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Many investors have turned to mortgage REITs for income, and some are taking a look at high yielding BDCs now too. The purpose of this article is to explain what each of them are and show some tables on how they have performed in the past and present, and to provide some possibilities that could lie in the future. BDCs have not been in the headlines as much as mortgage REITs, but they have performed very well over the past year and deserve a serious look by income investors in my opinion.

What is a BDC?

BDC stands for business development company. What they do is to help develop companies in exchange for money or equity and often offer loans too. They are very selective about picking companies they think will make a serious profit because they get part of it via equity or money or whatever deal they make. If the company they invest in doesn't do well, neither do they. They are very much like a larger scale version of the guys on the TV show "Shark Tank" where they offer to invest in your company for a percentage of it and offer money and expertise. The vast majority of them are registered as regulated investment companies. This means that the SEC requires them to distribute 90% of taxable income in the form of dividends. So, most of the income must go to shareholders by law, which can be a good thing for the investor seeking income if they pick the right ones. There are many different types. Due diligence is very important with these companies. Some specialize in technology companies, some energy companies, some leveraged buyouts, some recapitalization, etc. It is a very diversified group.

How have BDCs performed

The following 10 BDCs screened out as the highest return 1-yr Trailing Total Returns performers with current yields above 6% that have at least a 3-year history. Yields are extrapolated yields from the latest dividend excluding any special dividends. P/B is the price to book ratio. All data was gathered from Morningstar.

The Yield based on 9/21/11 price is what your dividend yield would be now based on your cost a year earlier. Here is an example to better explain why I think this is an important number. Let's say for example that I bought a stock last year for $10 that had a 10% dividend. If I am concerned about income, I am probably going to wonder if that dividend is going to be bigger or smaller or the same. In the case of the BDCs below, the average dividend went from 8.85% to 12.32% in one year meaning that your income increased substantially. A whopping 39%. Said another way, there were a lot of dividend increases!

Considering that there are only 30 some BDCs out there, some of these numbers are eye popping.

Business Development Companies Trailing Total Returns 1yr Trailing Total Returns 3 yr P/B

Price

9/21/12

Current Yield

Price

9/21/11

Yield based on 9/21/11 price
Triangle Capital (TCAP) 80.64% 37.90% 1.7 $25.75 8.08% $15.67 13.27%

Main Street Capital (MAIN)

75.95% 35.85% 1.7 $29.53 6.10% $17.56 10.25%
KCAP Capital (KCAP) 72.16% 28.95% 1.2 $9.30 10.32% $5.98 16.05%

Blackrock Kelso Capital (BKCC)

48.24% 20.33% 1.0 $9.96 10.44% $7.73 13.45%
KKR Financial Holding (KFN) 46.64% 37.51% 1.1 $10.36 8.11% $7.96 10.55%
TICC Capital (TICC) 43.17% 38.14% 1.1 $10.58 10.96% $8.32 13.94%
Hercules Technology Growth Capital (HTGC) 42.66% 12.69% 1.2 $11.39 8.43% $8.74 10.98%
Ares Capital (ARCC) 42.00% 28.95% 1.1 $17.53 8.67% $13.51 11.25%
Prospect Capital (PSEC) 39.40% 5.53% 1.3 $11.78 10.36% $8.45 14.44%
Medallion Financial (TAXI) 37.25% 19.16% 1.2 $11.95 7.03% $9.29 9.04%
Averages 52.81% 26.5% 1.3 8.85% 12.32%

What is a Mortgage REIT?

Just like BDCs, this can be a very complicated answer, so here is the short version. These are companies that hold residential mortgages. REIT stands for Real Estate Investment Trusts. Some of the companies just hold mortgages that are insured by federal government agencies and some mortgage REITs hold non-agency mortgages too. They are called hybrids and the ratio of agency to non-agency mortgages in their portfolios varies widely from hybrid to hybrid. The way they make their money is the difference between what they borrow the money for and what they collect off of the mortgages, known as the spread. Similar to BDCs, they are required by federal law to distribute at least 90% of their taxable income to investors. So, they have become popular with income investors.

How have Mortgage REITs performed

The following 10 mortgage REITs screened out as the best 1-yr Trailing Total Returns performers with current yields above 6% that have at least a 3-year history. Yields are extrapolated yields from the latest dividend excluding any special dividends. P/B is the price-to-book ratio. (All data gathered from Morningstar.)

Again, as with BDCs, I think the yield based on the 9/21/11 price is an important number. In the case of the mortgage REITs below, the average dividend went from 12.08% to 15.29% in one year. That would have been a 27% increase in income!

Considering that there are only 20 some mortgage REITs out there, some of these numbers, like the BDCs are eye popping.

