In my last column, I provided a brief primer on the business development companies (BDCs). But that was not my original intention.
I started that column by focusing on some of the high yielding BDCs, which may be considered as an alternative to mortgage real estate investment trusts (mREIT's). However, the issue I quickly ran into was that every other sentence ended up being an explanation of some aspect of the BDCs that was different than the REITs, so I decided to just do the primer.
Also, each BDC has unique operations, focus, and holdings, so it is difficult, and even inappropriate, to discuss them as a group.
In this column, I'll compare the general differences between BDCs holding loans containing real estate or some other hard asset that supports it and mREIT's.
Mortgage REIT's are most commonly invested in agency, residential, single family dwelling mortgages with long-term fixed rates that are purchased after they've been originated by lenders. These instruments are packed into residential mortgage backed securities (RMBS's).
These loans all have uniform underwriting guidelines and trade in a highly liquid secondary market. The market value of these loans are sensitive to interest rate changes, especially rising long-end treasury yields, as I've discussed previously.
The mortgage and hard assets related BDCs are typically invested in loans that are collateralized by commercial properties, with or without the land being included, or by other hard or fixed asset.
Although some of these loans may be packaged into commercial mortgage-backed security (CMBS) standards and thus highly liquid, most are originated as loans that do not meet security criteria.
These loans may be purchased from lenders, either banks or non-banks, once they are created, or by a BDC.
The commercial mortgages held are typically to companies that are not in the real estate investment sector, but that own improved commercial real estate as a part of their operations, manufacturing facilities, R&D centers, or simply office space.
These loans, in many cases, are structured with unique features, such as equity warrants. That precludes them from being included in a package of similar securities. As such, the loans do not trade in an established liquid uniform market.
Commercial mortgages usually have shorter maturities than residential mortgages, as well as adjustable interest rates. As a result, the market value of these instruments is typically less sensitive to interest rate changes.
In the 1980's, insurance companies, pensions and financial arms of utility companies tended to issue these types of loans.
But after the savings and loan crisis of the late 1980's and early 1990's, investment banks led by Bear Stearns and Lehman Brothers, created a system of organizing these kinds of loans into securities with uniform underwriting guidelines. They were originally called conduit lending ,but grew into what became the commercial mortgage backed securities market (CMBS).
The loans that could not be packaged either stayed with the originating banks or went to what is called hard-money lenders.
BDCs may be either be private or public finance companies that make hard money loans. These private hard money lenders typically operate within a single state and usually are focused on a specific industry, the most common of which is mortgage lending.
Borrowers typically use hard money loans when it is important to get a loan origination quickly, or when they can't, or won't, provide supporting documentation to obtain a lower-cost loan. These borrowers also often have ongoing relationships with BDCs, so that they can obtain fast financing when needed.
A BDC or hard money lender can typically move a loan request through to closing, before a bank-originated loan has even completed its first step of financing, or processing.
The increased interest-carrying costs are simply the cost of business for these borrowers, who find it is worth it to secure a rapid loan closing.
The publicly traded BDCs, with loan portfolios largely collateralized by real estate or other hard assets, are: Ares Capital Corporation (ARCC), FS Investment (FSIC), Hercules Capital (HTGC), Monroe Capital (MRCC), and Garrison Capital (GARS).
The dividend yield provided by each at 10% or higher, is very similar to that provided by the mREIT's currently.
Whereas the mREIT's will move in price depending on what interest rates do, a situation that is out of the control of the managers, BDC prices are much less impacted by interest rate changes and more tied to the performance of the investments made by the managers.
Income investors, as a result, should consider mREITs, BDCs and cross-hedging investments that can be complimentary and reduce their overall principal volatility