Yield Vs. Risk: A Delicate Balance

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Proper allocation of your investment capital is essential to building wealth. There are numerous asset classes you can invest in to help you achieve your financial goals. You can choose from stocks, bonds, mortgages, precious metals, cryptocurrencies, fossil fuels and a variety of other things, both tangible and intangible, all with a few taps on your smartphone screen. It has never been easier, or more dangerous, to invest than it is today. Information and analytical tools are ubiquitous and available to all, but, the most successful investors are careful to strike a balance between drive for yield and tolerance for risk no matter what asset type they are investing in. Real estate is no exception.

Working the land has always been essential to survival and without physical locations from which to produce goods and deliver services, our modern economy would not exist. Thus, those who own land and buildings are invested in something that, subject to market fluctuations, will always have value. Compare that to an investment in a buggy whip manufacturing company. Once a profitable item in high demand, the buggy whip suffered the risk of obsolescence when the automobile came along, sending the yield on producing them to zero.

The proper yield-risk balance depends on who is doing the investing. A 5% yield with low risk might be preferred over an 8% yield with moderate risk. Every investor’s tolerance for risk should be calibrated to their unique circumstances. High-risk investments should only be made by those who can truly afford to lose their invested capital. Most prudent investors make multiple investments with varying degrees of risk in their attempt to maximize overall yield while hedging against potential losses.

Let’s take an investment in US Treasury bonds versus real estate as an example. The on the 10-Year US Treasury bond, which fluctuates minute-to-minute, has recently been running just under 2%. It is widely considered to be a riskless investment and is thus used as a benchmark in evaluating risk premiums associated with other asset classes like mortgages, corporate bonds, and real estate.

When evaluating any investment, many investors apply a spread, or risk premium, over the yield on the 10-Year bond to help determine the price they can pay for the asset. So, if the going cap rate for a Class A office building is 5%, then a purchaser must accept a spread of 300 basis points over the 10-Year bond to account for the risk of market fluctuations like rent growth, operating expenses, potential vacancy, and other factors.

Is that a good deal or a bad deal? It depends on the size, strength, and composition of the investor’s portfolio along with current market trends. The 2% yield on the 10-Year bond just barely keeps pace with inflation, but if a portfolio is heavily weighted to higher risk investments, it might be the right call. Conversely, if the portfolio is made up of mainly low-yield, low-risk assets like sovereign bonds, taking the risk to own the office building might make perfect sense.

For investors looking for liquidity, investing in brick-and-mortar real estate is problematic. Tangible assets like commercial real estate can take months to sell, so the magic of a smartphone won’t work. That said, an investor can buy bonds backed by real estate, and can exit the investment quickly by selling his stake in a bond. Bonds are liquid. Real estate is not. So, the investor who may need immediate access to his capital may be better off accepting the lower fixed yield on the bond backed by real estate, or shares in a real estate investment trust (REIT) rather than pursuing a better yield through ownership of a specific real estate asset, which carries more risk. If they buy the bond or the REIT shares, they can exit the investment immediately. If they buy the real estate itself, it will take months to get out, but they also have an opportunity to increase their yield if they hold long term and market conditions change in their favor.

Yield chasing is a risky business, but it can be richly rewarded when things go right. Things can also get ugly when things go bad. Just ask the investors who invested in sub-prime mortgage bonds back in the early 2000s. The result: a systemic failure of the global financial system that makes clear the importance of evaluating and managing risk associated with all asset classes.

Could your portfolio use some rebalancing? Is your real estate producing a yield that is appropriate to your current risk? At the Kelemen Company, we have the tools, resources, and expertise to help you answer those questions. Just give us a call at (949)668-1110