REITs vs. BDCs: income investing or yield illusion?

Everyone who’s read my articles for more than a week knows I’m a fan of real estate investment trusts (REITs).

Commercial real estate (CRE) is part of who I am, though that’s not the only reason why I like REITs. I also appreciate their structure, which legally requires them to pay out at least 90% of their annual income to shareholders.

That’s why their yields tend to be higher than the average dividend-paying company.

They’re not alone in that regard, mind you. Business development companies, or BDCs, share the same mandate. As such, they’re often lumped into the same “high-income investing” bucket…

Even though they differ in almost every other way.

One was created to make CRE affordable for everyday investors. The other provides financing to small or otherwise sidelined businesses.

One is mainly backed by brick-and-mortar assets that bring in contractual rental income. The other makes money from complex loans to companies that aren’t easily serviced elsewhere.

So it should come as no surprise that “one” tends to be safer than the other overall.

Before 1960, it was only the wealthy who got to profit from CRE. “It takes money to make money” might as well have been said about this subject.

But when Congress created REITs, it allowed landlord-based businesses to offer shares – literal (fractional) ownership of their real estate realm – to investors of all shapes and sizes, including “the little guy.” Better yet, those shares came with automatic dividends.

All these decades later, REITS are well-established as income-oriented assets that, as a group, have survived:

They’ve even expanded through all of that into subsectors such as apartments, casinos, healthcare, manufactured housing, data centers, cell towers, farming, and billboards. And they’ve learned valuable lessons along the way that have strengthened their balance sheets.

The result is an investment category that’s growing even in the prolonged face of its supposed greatest enemy: higher interest rates. Established REITs are expanding. New REITs are forming. And new subsectors are being explored worldwide.

BDCs, for their part, were created in 1980 to expand capital access for small and middle-market businesses. They hold private loan contracts, with some venturing into the equity investment, warrants, and preferred securities spaces as well. Some even take stakes in their fellow lending vehicles or associated funds.

These assets aren’t always easy to evaluate from the outside (or even from the inside)… including when it comes to payment-in-kind (PIK) income.

PIK allowances let specific borrowers under specific situations essentially write IOUs in place of cash interest payments. Yet the BDC still records those transactions as income on paper.

This practice can only go on for so long, however, before it becomes an obvious burden to the lending institution – and its unsuspecting investors.

BDCs are also very sensitive to interest rates. Unlike with REITs, that’s a fact, not a misconception.

Their assets are directly tied to the credit markets. So when interest rates drop, it’s more difficult for them to maintain prior revenue levels. It’s as simple as that.

Since it helps to talk actualities instead of theories or generalities, consider Ares Capital Corporation (ARCC). This top-notch BDC pays generous dividends and has a strong reputation among income investors.

With approximately $30 billion in assets under management (AUM), Ares Capital is the world’s largest publicly traded BDC today. Since its 2004 initial public offering (IPO), it’s generated about 12% annualized returns including dividend reinvestment.

It stands to reason then that Ares is trading at just a 1% discount to book value. In comparison, many of its peers trade closer to the 20% mark.

Yet there are issues below the surface – including its increasing reliance on PIK income in order to remain competitive.

Last year, PIK interest and dividends totaled nearly $490 million, or about 34% of Ares’ net investment income. That’s up intensely from a decade ago, when that figure was closer to 8%.

This doesn’t mean shareholders should hit the panic button and sell all their stock, for the record. Ares actually has a reputation for low realized credit losses throughout its two-decade existence.

It’s just that, for almost half of that time, it’s had to partially cover its dividend through loan repayments, investment gains, portfolio realizations, and capital inflows instead of just the cash component of its interest and dividend income.

Investors should also consider how:

Most of its peers, meanwhile, have brought that latter figure up to roughly 80%.

Again, those competitors aren’t leading the pack like Ares is. There is that to consider…

Just as long as they also consider how this practice does diminish the stock’s “safe and sound” reputation. Ares is a leading BDC because it’s risking more.

I know I write about Realty Income (O) quite a bit. But that’s because “The Monthly Dividend Company” is such an excellent example of durable real estate cash flow.

Realty owns thousands of freestanding commercial properties around the U.S. and Europe. Then it leases them out under long-term, triple-net contracts, where tenants handle property taxes, insurance, and maintenance.

The kinds of companies that can handle that setup tend to be well-established with reliable and even growing cash flow. And this in turn creates predictable, understandable, and transparent rental streams for Realty Income.

This combination has produced one of the strongest balance sheets in the REIT industry, complete with:

That distinction can’t be overstated.

The markets may be up, but that doesn’t mean every single stock is. In fact, there are 10 previous market “darlings” that now trade at a steep discount.

Cell tower giants… specialized real estate… tech consulting firms… These out-of-favor companies may span the sectors, but they all beg the same question.

Are they bargains or value traps?

That’s what Nick Ward and I discuss in this week’s Wide Moat Show, with some interesting conclusions all around.

Catch the full episode right here.