REITs Vs. BDCs: A Lesson In Contrarian Investing (2024)

Some prefer real estate investment trusts ("REITs"). Others prefer business development companies ("BDCs"). I like owning both.

Often, the macroeconomic environment is supportive of both. But sometimes, economic conditions are good for one but bad for the other. That makes them complementary assets to own together in one's investment portfolio.

REITs And BDCs: Similarities And Differences

REITs and BDCs share in common the fact that they must both pay out at least 90% of their taxable income in order to avoid corporate-level income taxes. Instead of being double-taxed -- once at the corporate level and again at the shareholder level -- these vehicles avoid corporate taxes in exchange for their dividends being taxed as ordinary income rather than the "qualified dividend" rate.

REITs and BDCs also share in common the basic business model of issuing capital (a combination of equity, debt, and sometimes preferred equity) and using that to invest in assets at higher yields than their weighted average cost of capital ("WACC").

But that's basically where the similarities end. The biggest difference, in my view, between these two investment vehicles is that:

• REITs are fundamentally borrowers
• BDCs are fundamentally lenders

There are other differences, such as:

• Investing on the equity side of the ledger ("REITs") versus the debt side ("BDCs")
• Investing in long-lived assets ("REITs") versus short-term assets ("BDCs")
• Contractually fixed revenue streams that are rolled over based on market supply and demand ("REITs") versus variable revenue streams that float with interest rates determined by central banks ("BDCs")
• Providing a balanced total return of dividend income and appreciation ("REITs") versus returns coming overwhelmingly from dividend income ("BDCs")

And so on.

But for the sake of this article, the primary difference I want to highlight is the fact that REITs are borrowers of debt (some of which is floating rate), while BDCs are lenders of debt (almost all of which is floating rate).

All else being equal, rising interest rates are a headwind to REITs and a tailwind to BDCs, while falling interest rates are a tailwind to REITs and a headwind to BDCs.

But we should be a bit more specific, because most of REITs' debt is long-term (5+ years) in nature, while most of BDCs' loans have floating rates based on the shortest-term interest rate -- the overnight rate set by central banks.

So, more specifically, we can state that (again, all else being equal), REITs benefit from falling long-term interest rates, while BDCs benefit from rising short-term interest rates.

Both are basically spread investors, but during rising interest rates, that spread between WACC and investment yields typically narrows for REITs and widens for BDCs. During falling interest rates, the opposite typically happens.

With that in mind, take a look at the price performance of the broad-based Vanguard Real Estate ETF (VNQ) against the VanEck BDC Income ETF (BIZD) in the first several months of 2020, when COVID struck and incited a sharp drop in interest rates.

During this time, lower interest rates in addition to longer lease terms and an overrepresentation of financially strong tenants prevented REITs from falling as far as BDCs.

Meanwhile, BDCs got hit by the double-whammy of collapsing interest rates and a sudden economic shutdown that hurt many of their private, middle-market borrowers. If the federal government had not stepped in to provide emergency lending and grants to these middle-market businesses, the damage would have been even worse.

The situation so far this year could not be more different, though. The Federal Reserve has hiked their key policy rate aggressively, pulling long-term interest rates up with it, while the economy (i.e. middle-market borrowers and tenants alike) has remained strong.

As the market has realized that BDCs' borrowers have mostly been able to absorb these higher interest costs, and that BDCs have rewarded shareholders with dividend raises and special dividend payouts, BDC total returns have begun to meaningfully outpace REITs this year.

Again, the higher rates are a tailwind for BDCs and a headwind for REITs.

We can see this even clearer when looking at examples of top-tier BDCs against top-tier REITs this year. Here are my top five BDC holdings and top five REIT holdings. (And yes, I know that one of these is a mortgage REIT, but I view its business model as substantially similar to that of a BDC, only concentrated on real estate companies.)

I like BDCs that are able to maintain a premium to their net asset values over time, because this indicates an ability to issue capital for accretive investments on a regular basis. The higher the premium to NAV, the lower the cost of capital, generally speaking.

Of course, I like to buy these BDCs as close to NAV as possible, or at a discount to NAV in those rare circ*mstances, but the point here is that regularly trading at a premium to NAV is both an indicator and a facilitator of quality. It is the higher quality BDCs that tend to enjoy such a valuation premium in the first place, and once they have that valuation premium, they can use it to issue lower-cost capital in order to win bids on lower-yielding loans for higher quality borrowers.

