Real estate bonds in your investment portfolio. How much is too much?

You must have noticed that bonds love real estate and real estate loves bonds. While bonds can be issued for all types of businesses, it is no coincidence that the majority of bonds are issued for RE and usually for RE development in particular. RE development requires considerable upfront investment from shareholders, banks or bond investors, with large amounts of capital needed for a short period of time, hence due to the nature and flexibility of RE bonds, this instrument proves to be very popular amongst the RE developers.

We hear from investors that either they already have a big proportion of RE bonds in their portfolio, they are simply bored with this type of bonds, or that they are worried about the impact of economy on the RE market. While we always encourage investors to diversify their investments, and we are going to offer bonds from other sectors as well, we would like to note that not all RE bonds are the same or even similar and you can diversify your bond portfolio even within the RE sector.

Residential vs. commercial

You can always choose the type of RE that makes the most sense in the current economy or the specific type of projects that you see as particularly valuable in the district/city/region. Besides the most usual types of residential and commercial real estate, there are sub-groups such as residential units for sale or for lease, and commercial real estate goes far beyond offices with the recent examples of mixed-use developments, stock offices, etc. For example, in the current macro-economic environment we deem RE bonds for residential projects of good developers less risky in comparison to RE bonds for commercial projects that do not have a pipeline of potential tenants.

Risk level of the project

If your risk tolerance is higher, you can always diversify your bonds portfolio in terms of risk level of the project. While it is always a good idea to stay on the safer side, you can devote a part of your portfolio for riskier projects with usually higher returns, if you have reasons to believe they will succeed. The risk level can depend on a whole bunch of factors, including project conditions, financial strength of the developer, level of leverage, geographic location of the project and so on. For example, we deem the ‘second-home’ category projects relatively more risky in comparison to ‘primary-home’ projects, yet for some investors that level of risk is acceptable, as it also offers a higher level of return.

Financing stage

We have already talked about how bond financing works in different stages of RE project in our previous newsletters. Are you entering a bond issue that is in an early stage of the development or a late one? How much have the shareholders invested? Does the project have other investors/bank financing? Is the project almost complete and has the majority of pre-sales/pre-leases? These are all very different choices that you can make depending on your risk/return appetite.

Other factors

There are always other important factors of RE project that you can diversify over. One perspective could be the developer - you can choose a couple of reliable, visionary, financially stable developers that you want to invest into. Other scenarios could be diversifying through location, for example picking projects only in Vilnius, the capital of Lithuania, or contrary, investing only somewhere abroad.

Finally, arguably it is better to invest in projects/sectors that you can understand and while some sectors are quite hard to assess for non-professionals (think banking, tech or berry farming), RE makes sense for many of us, as the business models for specific projects are usually understandable, as well as one can easily access reliable market information and statistics. So, when you think about it, RE bonds are not as similar or boring as you may think.