martince2
I just closed on real estate deal.
I got a great rate from my loan officer and all of the numbers lined up nicely from an ROI standpoint.
I couldn’t pass up on the deal.
As you all know, I love passive income.
Dividends are great, don’t get me wrong.
But I like diversifying my income producing assets and I’m a big fan of “mailbox money” as well (monthly rent checks coming in).
This transaction leads me to an interesting discussion that I had with a friend recently that shed light on the incredibly powerful nature of compound interest…and why I prefer blue chip dividends to stagnant bond yields.
Why Buying Is Better Than Renting
My friend believes that the US residential real estate market is in a massive bubble and that renting, as opposed to owning, is the clear winner when it comes to wealth generation.
He didn’t want to hear about home price appreciation potential, citing long-term studies that showed average US appreciation in the 4-5% range over time.
“That compares poorly to the US equity markets,” he said. “So, why waste all of that money on a down payment when you could just rent and invest it?”
My reply was simple,
“Location, location, location.”
It’s cliche, I know.
But it’s true.
I don’t care about the average US home, I only care about homes in my area.
And in this case, I’m really only concerned about direct comps to my property, which are appreciating at rates well above his “average” figure because of the attractive demographics (population and job growth outpacing real estate development).
Note: BMW’s manufacturing plant is just 5 miles away.
With rent checks factored into the equation, I expect for this property to post total returns much greater than the market’s long-term averages.
And honestly, even if I weren’t planning to rent it, I think it would still be a great investment as a primary residence.
That didn’t matter to him, saying that where he lives, renting is much cheaper than paying a mortgage because of high interest rates.
Once again, I used the location argument.
You see, that’s not the case where I live.
Yes, interest rates are much higher now than they were a year ago; however, supply and demand is still working in my favor and therefore, rental prices on 2-3 bedroom units aren’t much different than what a mortgage would be.
“Therefore, why not own the asset and line your pockets with cash (equity) instead of someone else’s,” I asked?
He said it was different where we lived and didn’t want to hear about a house being used as a forced savings account for millions of Americans who, statistically speaking, aren’t likely to save any difference between a mortgage and rent (it’s true that some people are poor because of unfortunate circumstances that are largely outside of their control; however, a lot of people are broke because they have a hard time living below their means and frivolously spend their disposable income).
All he seemed to care about was property taxes and maintenance costs.
Maybe he bought a lemon one time and had a horrible experience, I don’t know.
But, I saw the light bulb turn on behind his eyes when I made my final point…
I said, the biggest difference between renting and owning is this: my mortgage rate won’t change over the next 30 years.
I can count on that (and even refinance it lower, should the opportunity arise). On the other hand, your rent is likely to increase, at a 5-8% annual rate, for the rest of your life.
That’s where compound interest really comes into play.
Let’s say we are both paying $2,000/month for our shelter right now.
Well, in 30 years, I’ll still be paying $2,000/month.
And assuming a 2% annual inflation rate between now and then, $2,000 today will be worth $3,623 in 2053 dollars.
In other words, my mortgage payment will look much cheaper in a couple of decades than it does today.
And if inflation is higher over the next several decades than it was in the past, then my theoretical savings are even greater.
Lastly, when my 30-year mortgage is up, I get to stop making payments (though yes, I’ll still be responsible for taxes and maintenance, which my rent checks should easily cover each year).
That isn’t the case for renters, they’re on the hook, paying someone else “mailbox money” until the day that they die.
Getting back to my friend…if he sees 6.5% average annual rent growth between now and 2053, he won’t be paying $2,000/month anymore. He’ll be paying nearly $13,300 in monthly rent.
Heck, even if his rent increases are only 5% annually, in 30 years he’s still looking at an $8,600 monthly payment. And assuming he lives a long, healthy life, that figure will continue to rise…yet, I won’t have a payment to make at all.
After hearing these numbers, I think he’s reconsidering his opinion.
Why Growing Dividends Are Better Than Bond Yields
And this same scenario is why I prefer the dividend yield provided by blue chip stocks over bond yields.