MAIN is the textbook example of this, which is why it is my largest BDC holding. The company explicitly aims to increase its NAV per share over time along with its monthly dividend.

Meanwhile, on the real estate side, four of my five largest REITs primarily (or exclusively) employ net leases, which are long-term contracts with fixed rental revenue streams and annual escalations rarely exceeding 3-4%. They also employ long-term debt ranging from 5 to 30 years in length, although most of them carry at least some floating rate debt on their balance sheets at times.

This year, especially since the beginning of May, the BDCs (and ABR) have significantly outperformed VNQ on a total return basis.

MAIN and ARCC, the two largest and arguably most conservative BDCs in this group, have understandably exhibited less volatility, both on the downside and upside. But they have also handily outperformed real estate so far this year.

Meanwhile, when comparing the five REITs against BIZD year-to-date, we find the mirror opposite.

All year, but especially starting in May, REITs have significantly trailed BIZD.

CCI, a telecommunications infrastructure REIT, has performed the worst not only because of the ~10% of its debt featuring floating rates but also because lease cancellations from the T-Mobile (TMUS)-Sprint merger are taking a bite out of revenue growth.

ARE, the leading life science real estate owner and developer in the US, has also suffered from investors mistakenly equating it with office buildings, a drop in venture capital funding for biotechs, and an activist REIT investor's short report.

Fundamentally, all five REITs continue to perform quite well, but the higher cost of debt has spooked many investors out of the names.

A Lesson In Contrarianism

Which is the better buy today for total returns over the next few years?

If we had asked that question in March or April 2020, during a period of collapsing interest rates and extreme economic pain for private businesses, the correct answer would have been BDCs.

Don't believe me? See for yourself:

That is because peak pessimism about BDCs (even greater than the pessimism for REITs) rendered phenomenal values for those stocks.

The same holds for BIZD against the five (in my opinion) best-in-class REITs discussed above, with the sole exception of VICI.

In the initial stage of COVID-19, VICI (the "Landlord of Las Vegas," as I like to call it) shed over half its stock price and market cap. The very experiential, in-person activities at VICI's casino properties were obviously severely curtailed by lockdowns and social distancing. But this selloff also primed the REIT for a robust rebound as Las Vegas reopened and the world returned to normal.

YTD, however, BIZD has outperformed VICI as we saw above.

But we can't invest by looking in the rearview mirror. We have to invest by looking out the windshield. No one can buy past returns, only future performance.

As the famous quip goes, "It's difficult to make predictions, especially about the future."

But in my view, the much better bet to make today with one's scarce investable capital is on REITs.

I think it's plainly obvious that sentiment is much stronger for BDCs than it is for REITs. In general, investors are pessimistic about REITs and optimistic about BDCs.

But this trend won't last forever. To quote the father of value investing, Benjamin Graham:

The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

I'm not advocating selling BDCs. I'm a buy-and-hold-quality-companies kind of guy, and I'm certainly not selling my high-quality BDCs (or ABR, for that matter). But I think REITs make the much better buy today.

It isn't just that the pendulum of investor sentiment has reached its end on its current path. After all, it is usually the case that something has to occur to make the pendulum stop and reverse course.

That something is the path of interest rates. We are at or very near the top in interest rates, not just by my own reckoning but by the projections of many experts. The forward path of SOFR (which is tied to the Fed Funds rate) is forecast to begin dropping dramatically in 2024 and settle out sometime in 2026.

While I agree with these forward projections in a directional sense, I don't at all buy the notion that rates will come down in a slow and controlled manner. They never do.

Like stock prices, the Fed Funds rate takes the escalator (or stairs) up during economic expansions and the elevator down during recessions.

Going back three decades, the Fed has never been able to gradually lower their policy rate over the span of a few years. The Fed has seemed to have three modes: slam on the gas, slam on the breaks, or coast.

If a recession comes sometime in the near future, and especially if the highest interest rates in 15 years break something in the economy, then interest rates will likely fall faster and lower than the expert projections indicate.

Historically, this is how it has worked out far more than the slow, gradual lowering of rates currently envisioned.

If the pattern of history plays out again this time, or even if it doesn't and the expert predictions for a slow, gradually downward drift of interest rates occur instead, REITs should outperform BDCs over the next few years.

While I remain a fan of BDCs, I view the five REITs discussed above as being uniformly better buys today than the four BDCs and one mREIT.

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