VNQ - REITs Vs. MLPs Vs. BDCs: Comparing 3 High Yield Income Vehicles

2023-11-15 08:05:00 ET

Summary

• REITs, MLPs, and BDCs are very popular among income investors.
• Each has unique pros and cons.
• Overall, REITs are likely the most opportunistic today. Here's why.

Co-produced by Austin Rogers

Three investment vehicles are particularly popular among income investors:

• Real estate investment trusts ("REITs")
• Master limited partnerships ("MLPs")
• Business development companies ("BDCs")

Each is designed to pay out as much earnings as possible while generally retaining relatively little cash for reinvestment. In some cases, however, companies are able to pay out lower amounts of their earnings and retain a large portion of cash flow.

In some ways, comparing these three investment vehicles is like comparing apples to oranges to melons, because each of these three uses different financial reporting methods and metrics.

Here are the relevant earnings/profit metrics for each investment vehicle:

In what follows, we compare and contrast these three investment vehicles, starting with an examination of each unique business model. We then look at a comparison of each vehicle for tax considerations, and finally, we look at a total return comparison for each's associated indexes.

Business Model Comparison

All three of these income vehicles have one thing in common: Since they pay out most of their cash earnings as dividends, they rely on external capital sources to grow their asset bases. Thus, growing cash earnings per share relies on management consistently investing in assets at effective yields above the company's cost of capital.

Aside from that fundamental similarity, however, these three vehicles have some important differences in their business models.

REITs invest either on the equity side in direct property ownership or on the debt side through extending mortgage financing to landlords or property developers. Most REITs are equity REITs, basically commercial real estate mutual funds with large portfolios of properties. The rent is used to pay all operating, administrative, and debt servicing expenses, and the remainder is FFO or AFFO. REITs typically pay out anywhere from 50% to 95% of their AFFO as dividends.

REITs can grow revenue both internally and externally. Internal growth comes through rent growth, while external growth comes from portfolio expansion -- i.e. property acquisitions.

To give an example, STAG Industrial ( STAG ) owns single-tenant industrial buildings. The REIT's revenue and AFFO have been growing from the combination of rent growth at existing properties and accretive acquisitions of new properties.

MLPs own midstream energy assets such as pipelines, storage facilities, processing plants, and export infrastructure. The standard model in the midstream sector is a take-or-pay contract, where customers pay for the use of the company's assets regardless of how much volume passes through them or where the prices of oil and gas are.

Like REITs, MLPs can grow revenue both internally and externally. Internal growth comes from fee escalations, while external growth comes from building or acquiring more midstream assets.

The gold standard MLP is Enterprise Products Partners ( EPD ), which boasts a quarter-century record of distribution growth, conservative financial management, and strong internal and external growth.

Finally, BDCs are private lenders. They extend generally short-term loans to middle-market businesses that have limited access to bank loans and (usually) zero access to the bond market. These loans tend to be used for recapitalizations, leveraged buyouts, management buyouts, major acquisitions, or business expansions.

Importantly, BDCs invest almost entirely in floating-rate loans with interest rate floors. This limits the downside from falling interest rates while maximizing the upside from rising interest rates.

Most BDCs' primary channel of providing shareholder returns is through dividends. Since they pay out almost all of their DNII as dividends, they retain very little cash, their net asset values ("NAVs") tend not to grow much, and their share prices don't provide much appreciation over time.

One exception to this is Main Street Capital ( MAIN ), a BDC that maintains a lower payout ratio in order to retain more cash for reinvestment, thereby growing NAV per share and driving stock price appreciation over time.

Tax Comparison

Most dividend-paying stocks are double-taxed. That is, the corporation pays tax on its profits, and then shareholders are taxed at the qualified dividend tax rate on the dividends they receive.

But a handful of corporate structures enjoy a special tax status where the company's income is taxed only once at the shareholder level. These are known as "pass-through entities" because instead of being taxed at the corporate level, the tax requirement is passed through to shareholders only.

Pass-through entities, including REITs, MLPs, and BDCs, each have slightly different tax rules.

• REITs must pay out at least 90% of their taxable income as dividends in order to avoid corporate-level taxation. (Although, REITs are still responsible for the payment of property taxes.) In exchange, these dividends do not enjoy qualified dividend status but are instead taxed as ordinary income. However, the 2017 Tax Cuts & Jobs Act did install a 20% reduction in the tax rate on REIT dividends. So, all else being equal, REIT dividends are taxed at 20% less than one's ordinary income tax rate.
• BDCs are similar to REITs in that they must pay out at least 90% of their taxable income as dividends. One unique aspect of BDCs is that they typically take equity stakes in their borrower companies as co-investments. These equity stakes often generate qualified dividends, which can then be passed through to BDC shareholders as qualified dividends.
• MLPs are slightly different than REITs or BDCs in that they are not required to pay out any threshold of taxable income because they are publicly traded limited partnerships. MLPs get multiple forms of preferential tax treatment, including non-taxation at the LP level, but unitholders in the MLP receive K-1 forms for tax purposes, which are more complicated than 1099-Div forms.

