Co-authored by Treading Softly.
Have you ever been extremely frustrated when something simply doesn't work?
I'll admit that I get the most frustrated when I can't find the tools I need for a home improvement project. Can't find where you left the hammer? Grab another heavy tool and pound away! Sometimes it works, sometimes you bend the nail or break the handle of the tool that wasn't built for such force.
Many people come up with ingenious ideas and, using that ingenuity, trying to use one tool in place of the proper tool - only wonder why it doesn't work.
When it comes to the market, it is one of the greatest wealth generators in all history. Despite this, many will lose thousands of dollars, even millions of dollars, in the market every year because they're not using it how it's designed to be used. The market is no place for an impatient investor. The stock market will make millionaires out of gamblers and will cause bankruptcies for gamblers as well.
At the end of the day, as a professional income investor, I am leveraging the market's ability to generate wealth to create an unstoppable income stream. An income stream that simply does what it is designed to do: paying me strong income on a recurring basis without me having to babysit it. My portfolio constantly rings with the sound of new dividend dollars pouring in day after day. The market can be a great tool for the job when you are trying to produce a large income stream.
Today I want to reveal two holdings that I have in that portfolio that continue to pay me excellent income.
Let's dive in!
Pick #1: WPC - Yield 6.7%
W. P. Carey Inc. (WPC) is a well-diversified triple-net REIT. Net leases are a leasing structure that puts the responsibility for property-level expenses on the tenant.
The structure appeals to tenants who want control over the property, which is most similar to ownership, and not be reliant on calling the landlord for every little thing. Since the landlord is not obligated to handle day-to-day operations, the rent is typically lower.
For landlords, the appeal is that triple-net leases have fewer expenses. The landlord is typically only responsible for major structural capital expenses like replacing the roof - things that occur rarely but are generally predictable well in advance.
One of the greatest benefits of the leasing structure is that it is easily adapted to most types of businesses. WPC owns industrial, warehouse, retail, office, and self-storage properties.
With a diverse array of property types and tenant industries, WPC is well-insulated from weakness in any particular sector. Source.
As a result, even though the COVID pandemic, WPC was able to maintain very high and stable occupancy of its properties.
Since going public in 1998, WPC has raised its dividend every single year, reaching 25 years of dividend raises this year.
Since 2001, WPC has had the habit of raising the dividend every single quarter - an impressive achievement through two major recessions and COVID.
One headwind that WPC had been experiencing through most of the 2010s was lackluster same-store rent growth. Persistently low inflation and low interest rates created an environment where prices for new properties were high, and rent growth was well below 2%.
Today, that has changed in a dramatic way. WPC is now seeing 4.3% same-store rent growth.
While this is likely to slow down as inflation declines, it will still remain above average for several years, and future rent increases will be based upon the now higher rents.
WPC has been very busy acquiring new properties; it is a buyer's market with sellers exploring sale-leasebacks as an alternative method to access capital and a lack of credible buyers in the market for multi-million dollar properties.
In the last earnings call, CEO Jason Fox noted that deals this year have occurred at an average cap rate of 7.2%, 120 bps higher than deals last year. He went on to describe other changes in recent deals (emphasis added):
"Today, we're focused on deals with going in cash cap rates in the 7s, which translates to unlevered IRRs in the 8s and into the 9s taking into account the rent growth we're able to achieve over long-term leases. In our new deals, we're achieving higher rent growth than we have historically. For example, deals with fixed rent bumps completed in the first half of 2023 had rent increases averaging just under 3% compared to historical averages around 2%. We, therefore, continue to generate a comfortable spread to our cost of capital and have a positive outlook on our ability to win deals and deploy capital accretively over the second half of the year."
Like every other company on the planet, WPC has seen its cost of capital increase. So, acquisitions today have had only a modest impact on current earnings. However, the future potential is much higher, as eventually, WPC's cost of capital is likely to come down. Meanwhile, WPC will own a lot of properties with fixed rent increases at 3%. With a Federal Reserve that is absolutely committed to getting inflation to 2%, those 3% fixed increases are likely to be looking really fantastic in a couple of years.
