Sunday, June 22, 2014

Why higher interest rates don't scare me away from these stocks

As many have realized I own a lot of securities in the REIT and BDC industries.  Many have expressed concerns about when interest rates rise these income investors will steadily decline.  While that may be the case I am not sure that it is a given.  There is a lot of time for companies to plan and structure accordingly to minimize the risks now.  Sometimes management can have the foresight to take a hit now for a more prosperous future.  Here are a few examples of why higher interest rates do not frighten me.  I will use a company from each sector and run through why I think they can continue to outperform the overall market.  These companies are showing that management has shareholders best interest in mind.

REIT:  Realty Income (O)-  This company has paid 527 consecutive monthly dividends.  The company raises the monthly dividend every quarter by a very small fraction.  They started with just one Taco Bell property in 1969 and have grown to owning over 4,200 today.  They have many good quality tenants in their top 10 by weighted average.  The 528th straight monthly dividend and 76th dividend raise since their 1994 IPO was just declared for July.  This is not the only thing that is attractive, but the growth and scale helps the company raise funds from cheaper sources before interest rates do rise.  When interest rates start to rise I don’t think they will shoot up too quickly because of the fragile economy. Realty Income is like many REITS and uses secondary stock offerings to raise funds to acquire properties and a credit facility. 
Too many people confuse equity REITS with mREITS.  Most equity REITS are much safer in my opinion then mortgage REITS.  Realty Income belongs to the safest class of equity real estate companies in that they are a triple net lease REIT.  This means they are able to take in rent payments with built in annual bumps in rent.  The companies that operate the businesses are then required to pay for maintenance, taxes, and equipment fees.  Realty Income then takes some of the rent from their earnings known as Funds from Operations (FFO) or Adjusted Funds from Operation (AFFO) to pass on to shareholders in the form of dividends.  A REIT that passes on 90% of earnings to shareholders is able to escape being taxed at the corporate level.  The individual must pay their ordinary rate of taxes on all dividends from Realty Income instead of getting the preferential treatment of qualified dividends that taxes cannot exceed the 15% rate. 
BDC: Prospect Capital Corporation (PSEC)- Prospect loans money to small and midsized businesses and gets paid back with interest.  It is important they are able to do necessary research to make sure risks of default are not too high.  One thing I am not too happy about is the externally managed for a fee of 2% segment. I think they’d be better if ran the company internally similar to MAIN Street Capital (MAIN).  When banks are tough on loaning to these companies BDC’s can step in and fill the gap.  Sometimes they can invest in companies and take them over or take them public and sell their investments for a nice profit.  I am very impressed with the educations of Prospects senior management and think they are some of the best in the business.  The dividend visibility is clear as the dividends have been declared for the rest of 2014 on a monthly basis. There are ways to lend while being even more profitable when interest rates rise.  I am no expert, but management at Fifth Street (FSC) and Prospect expect to lend using floating rate loans that over the long term help offset the risks of rising rates and actually profit from higher interest rates.  There are some risks of dividend cuts because it is hard to avoid defaults when lending to some risky businesses to generate 10-12% yields.  This is because they raise funds by selling stock and sometimes to do under their Net Asset Value (NAV).  This dilutes shares temporarily and makes more shares outstanding and costs for the company to pay out the dividends.

Full Disclosure: Long O, PSEC, MAIN, FSC
Photos Source: Respective companies logos from Google Images



  1. Thanks for sharing your insight about higher interest rates and REITs. I know that a lot of these investments are in many dividend blogger portfolios because of their high yield. I happen to agree that interest rates rising will not fully affect these types of companies as the increase is expected to be gradual and when rising from close to 0% to even 1% or 2% we'd still be in a historically low interest rate environment. I have been looking to diversify into the REIT space a bit. Specifically, the health care segment. Haven't pulled the trigger yet.

  2. Thanks DivHut,

    Healthcare REITs should be a pretty good segment to invest in. I only own LTC mostly in that space, but have considered OHI and others at times. I'll be watching to see what you end up picking up!