REITs and bonds offer a consistent income stream but are two different types of investments.
What Are REITs?
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating commercial real estate.
REITs can own or invest in properties like office buildings, apartments, hotels, shopping centers, and self-storage, to name a few. There are also mortgage REITs that provide financing for real estate by purchasing mortgages or mortgage-backed securities from banks and other originators.
REITs can be publicly traded or non-traded. Publicly traded REITs are easily bought and sold on a stock exchange like the NASDAQ or NYSE. Non-traded REITs are operated outside the public market and are subject to less regulatory oversight.
What Are Bonds?
Bonds are debt securities corporations, municipalities, or government entities issued to raise capital. When an entity issues a bond, it is essentially borrowing money from investors, who purchase the bonds in exchange for a promise of regular interest payments and the return of the principal (the amount invested) at the bond’s maturity date.
Bonds are considered fixed-income securities because they typically pay a fixed interest rate. The interest rate is determined by several factors, including the creditworthiness of the issuer, prevailing market interest rates, and the length of time until the bond’s maturity date.
Investors can buy and sell bonds on bond markets, and the bond prices fluctuate based on changes in interest rates and other factors that affect the issuer’s creditworthiness.
Bonds are often seen as a relatively safe investment compared to stocks because the interest payments and principal repayment are typically more predictable. However, there is still some risk associated with investing in bonds.
How are REITs and Bonds The Same?
Below, we explore the similarities between REITs and Bonds.
Passive Income
REITs and bonds are primarily for income-oriented investors and can be a good source of passive income.
Most REITs generate rental income from real estate properties, which can be a steady income stream, while bonds generate income through coupon payments.
Liquidity
Most REITs and Bonds trade are publicly traded, thus making them easy to buy and sell without significantly impacting the price of these securities.
Accessible to Retail Investors
Another similarity between REITs and bonds is that retail investors can easily access them through most online brokers.
Inflation Protection
Both REITs and bonds can offer some degree of protection against inflation. REITs can provide inflation protection because rental costs and property values tend to rise with inflation.
Meanwhile, bonds can also provide some inflation protection if they offer a floating rate bond where the rate is pegged to inflation, like Treasury Inflation-Protected Securities (TIPS).
Market Value Fluctuation
REITs and bonds can fluctuate in value based on market conditions. The market value of REITs can be affected by changes in interest rates, economic conditions, and real estate market trends.
Similarly, the market value of bonds can be affected by changes in interest rates, credit ratings, and the issuer’s financial health.
How Are REITs and Bonds Different?
While REITs and bonds can provide income to investors, they are fundamentally different types of investments.
Income Stream
REITs generate income from rental income and property sales, while bonds generate income from interest payments. REITs typically pay out a portion of their rental income as dividends to investors, while bonds may have a fixed rate or pay a benchmark rate such as SOFR plus a spread.
Tax Treatment
REITs are unique because they are required to distribute at least 90% of their taxable income to shareholders as dividends.
As such, REIT dividends are generally taxed at ordinary income tax rates, which are less advantageous than the qualified dividend rate.
Meanwhile, the taxation of bonds can vary depending on several factors, including the type of bond, the issuer of the bond, and the location of the bondholder.
Generally speaking, bond interest is subject to federal income tax and possibly state and local income taxes, depending on the jurisdiction. However, some types of bonds are exempt from certain taxes or have lower tax rates, such as municipal bonds issued by state or local governments.
Interest Rate Sensitivity
Another key difference between Bonds and REITs is interest rate risk.
Bonds are susceptible to changes in interest rates because they are usually fixed-income securities, meaning their value is directly affected by changes in the prevailing interest rates.
Bond Prices and Interest Rates have an inverse relationship. When interest rates rise, the yield on new bonds increases, which makes them more attractive to investors.
As a result, the price of existing bonds with lower yields decreases because investors can buy new bonds with higher yields instead. Conversely, when interest rates fall, the yield on new bonds decreases, which makes existing bonds with higher yields more attractive, causing their prices to increase.
Example:
suppose an investor purchased a bond with a 5% yield when the prevailing interest rates were 5%. If interest rates rose to 6%, a new bond with a 6% yield would become available, making the existing bond with a 5% yield less attractive to investors. To sell the bond, the investor would have to lower its price, thereby increasing its yield to compensate for the higher prevailing interest rates.
Stock Market Correlation
Publicly traded REITs tend to correlate highly with the overall stock market.
A correlation of 1 means a stock or sector moves precisely with the overall stock market.
According to a Morningstar.com analysis, the FTSE NAREIT Equity REIT had a correlation of 0.59 with the CRSP 1-10 U.S.Estate Market Index, which represents nearly 100% of the investable U.S. Equities Market.
So if the total stock market moves down 10%, the equity REIT market is expected to drop 5.9%.
Meanwhile, bonds tend to have a negative correlation with the stock market. Investment giant Schroders points out that bonds have a negative correlation of 0.35 with stocks.
If you are a buy-and-hold investor or can not stomach periods of extreme volatility, you may want to think twice before investing in the real estate market through REITs.
You might also be interested in Real Estate vs. Stocks.
Capital Stack Position
Within the capital stack, Most REITs are considered equity investments, meaning in the case of default, equity investors are the last to receive any money back. Meanwhile, bonds are considered debt investments, so in the case of default, bondholders will be entitled to any claims before equity investors.
When comparing REITs and Bonds, most individual investors don’t have to worry about default risk if they invest in an investment-grade bond ETF, which can help diversify their risk across bonds of different tenors and quality.
Maturity
When a Bond is issued, it has a fixed maturity, so at that maturity date, the issuer must return the total investment amount plus the accrued coupon. Meanwhile, REITs do not have a maturity date; REIT managers may buy and sell properties at their discretion, but there is no legally binding maturity date in most cases.
Performance & Yield
Let’s take a look at the historical performance of REITs vs. Bonds.
Historical Performance: REITs vs. Bonds
Over the long term, REITs have historically provided higher total returns than bonds.
According to Nareit, the total return of U.S. REITs from 1972 to 2020 was 9.5%, compared to the total return of U.S. bonds, which was 5.8% over the same period.
Dividend Yield: REITs vs. Bonds
REITs typically have higher dividend yields than bonds. According to Nareit, the dividend yield of U.S. REITs was 3.77% as of December 31, 2020, while the yield on the Bloomberg Barclays U.S. Aggregate Bond Index was 1.22% over the same period.
How to Incorporate REITs and Bonds In Your Portfolio
If you want to become an investor, it’s essential to have a well-diversified portfolio and choose the right type of bonds:
There are many types of bonds to choose from, including:
Corporate bonds, municipal bonds, and government bonds. Each type has its risk profile, so choosing the right kind of bonds for your portfolio is important.
Consider bond funds: Instead of buying individual bonds, you can also invest in bond funds. These funds hold a portfolio of bonds, providing diversification and professional management.
Determine how much to invest: As with any investment, it’s essential to determine how much you want to invest in bonds. A common rule of thumb is to allocate a percentage of your portfolio to bonds equal to your age. For example, if you are 30 years old, you might consider allocating 30% of your portfolio to bonds.
Monitor your investments: As with any investment, it’s important to monitor your bond investments to ensure they continue to meet your investment goals and risk tolerance. You should also review your portfolio regularly and rebalance as necessary to ensure it remains diversified.
