Author Topic: Asset allocation - are rental houses more like stocks or bonds?  (Read 1947 times)

Mr. Boh

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Asset allocation - are rental houses more like stocks or bonds?
« on: October 25, 2017, 03:20:10 PM »
I have been thinking about my asset allocation lately, specifically how to classify my rental properties. For most of my investment life I have had no bonds, only stocks and then later real estate. Admittedly I have been aggressive but it has worked out so far. I managed to ride out both the dot com crash and the great recession without panicking so I feel confident that I will be able to ride out future corrections and crashes. However I'm getting older and I now have more assets to protect so I have been rebalancing. What I'm struggling with is where am I on the risk curve when all assets are accounted for.

Here is an approximate breakdown:
65% in stocks
10% in bonds and cash
25% in rental property
   
These figures reflect a recently purchased rental house which was bought with cash from the sale of stocks. It was my intention to lower my risk profile by switching stock for real estate. I realize that the condition of a rental house and it's location are big factors in how risky it might be but I feel that my properties are low risk all things considered. I also feel that the broader diversification of having three entirely different asset class lowers my risk profile somewhat. I have been a landlord for a long time and these investments have always seemed bond-like with the steady income, yet the capital appreciation seems stock like.

I guess what I'm saying is that rental houses have been a great investment for me so far but I don't know how risky they are in an academic sense. To me they don't feel terribly risky and it seems to me that my overall asset allocation would have a similar risk to a 75% stock 25% bond portfolio. Can someone shed some light on this subject for me or at least tell me why I'm wrong?

Thanks.

P.S. I didn't post this in the real estate forum because it's more of an asset allocation question.


matchewed

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Re: Asset allocation - are rental houses more like stocks or bonds?
« Reply #1 on: October 25, 2017, 04:42:19 PM »
Neither.

Your rental property as equity is just the house. It may or may not appreciate/depreciate in price according to your local real estate market.

The rental income is just income.

Mr Mark

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Re: Asset allocation - are rental houses more like stocks or bonds?
« Reply #2 on: October 26, 2017, 12:13:54 AM »
Yeah good question.

It's not easy to get good historical data on rentals compared to 'pure' equities and bonds because (1) it's such a locality dependant thing* except for (2)the REITs and super-REIT funds, but those are a quite recent thing.

They are IMHO a distinct asset class. If you own the properties they act as an inflation hedge similar to equities (rents go up, house value rises), even more so if you have a big fixed rate mortgage on them.  They also then have special and unique USA tax treatment with the whole depreciation thing (and your expenses and loan interest is tax deductable). Downside is it is not exactly a totally passive investment, and can suffer from being location and tenant dependant (imagine if you are hit by floods or earthquakes, or your tenant doesn't pay rent and runs a meth lab in the spare bedroom) but upside can be great in the right area (growing population and jobs) when you can get amazing 'cash on cash' returns AND equity growth (just ask AREBELSPY).

If you own them via REITs they have historically (~26 years) shown lower Beta and higher Alpha than the general market*, so they acted to reduce portfolio volatility and increase risk adjusted returns, but note the distributions from REITs may not be as tax advantaged as equity LTCG or qualified dividends. Also REITs tend to be leveraged, so their value can show a bond-like response to interest rate changes.

I like them and think they can be a good addition to an AA. MMM uses local rental property to great effect. Tax benefits also very handy especially once FIRE.


*see
https://www.reit.com/data-research/research/market-commentary/reit-volatilities-sharpe-ratios-beta-alpha-and

smallstache

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Re: Asset allocation - are rental houses more like stocks or bonds?
« Reply #3 on: October 26, 2017, 04:02:00 AM »
I view asset classes as follows:

Paper assets:  stocks and bonds.  They are no different from each other...both are a prediction that the underlying businesses or governments will generate sufficient cash flow and increase value.

Hard assets:  rental properties, precious metals, fine art, etc.  These can be held for income as in the case of rent or capital appreciation.

Small business:  uses mix of self help and hired labor to generate income.

In OP's case, he has a 75%/25%/0% mix.

MrSpendy

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Re: Asset allocation - are rental houses more like stocks or bonds?
« Reply #4 on: October 26, 2017, 07:24:25 AM »
David Swensen, longtime CIO of Yale's Investment Office, has a useful framework in his book Pioneering Portfolio Management.

Real Estate is in between stocks and bonds. the longer the lease and the more creditworthy the tenant, the more bond-like. So a 40 year triple net lease to a Walgreens is very bond like, whereas if you own a motel in the ghetto that rents by the hour, that's about as equity-like as it gets. A lease is a promise to pay x for x period of time and the frequency of having to go win new leases and the variability in operating costs (a triple net lease passes through costs and are generally long, ergo lower variability and more fixed income like, whereas a hotel must get new "leases" every day and does not pass through its costs directly to its customer).

Additionally at the end of the lease, the residual value (value of the property) is variable rather than fixed, adding to the equity like nature of owned RE.

With this framework, I'd say operating  single family / multi-family residential more closely resembles running an operating business, and is therefore "equity-like" in terms of risk / reward, broadly. 

Of course asset specific factors (location, leverage, condition of the property, operational intensity, etc) will muddle the picture.
« Last Edit: October 26, 2017, 07:51:11 AM by mrspendy »