It's worth noting that for all three of these types of pass-through entities, dividends can be classified as capital gains or return of capital in addition to non-qualified income.

Capital gains are taxed just like any other capital gains (short-term as ordinary income and long-term at the qualified rate), while the return of capital is tax-deferred, reducing one's cost basis in the holding. MLP distributions tend to be mostly if not entirely ROC, which defers taxation until the holding is sold.

REITs and BDCs are ideally held in tax-advantaged accounts such as traditional or Roth IRAs, while MLPs typically work better in taxable accounts due to limited taxable dividends and the possibility of unrelated business taxable income ("UBTI") that could create tax complications for unitholders in sufficient amounts.

Another tax benefit of MLPs that is worth mentioning is the ability to bequeath units to one's heirs on a stepped-up basis. Upon one's death, one's heirs would receive the MLP units with a new cost basis equal to the market value at the time, instead of the marked-down cost basis from however many years of gradually reduced cost basis from ROC-classified distributions.

Total Return Comparison: REITs Vs. MLPs Vs. BDCs

When it comes to total returns, each of these three vehicles has a slightly different profile.

• REIT returns come from a mix of dividends and stock price appreciation
• MLP returns come mostly from dividends but also appreciation to a lesser degree
• BDC returns come almost entirely from dividends but may see appreciation over long periods of time as well

As such, REITs tend to have the highest valuations and lowest dividend yields, averaging 4-5%. MLPs have lower valuations and higher dividend yields, typically in the 8-10% range. BDCs have the lowest valuations and highest dividend yields, typically ranging from 9-12%.

Pre-COVID, REITs tended to generate the highest total returns. In fact, REITs generated the highest total returns right up until the Fed's aggressive rate-hiking cycle began a year and a half ago.

In the chart below, REITs are represented by the Vanguard Real Estate ETF ( VNQ ), MLPs by the Alerian MLP ETF ( AMLP ), and BDCs by the VanEck Vectors BDC Income ETF ( BIZD ).

Due to BDCs' floating-rate loan portfolios as well as the fact that the economy has remained strong enough to prevent defaults from spiking, BDCs recently overtook REITs in total returns.

Since the beginning of 2022, this outperformance has been massive:

But of course, if and when interest rates begin to sustainably decline, this outperformance should reverse. That is especially true if the economy dips into recession, as BDCs will almost certainly suffer an uptick in loan defaults.

What about MLPs? As you can see from the chart above, MLPs have performed poorly on a total return basis since the oil price crash in 2014-2015.

But like BDCs, midstream companies of all kinds have dramatically outperformed REITs since the beginning of 2022. In fact, due largely to strong cash flows and high dividend payouts, MLPs have outperformed their C-corp brethren on a total return basis over that period:

The reason for this pertains to energy prices as well as self-funding capacity.

MLPs and energy infrastructure corps were generally more highly leveraged than REITs, and with higher payout ratios leading up to the oil price crash in 2014-2015. After that, however, midstream companies "found religion" when it came to financial management and began to systematically reduce leverage and payout ratios. This was a multi-year process that involved years of mediocre performance.

But today, midstream companies on average are lower-leveraged and have lower payout ratios than REITs. On an ongoing basis, many if not most are now self-funding, requiring little to no equity issuance to fund their business model.

Plus, compared to the low energy price era of the late 2010s, oil prices today are much more amenable to steady cash flows.

In comparison, REITs have somewhat higher leverage and payout ratios on average (although both are still much lower than in the pre-GFC era) than midstream companies.

To be clear, we believe REITs generally perform about as well as midstream companies on a fundamental basis through periods of rising inflation and interest rates.

But the market's perception definitely seems to be more negative on REITs than midstream right now.

Interestingly, there seems to be a strong correlation between REITs and bonds, where REITs are basically just viewed as bond proxies in today's market.

You can see in this chart the strong, inverse correlation between the movements of the BBB corporate bond yield and REIT stock prices.

Meanwhile, despite long-term take-or-pay contract structures that make midstream far more stable than the average energy company, MLPs and energy infrastructure companies exhibit a fairly strong correlation with the price of oil.

Bottom Line

Each of these three investment vehicles can certainly play a role in a diversified income portfolio.

As you can see, they all have slightly different business models and performance drivers that make them complementary to one another. In an environment where one underperforms, one or both of the others may be outperforming. And when the environment shifts, the relative performance likely shifts as well.

Although MLPs and BDCs have enjoyed a very strong run over the last few years, we believe REITs are the most opportunistically priced right now for outperformance over the next few years.

For further details see: