If dividend-oriented investors could be compared to an item of clothing, I’d pick a charcoal gray or navy blue suit (I’m the navy type). In stocks, as in clothes, we want something that is reliable, provides value, and isn’t flashy.
But what if the navy or gray suit came with a neon paisley lining and was worn with an open-necked shirt, or no shirt at all?
That kind of wildness is what comes to my mind when I think of the two classes of companies that attract the interest of dividend-oriented investors but are much different from the large-cap, brand-name companies we typically think of as dividend stocks. Specifically, I’m speaking about real estate investment trusts and business development companies. While their relatively high dividends in today’s low-interest rate environment make them attractive, their unique structures and risk parameters require extra attention.
First, a bit of explanation.
Real estate investment trusts, or REITs, were created by Congress in 1960 to make it easier for individuals to invest in big, income-producing real estate investments in the same way they can invest in publicly owned corporations or mutual funds. REITs must pay out 90% of their income as dividends to shareowners in order to retain their tax status as REITs. You can always take a look at our Top 219 REITs to see which one suits your portfolio best.
Business development companies, or BDCs, are also creations of Congress (1980) that were designed to invest in small- and medium-sized businesses. Like REITs, they pay no corporate income tax if they pass along 90% of their taxable income to investors in the form of dividends.
REITs and BDCs sound like ideal investments for dividend-oriented investors. And they can be, but they also have their weaknesses.
REITs, which have been around longer, have suffered many periods of booms and busts, just like other equity classes. In 2007 and 2008, for instance, REITs lost about 18% and 37% of their value, respectively, according to the FTSE NAREIT All REIT Index. Over the next two years, the index gained 27% and almost 28%, respectively. Sometimes REITs deliver performance uncorrelated to other equities — providing a much desired zig when the overall stock market zags — and at other times REITs correlate closely to other equities. Their value also waxes and wanes with the real estate cycle, so that when demand for space is strong and construction lags, their share prices typically rise.
BDCs are newer and have not experienced as many cycles, but their performance can also be volatile. In 2008, BDCs lost 45% of their value as measured by the Wells Fargo BDC Index, while the overall market, as measured by the MSCI Broad Market Index, lost 37%. The next year, BDCs were up 43%, while the overall market gained about 29%.
For investors considering REITs and BDCs, the hardest job is trying to figure out what’s going on under the hood. The financial statements of both kinds of companies can be complex, confusing, and hard to decipher. And even if you do figure it out, deciding whether the potential rewards outweigh the risks isn’t something a spreadsheet can answer.
The Bottom Line
So here’s what may be the bottom line: REITs and BDCs can look very appealing, but don’t rush in without doing a lot of homework first and observing the categories from the sidelines before plunging in.
We’ll be coming back to REITs and BDCs again, with suggestions for doing the right kind of homework. In the meantime, if you’d like to dig a little deeper on REITS now is the perfect time to dive into our Guide to REIT (Real Estate Investment Trust) Dividends.
Evan Cooper, is an award-winning financial journalist. After reporting on business at The Miami Herald, Evan worked on Wall Street at the New York Stock Exchange, the Securities Industry Association and Drexel Burnham Lambert. He was Editor-in-Chief of On Wall Street, a publication for financial advisors, research editor of Institutional Investor, and Deputy Editor of InvestmentNews, where he was honored by the Society of American Business Editors and Writers with a “Best in Business” award for his online opinion column.