fund capital improvements, expand onto new land, or to pay for other improvements. One common way to borrow money is by issuing debt obligations, such as corporate bonds.
Buy land. They aren’t making any more of it.
- Mark Twain
The Corporate Bond Market
Corporate bonds act as fancy IOUs. The bond is a loan from the investor to the issuing company, which eventually pays back the principal after the bond matures. Most bonds also include regular interest payments, or coupons, between the issue date and maturity date.
Companies issue bonds when they want to raise money without sacrificing ownership (as happens when issuing new stock).
Unlike stocks, bonds typically have a defined payment schedule and a guaranteed return of principal. Further, if an issuing company declares bankruptcy, its bondholders have priority over shareholders after the assets are divvied up. For these reasons, bonds are generally considered less risky than equities.
There is a lot of corporate debt. Other than government bonds, such as U.S. Treasuries, corporate bonds make up the largest section of the global bond market. In 2016, the value of the global corporate bond market was between US$5 to US$6 trillion.
Real Estate Bonds
Real estate bonds function like any other corporate bonds — they just happen to be issued by real estate companies. Real estate companies, especially in Asian markets such as China, Hong Kong, and Singapore, issue many bonds.
After the global financial crisis of 2007–09, many traditional lenders were unwilling to extend credit to real estate developers for investment projects. To secure financing, many turned to corporate bonds as an alternative.
To see a high-profile example, consider how Extell Development, a New York City-based real estate development company, raised about US$300 million by issuing bonds on the Tel Aviv Stock Exchange (TASE) to fund new building projects. The bond offering was collateralised against Extell’s existing properties in Manhattan.
Do not confuse real estate bonds with mortgage bonds, which may be issued by almost any corporation. A mortgage bond places a lien against corporation’s property (typically the 1st lien), thereby giving the bondholders the right to sell the property in the event of default.
Corporate Bonds and Real Estate Loans
In fact, bonds (regardless of the issuer) are a truly vital component of the greater real estate lending market. Interest rates and yields for all asset classes are linked, and the rates charged by banks (and other lenders) on commercial real estate loans is affected by bond rates. The 10-year U.S. Treasury note is particularly important to the global real estate market.
How to Use Bonds to Gain Exposure to Investment Real Estate
Buying real estate bonds is an indirect way to gain exposure to investment real estate. Rather than owning the property itself (or a share of the property), the bondholder receives a claim to future income from the real estate company.
The company’s income might — and should — come from the rents generated by the investment property. Through this indirect route, the real estate bondholder receives limited exposure to the future performance of the real estate market.
Consider these before you BUY that REAL ESTATE BOND
- CREDIT RATING: Does the issuing company have the financial capability to honour their debt obligations?
- RETURNS: Can you find more competitive returns elsewhere? Corporate bonds are rarely the highest-yielding assets, except in sub-investment grade (junk) bond markets.
- INFLATION: Do you anticipate high levels of future inflation? Even if the real estate bond yields above the rate of inflation, bondholders do not participate in rising real estate prices (which can be caused by inflation) in the same way that shareholders do.
- REVENUE MODEL: Will the value of the underlying real estate — based on resale value or rents — justify the amount paid for the debt? In other words, is the property going to cash flow enough to allow the issuing company to pay you back.
- INTEREST RATE: There is an inverse relationship between the price of a bond and its interest rate. During low interest rate periods, bonds tend to have low yields and can be relatively expensive to purchase.
In our next article, Avenue 28 covers direct investment strategies for real estate investors.