Companies need access to capital to support their long-term growth efforts. Business development company (BDC) Ares Capital (ARES 0.37%) provides that cash via loans. Real estate investment trust (REIT) W. P. Carey (WPC 0.05%) buys properties from companies in sale/leaseback deals, allowing them to monetize assets for cash.

While BDCs and REITs are very different entities, the basic goals of their customers can be very similar. But for more conservative types, W. P. Carey's approach will probably be a better fit.

The riskier option

As a BDC, the basic business model for Ares Capital is to raise its own capital at advantageous rates and then lend it out to companies at higher rates. This can be a very profitable business model. The big risk is that a borrower's business doesn't do as well as expected and it ends up defaulting on the loan. There will always be customers that fall into this camp, no matter how careful management is in selecting its partners. The company's non-accrual rate (loans that aren't being paid) was 2.3% at the end of the first quarter -- up year over year but, according to management, below its 15-year average. That suggests that things may be getting tougher for the BDC's customers.

Hands holding blocks spelling Risk and Reward.

Image source: Getty Images.

An advantage today is that around 70% of Ares loans are variable rate, so they generate more interest income as interest rates rise. But the glass-half-empty view of this is that it's also a risk, since the borrowers are also facing higher interest costs, which increases the risk they won't be able to pay. That said, the net asset value per share (basically the value of the loan portfolio on a per-share basis) rose five cents in the first three months of 2023 to $18.45. Net investment income was at $0.60 per share, up from $0.41 in the first quarter of 2022. It's not a bad story.

Here's the catch: If the companies to which Ares has lent money don't pay, there's a real risk that the principal is just gone. Yes, there may be collateral of some sort, but getting to it, as other creditors also look to be paid, isn't a simple matter. And, while times are good today, a recession could quickly change the portfolio's performance for the worse (not the increase in non-accrual loans already being seen). This isn't an idle issue, given that a number of BDCs went bankrupt during the Great Recession and the fact that Ares cut its dividend roughly 16.5% in 2009.

A more conservative approach

W. P. Carey also provides cash to companies, just in a different way. The REIT's sale/leaseback transactions allow a company that owns real estate to sell it, raising money for other purposes, while then renting it back under a long-term lease. In this way, the lessee retains access to the property while still accessing the cash tied up in the asset.

These leases also generally require the renter to pay for most property-level expenses (called a net lease). That may seem like a negative, but it means the lessee controls the property's upkeep. This may be important to their business, since a landlord might skimp on such expenses to save money.

This is all a win for W. P. Carey, because it owns a new property, expanding its portfolio, and it comes with a long-term tenant attached. Meanwhile, the average lease length for W. P. Carey is nearly 11 years, which should be more than enough time to ride out most economic downturns. The REIT has built-in rent escalators as well, so rents rise over time, helping W. P. Carey keep up with inflation. Somewhat uniquely in the REIT space, W. P. Carey also diversifies its portfolio by property type and region, so it has plenty of opportunities to find attractive new investments in just about all markets.

The proof is in the pudding here, given that W. P. Carey has increased its dividend every year since it came public in 1998. That includes during the Great Recession that resulted in a dividend cut at Ares. A key difference here is that W. P. Carey owns properties that it can release or sell if a tenant stops paying rent. Ares doesn't have that level of built-in protection with its loans. 

More yield, more safety

Ares, with its 3.7% dividend yield, is a perfectly fine BDC. But if you are looking for dividends, W. P. Carey's yield is much higher at roughly 6%. W. P. Carey's dividend track record is also better and its business has more built-in protection, given that its income is backed by physical assets it owns. If you are looking at Ares as a dividend play, you might be better off considering an alternative like REIT W. P. Carey.