WPC is buying properties at a higher cap rate today, which is nice but is somewhat offset by WPC's own higher cost of capital. The real value in these acquisitions is not the immediate income. The real value is that WPC is getting deals with materially better terms that will provide much higher future rent growth than WPC saw in the 2010s.
Patient investors will be well rewarded over the coming decade as WPC continues its pattern of quarterly dividend hikes, and the pace of those hikes will likely be much faster in the next decade than they were the past decade because of the groundwork WPC is laying today.
Pick #2: ARCC - Yield 9.9%
Ares Capital Corporation (ARCC) is the largest and one of the oldest publicly traded BDCs (Business Development Companies). BDCs serve as lenders to the "middle market" - businesses that have lending needs that go well above credit cards but don't have access to public debt markets.
ARCC's focus is on the "upper middle market", with their average borrower having an annual EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of over $300 million. Source.
ARCC has an advantage of scale compared to peers, and it uses that advantage to make loans to larger private companies. ARCC's large size gives it the ability to make larger loans, while still maintaining significant diversification.
BDCs are lenders. The basic business model is to borrow at fixed interest rates and make secured floating-rate loans to borrowers - a fantastic strategy in a rising interest rate environment. Rising interest rates have provided strong tailwinds for ARCC's earnings, and we have seen ARCC's regular dividend increase from $0.40/quarter in 2020 to $0.48/quarter today.
ARCC is not alone; many of its peers have also raised their dividends. It is simply a fantastic environment for BDCs. What makes ARCC stand out is its proven history of credit quality.
Whenever you are in the lending business, inevitably, some folks won't pay you back. It comes with the territory, and it is unavoidable. With high-quality underwriting, losses can't be completely avoided, but they can be minimized. This is an area where ARCC has a strong track record:
Since 2004, ARCC has realized a loss rate of just 0.1% on their first lien loans and 0.2% on their second lien loans. This is substantially better than industry averages and is especially impressive when considering that this outperformance was over 19 years and included the Great Financial Crisis.
In addition to strong underwriting, ARCC has a track record of turning lemons into lemonade. Using the resources of its manager Ares Management (ARES), ARCC is frequently able to work out deals with borrowers, modifying loans and taking equity. Unlike bank lenders, which run to court, BDCs exercise the "development" part of their name and are willing to work with companies to turn around their businesses - when successful, it benefits everyone. The BDC gets a return that is sometimes larger than the original debt investment. The company stays in business and becomes profitable - a win/win situation for everyone involved.
ARCC has realized $1.255 billion in credit losses, but those are more than offset by $2.265 billion in realized gains.
So, while others are running around in fear of the next corporate debt crisis, I'm happy to be holding onto ARCC - a BDC that has demonstrated high-quality underwriting and an ability to turn difficult times into profits. ARCC has a scale advantage, and through ARES, it has the advantage of connections. When a portfolio company runs into trouble, ARCC has the resources and the skills to achieve the best results.
Conclusion
We can smash it with W. P. Carey Inc. and Ares Capital and enjoy a strong, passive income stream because the management teams of both companies know exactly what they're doing. Both of these companies have a long history of raising dividends or paying supplemental dividends to their shareholders, rewarding them for being co-owners of the company.
I love to manage a portfolio filled with companies exactly like these two because it means I don't have to babysit my portfolio. Instead, I can go out and do what I want to do every day, knowing that the management teams of these companies are doing right by me and by the company itself; all I have to do is cash my dividend check every quarter.
Let me ask you this: Does your portfolio pay you for owning it, or do you have to babysit your portfolio? Instead of having to allot time every week to worry about your portfolio, why don't you take that time and use it for something that you can enjoy instead, like having a hobby?
The beautiful thing about my portfolio is that I have the choice - I can babysit it, or I can go have a hobby. The choice is mine; that's true financial freedom.
That's the beauty of my Income Method. That's the beauty of income investing.
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