Should You Forget Realty Income and Buy a BDC Instead?

Realty Income (NYSE: O), one of the world's largest real estate investment trusts (REITs) with a portfolio of over 15,500 commercial properties, is often considered a stable income investment. It's one of the few REITs that pay monthly dividends; it's raised its payout 136 times since its 1994 IPO; and its forward yield of 5.8% still beats the 10-Year Treasury's 5.1% yield.

But over the past 10 years, Realty Income's stock price has declined 7%, compared to the S&P 500's (SNPINDEX: ^GSPC) 260% gain. With reinvested dividends, Realty Income delivered a total return of 49% -- compared to the S&P 500's total return of 325%.

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Realty Income underperformed the market for two main reasons. First, it constantly issues new shares to fund its real estate acquisitions. That dilution increased its share count by 264% over the past decade, and it will issue more shares for the foreseeable future. Second, it's vulnerable to rising interest rates, which make it more expensive to buy new properties while hurting its existing tenants -- which include grocery stores, convenience stores, and hardware stores.

So instead of investing in Realty Income or other REITs for income, should you invest in a business development corporation (BDC), which actually benefits from rising interest rates?

REITs vs BDCs

REITs and BDCs both distribute at least 90% of their taxable income to investors as dividends to maintain lower tax rates. However, their business models are completely different.

Equity REITs buy properties, rent them out to businesses, and split the rental income with their investors. BDCs provide financing for smaller "middle market" companies that can't secure loans from conventional banks because they're considered higher-risk clients. In exchange for taking on that risk, they charge higher interest rates than banks.

Most BDCs peg their floating-rate loans to the Federal Reserve's benchmark rates. Therefore, rising interest rates generally boost their net interest income -- but they can't rise so high that they hurt their portfolio companies and cause them to default on their loans.

Which BDC is a reliable long-term investment?

Smaller BDCs can be risky because they aren't adequately diversified to withstand a recession. However, Ares Capital (NASDAQ: ARCC) -- the world's largest BDC -- is a lot safer. It's invested in 619 companies across its $29.3 billion portfolio, allocating 59% to first-lien secured loans and 4% to second-lien secured loans.

Over the past decade, Ares' stock price has risen by only 20%. But including reinvested dividends, it delivered a total return of 210%. It currently pays a massive forward yield of 10.3%.

That high yield might seem like a red flag, but it's paid continuous dividends for the past 16 years. Analysts expect its EPS to decline 5% to $1.91 this year, which falls short of its forward dividend of $1.92, but to rise 2% to $1.94 in 2027.

To maintain that stable growth, Ares needs the Fed funds rate -- currently at 3.75%-4.00% -- to remain in a "Goldilocks" zone of about 3.5%-5%. As long as it stays there, Ares can maintain healthy net interest margins, avoid defaults, and continue investing in additional companies.

At $18, Ares also looks undervalued at 9 times next year's earnings. Therefore, Ares -- and similar BDCs -- might seem like better income plays than REITs in this choppy market.

However, BDCs will still struggle to outperform the S&P 500 over the long run, since they need to distribute most of their earnings to investors rather than reinvesting that cash back into the business. Like REITs, they also continually issue additional shares to fund new investments. Therefore, BDCs might be appealing to some income-oriented investors, but they might not be the best fit for those seeking larger, longer-term compound returns.

Leo Sun has positions in Realty Income. The Motley Fool has positions in and recommends Ares Capital and Realty Income. The Motley Fool has a disclosure policy.