Mortgage Real Estate Investment Trusts Trailing Total Returns 1 yr Trailing Total Returns 3 yr P/B Price 9/21/12 Current Yield Price 9/21/11 Yield Based on 9/21/11 Price
Newcastle Investment Corp (NCT) 95.67% 44.84% 2.5 $8.00 11.00% $4.55 19.34%
Invesco Mortgage Capital Inc (IVR) 58.14% 12.62% 1.1 $20.47 12.70% $15.44 16.84%
Two Harbors Investment Corp (TWO) 51.54% 18.03% 1.5 $11.70 12.31% $9.35 15.4%
American Capital Agency Corp (AGNC) 45.53% 20.86% 1.3 $35.17 14.22% $27.12 18.44%
Dynex Capital Inc (DX) 42.30% 17.29% 1.1 $10.85 10.69% $8.59 13.50%
MFA Financial Inc (MFA) 40.18% 13.28% 1.1 $8.59 10.71% $6.87 13.39%
Capstead Mortgage Corp (CMO) 34.66 8.82% 1.1 $14.43 9.98% $12.38 11.63%
Cypress Sharpridge Investments, Inc (CYS) 32.00% 14.63 1.5 $14.88 12.10% $12.25 14.69%
Armour Residential REIT Inc (ARR) 31.95% 4.92% 1.3 $7.58 14.25% $7.02 15.38%
Resource Capital Corp (RSO) 26.63% 15.52% 1.2 $6.25 12.80% $5.59 14.31%

Averages

45.86% 17.08% 1.37 12.08% 15.29%

BDCs and REITs compared past and present

Based on Trailing Total One Year Returns, the BDCs above gained an average of 53% vs 46% for the REITs. But, those are both huge numbers.

Based on Trailing Total Three Year Returns, the BDCs one again, 27% to 17%. The BDCs' numbers are impressive

Based on Current Yield, the REITs have an advantage averaging 12.08% to 8.85% for the BDCs.

Based on how much dividends increased over the last years, the BDCs beat the REITS 39% to 27%.

Base on Price-to-Book Value, they are similar with the REITs average 1.37 and the BDCs 1.3.

Which might do better in the future as a group?

It depends on what happens, of course. If the economy tanks, but somehow doesn't take real estate with it (seems unlikely to me), the REITs would likely muddle through, but the BDCs would likely drop like a rock. They are very dependent on the health of the economy. If the economy is stable to up, the BDCs might just continue their run for quite a while.

REITs are more interest-rate dependent. Rates are very low right now, which has been very favorable for them. There is a huge debate on SA right now about what effect the the Fed's latest actions will have on them. The Feds says it is going to buy up more mortgage-backed securities, which theoretically should lower the interest rate that borrowers will pay for a mortgage. It also would mean that REITs buying federally backed mortgages won't have as big a spread. When interest rates fall, the value goes up. The rate they borrow at will stay about the same, but the rate they lend at will have to be lower. So, they will make less, right? Maybe, maybe not. They may increase their leverage to increase their income, and some have hedges in place that will make up at least part of the difference. The hybrid REITs may switch to more mortgages that are not federally insured that will be less effective. Ironically, the lower interest rates will also mean that the mortgages they hold now will likely be worth more. They are like bonds. So, we could have a scenario where the book value of these stocks goes up while their dividends remain constant or start going down for a while. There is an unknown factor with refinancing too. If more people refinance at lower rates, they will lose those mortgages and have to buy new ones at less favorable spreads. The only thing that is clear is that it is unclear and some REITs will weather the storm better than others. Probably, at some point the fed will let up and interest rates will start to rise. So, when interest rates rise, what happens? Another major debate. If they rise slowly and spreads increase, some REITs may hedge well and do very well. Others may not. Very unclear.

BDCs are not as interest-rate dependent. They are much more dependent on economic conditions. If we go on an economic recovery path, I suspect they will do extremely well. In a better economy, there will be lots of companies wanting to use their services and they will have lots of them knocking at their door. In a better economy, the businesses they develop will do better, and so they should make more money. I think even a slow recovery will work for them as they have done well over the last year when things were just kind of muddling through.

Conclusion

The REIT situation seems unclear to me, but I feel pretty good about the BDCs right now. The reason is I feel the economy is going to be stable with a long slow recovery over several years, which is an environment BDCs could do well in. I personally am moving some of my own money out of REITs and into some BDCs. I am keeping the non-agency REITs though as I suspect they will be less affected by the Fed's buying habits here.

There are many newer REITs and BDCs that did well over the last year too that were not included because for the purpose of this article I wanted to compare companies that had been around for a few years. Those are conversations for another article!

Source: Retirement Income: BDCs Vs. Mortgage REITs