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.
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.
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.
Full
Disclosure: Long O, PSEC, MAIN, FSC
Photos Source: Respective companies logos from Google Images
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.
ReplyDeleteThanks DivHut,
ReplyDeleteHealthcare 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!