BDCs Vs. REITs: Comparing Returns For Higher-Yield Investors
Summary
- BDCs continue to easily outperform with only a handful of REITs providing investors with annualized returns of over 10% since 2019.
- Most mortgage REITs and many of the equity REITs have had negative stock price performance over the last 21 months.
- For the same amount of income with less risk, it's better to invest 50% less capital in BDCs at 8.8% compared to equity REITs at 3.0% to 3.5%.
- BDCs have been deleveraging, reducing fixed borrowing rates, shifting portfolios into secured assets in non-cyclical sectors with stronger covenants, and improving net interest margins.
- These changes have resulted in much stronger balance sheets ready for anything from an economic recession to an overheated economy driving inflation and higher interest rates.
- Looking for a portfolio of ideas like this one? Members of Sustainable Dividends get exclusive access to our model portfolio. Learn More »
As discussed in "This High-Yield Sector Continues To Pummel REITs" and "REITs Continue To Underperform BDCs," Business Development Companies ("BDCs") easily have outperformed Real Estate Investment Trusts ("REITs") and are starting to get some "respect" for the reasons discussed in previous articles (see list below) including stronger credit performance than many private equity/debt funds and even many banks during recessionary periods, maintaining and often improving dividend coverage while others are cutting.
What did BDCs do before and then again during the pandemic?
- Deleveraged with lower debt-to-equity ratios positioned to take advantage of economic recovery
- Issued longer-term unsecured borrowings at very low rates and reduced rates on credit facilities
- Shifted portfolios into secured first-lien assets with stronger covenants
- Continued to focus new investments in non-cyclical sectors
- Reduced non-accruals and increased book value/NAV per share
Quick Introduction to Business Development Companies ("BDCs")
Similar to REITs, Business Development Companies ("BDCs") are regulated investment companies ("RICs") required to pay at least 90% of their annual taxable income to shareholders, avoiding corporate income taxes before distributing to shareholders. This structure prioritizes income to shareholders (over capital appreciation), driving higher annual dividend yields that mostly range from around 6% to 11% as shown in the table below.
Comparison of BDC and REIT Returns Since 2019
As shown in the articles linked above, BDCs have easily outperformed REITs over the short and long term. It should be noted that the BDC sector is relatively new and many of the best BDCs have not been publicly traded for longer than 10 years.
BDC pricing (multiples and yields) continues to head back to levels from early 2014 before the S&P and Russell removed BDCs from their indexes due to concerns cited by the indexes, including the distortion of expense ratios driven by AFFE rules. This was predicted and discussed last year in "New SEC Rules Could Improve Pricing For The BDC Sector."
The following tables show the updated returns over the last ~21 months including WF BDC Index ETN (BDCZ) which continually underperforms the average for the reasons discussed in "ETFs Are The Worst Way To Invest In This High-Yield Sector."
I do cover some of the lower return BDCs including AINV due to being one of the "older" BDCs and FSK only due to being one of the largest in the sector especially after taking into account the merger with FSKR. It should be noted that BDCZ has quite a bit of exposure to many of the lower-performing BDCs including FSK and FSKR that previously accounted for more than 15%.
The "Other BDCs" include many of the lower performing companies that I do not actively cover including SLRC, SCM, OXSQ, PFX, BKCC, FCRD, and LRFC. It should be noted that all of these BDCs with the exception of BBDC have not reached their pre-COVID stock price levels. Also, most of these BDCs have cut their dividends.
The following tables assume that you purchased each position at the close of Dec. 31, 2019, and sold at the close of Sept. 22, 2021, collecting (not reinvesting) the dividends (includes paid, accrued, specials, and supplementals). The “Annualized” return shown does not use a simple average but shows the actual compounding of annual returns. This is the true return each year.
- Please see the end of this article for my takeaways from these tables.
The top performers were predicted/discussed in recent and previous articles including:
- Buy This Dividend Growth Stock Currently Yielding 8.0%: OCSL
- Excellent Dividend Growth Stock Currently Yielding 9.1%: CSWC
- Newtek Business Services: Initiating Coverage
- Excellent Dividend Growth Stock Currently Yielding 8.6%: FDUS
- Venture Debt Players Yielding 9% To 10% For Your Portfolio: HTGC/TPVG
- Top BDC Pick For 2020: TSLX
- ARCC: 9.4% Yield, Provides Preliminary Results
The following tables show the updated comparable REIT returns for many/most of the popular companies discussed here on Seeking Alpha along with the Vanguard Real Estate Index Fund (VNQ) and a Mortgage REIT Index (REM) which have outperformed many/most REITs.
As mentioned in previous articles, I only invest in VNQ (during market pullbacks) for my REIT allocation which has easily outperformed many of the popular and/or larger REITs including AVB, ESS, ELS, EQR, SPG, ADC, WPC, FCPT, O, NNN, STOR, and PSB.