My portfolio is full of companies that have not only paid, but increased, their annual dividends for decades.
Obviously, I can’t predict the future; however, looking at their talented management teams, their competitive moats, balance sheets, and cash flows, I suspect that history will continue to repeat itself when we’re talking about the highest quality dividend growers.
For instance, Realty Income (O), my largest holding, has produced a 4.9% dividend growth CAGR over the last 20 years.
Federal Realty Investment Trust (FRT), which has the longest annual dividend growth streak of any REIT at 55 years, has posted a 3.9% dividend growth CAGR over the last 20 years.
Our highest rated apartment REIT, Mid-America Apartment Communities (MAA), has produced a 4.2% dividend growth CAGR over the last 20 years.
And there are numerous non-REIT stocks that have posted even stronger long-term dividend growth rates, such as:
- Coca-Cola (KO) has a 20-year DGR of 7.5%
- Johnson & Johnson (JNJ) has a 20-year DGR of 8.8%
- Parker-Hannifin (PH) has a 20-year DGR of 12.8%
- S&P Global (SPGI) has a 20-year DGR of 9.7%
- WEC Energy Group (WEC) has a 20-year DGR of 10.3%
…just to name a few.
You could go from sector to sector and find numerous companies with multi-decade long dividend increase streaks.
There are currently 148 companies on the US Dividend Champions list (at least 25 years of consecutive increases).
And all of these companies are not only generating long-term wealth for their shareholders, but more importantly, protecting the purchasing power of their passive income streams from being eroded away by inflation.
Bond yields don’t do this.
If you buy a 30-year US treasury note it yields 4.17% right now.
Anyone who buys that today can expect to receive a 4.17% annual yield for decades. That’s great. But, 4% of today’s dollar isn’t going to amount to much in 30 years.
Assuming the Fed manages to hit its 2% inflation rate and maintain it for 30 years, then every $1,000 of purchasing power that a person has today will be worth only $552 in 2053.
If inflation is tough to tame and 3% ends up being the new norm over the next 30 years, then that $1000 in purchasing power is reduced to just $412.
The US 10-year yield is 3.93%.
That’s great too, but it isn’t compounding.
Anyone who buys and holds that treasury note to maturity today can expect to receive 3.93% annually.
Well, looking at a 2% inflation rate over the next decade, every $1,000 in purchasing power that an investor has today will be worth $820 in a decade.
And, if inflation stays hot and averages, say 3%, per year, then that $1,000 in purchasing power is reduced to just $744.
On the other hand, if a company like Realty Income, for instance, continues to provide investors with ~4% annual dividend growth then every $1,000 in dividends it generates today will turn into $1,480 in 10 years.
Johnson and Johnson’s 5-year DGR is 5.8%.
If this AAA-rated blue chip continues to provide 5.8% dividend growth over the next 30 years, then every $1000 in dividends that it pays today will turn into roughly $5,400 in three decade’s time.
This is why organic compounding (annual dividend growth) is so important.
Owning assets that pay stagnant yields is a great way to lose out to inflation over the long-term.
On the other hand, people who own dividend growth stocks get to sleep well at night knowing that their income is rising year in and year out.
Why I Don’t Sleep Well At Night With Bond Yields
It’s true that the income provided by US treasury notes is extremely reliable.
If the US ever stops paying interest on its debt, the entire world (and the US stock market) will have major problems.
In that scenario, it likely won’t matter what investment assets we own, because we could be staring down the barrel of Armageddon as a species.
So, in the meantime, I’m very happy to focus my investments on stocks and physical real estate.
I can monitor dividend safety metrics (sales growth, cash flows, debt levels, margin expansion/contraction, etc.) to ensure that my dividends are safe and likely to continue to grow.
As a landlord, I can make sure that I’m buying properties in areas with attractive demographic growth rates that will allow me to raise rent on an annual basis (typically at a rate that exceeds inflation).
With that in mind, I don’t see any reason to maintain an outsized bond allocation.
I sleep well at night owning assets that see their value and the income that they produce reliably compound over time.
Note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