Using Volatility to Increase Your Returns
The only time I use tables with calendar measurements of total returns is to compare with other investments over the same period. However, nobody buys a stock at end of the trading day on December 31 and simply holds without buying more on the dips. At least not my savvy subscribers. As discussed earlier this year in "Using 'Sell In May' To Build Your 10% Dividend Yield Portfolio," we use volatility to increase our returns easily beating the S&P 500. The last time I made multiple purchases of more than two BDCs was 12 months ago that easily outperformed the S&P 500 during the same period:
ARCC Example
The following table and chart provide an excellent example of making multiple purchases of ARCC (which is now my third-largest position) typically when its relative strength index ("RSI") was closer to 30. However, it should be noted that the best prices came shortly after an RSI of 30 was hit and then went lower. I'm very happy with these returns currently averaging 30% annualized but please keep in mind that my most recent purchases were much larger as I continue to have confidence in management to perform over the longer term.
The following tables show the total returns for many of my other larger positions including CSWC, HTGC, and TSLX. It should be noted that CSWC is a newer position as I have only held for a little over two years but I have added quickly and it is now my second-largest position for the reasons discussed in the article linked above.
Why do REITs Underperform BDCs?
The first thing that stands out from the previous tables is that 100% of the mortgage REITs and 50% of the equity REITs have negative stock price performance over the last 21 months and only a handful have provided investors with annualized returns of over 10%. This was surprising for me as I spend most of my time covering BDCs and only a handful that I cover have meaningful stock declines over the same period. Of course, BDCs have also been paying much higher dividends compared to equity REITs which is taken into account with their relatively higher total returns.
Upcoming articles will discuss many of the reasons that the average REIT underperforms the BDC sector including return on equity ("ROE") measures and dividends/distributions paid to shareholders and some simple fundamentals including changes in net asset/book values.
As mentioned earlier, most BDCs continue to position their portfolios away from cyclical sectors and into growth, technology, defensive sectors that will continue to do well over the coming quarters. Also, almost every BDC used the recent pandemic to strengthen their balance sheets with longer-term unsecured borrowings at extremely low fixed rates. These changes have resulted in much stronger balance sheets ready for anything from an economic recession to an overheated economy driving inflation and higher interest rates. Please see "Positioning Your Portfolio For Higher Interest Rates" discussing improved net interest margins likely driving higher dividends over the coming years.
I will likely not spend much time on mortgage REITs as I do not see these as long-term holding positions due to their terrible performance over the short and longer term. The following table shows the change in mortgage REIT distributions for the companies listed in the previous tables (excluding GPMT which became publicly traded in 2017) showing an average decline of almost 50% ranging from around 30% to 67% decline (yikes!) for NRZ:
Summary and Takeaways
The upcoming articles will discuss portfolio allocations for BDCs and REITs, total return comparisons between additional (smaller and less known) BDCs and REITs, other considerations including risk and pricing volatility. The following table includes the return comparisons from the previous tables with some quick takeaways below that will also be discussed in upcoming articles.
What's the best way for yield-oriented investors to maximize their returns over the long term while earning solid dividends?
- Adjust portfolio allocations including higher amounts of BDCs compared to REITs as they have been outperforming over the longer and short term.
- For the same amount of income with less risk, it's better to invest 50% less capital in BDCs at 8.8% compared to equity REITs at 3.0% to 3.5%.
- If you're investing for higher total returns, especially in a rising rate and/or inflationary environment, it's likely better to invest in higher quality BDCs than REITs.
- If you're investing mostly for higher yield it's better to use a typical/average BDC vs. mREITs.
- For your REIT allocation, you can use VNQ which outperforms the average but with a lower yield. Also, VNQ has much better diversification than BIZD/BDCZ simply due to the size of the sector.
- Mortgage REITs are terrible long-term holdings but can provide higher yields and returns if traded correctly. REM is lower yield but also could reduce the risk for that portion of the sector.
- Do not use ETFs (such as BDCZ/BIZD) to invest in the BDC sector as they have historically reduced the distributions paid (even when many BDCs are increasing), with higher price volatility during downturns, and continually underperform due to poor allocations and fund fees as discussed in "ETFs Are The Worst Way To Invest In The BDCs."
- Investors can easily make higher returns by taking advantage of pricing volatility.
BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.
The information in this article was previously made available to subscribers of Sustainable Dividends, along with access to several features not available on the public side including the BDC Google Sheets and:
This article was written by
I work with and for various private wealth managers, institutional and accredited investors. My goal for articles on Seeking Alpha is to bring exposure to business development companies (BDCs) that finance small to medium-sized businesses, typically overlooked by banks. BDCs are an instrument for investors to earn healthy dividends by avoiding double taxation at the corporate level and allowing income to flow directly to shareholders. Please see website link below for more information.
Email: buzz@bdcbuzz.com
Website: www.bdcbuzz.com
Newsletter: www.bdcbuzz.com/contact.html
Analyst’s Disclosure: I/we have a beneficial long position in the shares of VNQ, OCSL, CSWC, HTGC, FDUS, TPVG, GLAD, CGBD, TSLX, ARCC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (167)
Learning alot from you articles.
Thanks,
R. Brown
I’ve held NRZ since 2015 and while the distro cut, and share price crater last year were painful, I am confident the divy will continue to rise and share price will get back to 16.
——
Curious to know others’ thoughts here?
