When Rates Move, Who Wins?

0:04We're breaking down the businesses that stand to benefit most when borrowing gets cheaper. Today on Motley Fool Money.

0:19I'm Emily Flippen and today I'm joined by analysts Jason Hall and David Meier to discuss the industries and businesses that are actually impacted by interest rates. After last week's signaling from Federal Reserve Chair Jerome Powell at Jackson Hole that we'll likely be looking at at least one rate cut this year, it's fair to ask what the real impact may be. We'll touch on bond proxy stocks and financials, but to start, real estate. Now, Dave, you've talked a lot in the past about how home builder sentiment has reached new lows, but mortgage rates are directly tied to Federal Reserve policies, and many argue that all it would take is a few basis points and lower rates to really quickly ignite that real estate demand.

0:59Do you think that actually will come to fruition, especially given the other environmental impacts that we're seeing today?

1:05David Meier:I think it'll take more than a few basis points, but directionally, I think this is correct. I mean, lower interest rates help home builders in so many different ways. First, the lower rates make it easier for potential buyers and that defects demand. So yeah, with lower rates, you could see demand rise. Plus, the other thing is right now, home builders are giving lots of incentives away in order to get people to make a purchase within a higher interest rate environment. So, lower rates could actually mean less builder incentives and potentially more profitability for the builder on a per-build basis.

1:42David Meier:So clearly buying and building houses are big decisions and they take time. But I think lower rates being a catalyst for additional building can help other macro variables over time as well. One thing about home builders that's important too is they're also big consumers of debt. And usually for long periods of time because they buy land that they hold for multiple years and they finance that land because they just don't have a bunch of cash laying around. So it helps them on both ends of their balance sheet and operating statement. That's a good point, Jason, but I'll play devil's advocate here too.

2:12We just say we still see affordability at all time lows. And, um, I don't know if there's necessarily going to be, we presume that there's a bunch of people sitting on the sidelines, waiting for interest rates to come down or home builders sitting on the sideline, waiting for interest rates to come down to build, um, that prices will actually move further down. Even if interest rates come down, it's possible that we still have people, even with lower interest rates that are priced out of the home market entirely.

2:37David Meier:That's exactly right. I will say this as a person who has bought two new homes, their builders are always reluctant to give on price. So price is not something they typically use in the negotiating table. I can understand why. Jason, you've analyzed economic measures as part of your research process for years. I mean, housing accounts for nearly a third of all the goods and services that are part of our consumer price index. Nearly 20 % of total GDP all comes down to housing. So needless to say, it's pretty important, but not all that impact is home building. Actually, a majority of it is things like housing services, which is just a fancy way to say like rent that in my opinion, and I think in my experience is arguably less impacted by interest rates.

3:20So how should one think about that segment of the housing market within the context of rate changes? Yeah. So we think about CPI and a lot of times when it comes to something like rent, we don't think about the rents that people already have a contract for. That's priced in, right? You're still rolling in that existing lease agreement. But we think about the people that are out looking for a new place. And it's like, wow, this costs a lot more than it did a couple of years ago when I was looking for an apartment. Right. But I think what we forget, too, is that interest rates actually do affect rents in a bigger way than we realize, because the vast majority of commercial real estate is financed.

3:55So those rates are there. Walker & Dunlop, which is a major player in multifamily residential real estate finance, put some really good information in their presentations and their Q2 earnings presentation. One of the things that they showed was that back in 2021, there was more than$250 billion in capital raised for private real estate investments. Last year,$125 billion. So, we're talking half as much. What changed? Interest rates. Real estate uses a lot of debt to fund those deals. So, as an investor, one of the trends worth following is the amount of cash sitting on the sidelines for real estate.

4:32So, 100 downlop estimates there's about$400 billion in dry powder, so to speak, that's nearing the end of its investment period in real estate funds. It's a lot of money that could be deployed into more supply in the years ahead. That could accelerate. And I think that could be good on the supply side. Maybe not bring prices down, but as people's incomes go up, maybe people's incomes go up faster than the prices will go up. And that could help some with the affordability. Fair point. But I have to ask, how does this all accrue to value for investors? Are there certain stocks or industries, home builders, REITs?

5:06I mean, there's so many different ways to play these trends.

5:08David Meier:Yeah, I'll start. I have to wonder if rocket companies, ticker RKT, wouldn't be a big beneficiary of lower rates. So it has a mortgage origination business, and that would actually stand to benefit both on the home building side, but on the resale transaction side. And speaking of transactions, it just acquired Redfin, the home selling platform. So, unfortunately, the Rocket's stock price is up pretty sharply off the April lows. And perhaps some of that is an anticipation of rates falling that's been talked about for quite a while. But that's where I'd be looking for sure for opportunities. Yeah, David, another part of Rocket that's set to benefit is not just the writing of the mortgages, but their servicing business, which is set to get a lot bigger with another acquisition that's in the pipe there too.

6:01So I think that's an interesting one. But I'll make the case for home builders, if you're targeted, looking at the ones that are really good originators. In other words, they're good about buying land in areas that it makes sense, they get a good price, and they're really good at building and pricing their products. Green Brick Homes, I think is a good example, ticker GRBK. It could benefit a lot. I don't think second half of this year. I think this is like a multiple year trend because lower rates should prove to be a boost. I think there is pinup demand, despite the lack of affordability for a lot of people.

6:33There's still plenty of people that make plenty of money that in the right geographies where there's economic opportunity are interested in green brick could benefit. I think REITs like realty income, ticker O, already has really good access to lower cost capital, it's an advantage against a lot of its competitors, is set to get a boost in a way we don't necessarily think about as an investor. They have a lot of debt already, and they're going to have to refinance that debt as it matures. Lower rates means that they're going to be able to refinance at a little more appealing rate than they would have gotten, say, a year ago.

7:07And that means less money having to go out the door to pay those finance costs and more that they get to retain to grow their dividend.

7:13David Meier:So Jason, with those two ideas, are you saying quality is not a function of the rate environment. Those are good, high quality businesses. That's the key, right? That's exactly it. Throwing ideas at the wall and chasing return is one thing. Focusing on quality still matters maybe even more in this environment because that's where you get the sustained benefits of this and not just a little bit of bump because you're chasing what you read on Wall Street bets. And you can even make the argument that interest rates in general are always going to be some element of cyclical, which is to say they will go up and they will go down over time in a typical cycle.

7:48And while it's hard to predict exactly what that looks like, the thesis for our company and an investment should be so much bigger than just what is the current interest rate regime or where do I see the interest rate regime going? It should be doing something that's likely to provide long-term value outside of the factors that they don't have control over, like interest rates. Yeah, that's exactly right. We'll circle back potentially to REITs and some other dividend paying investments at the end of the show, but up next, we're digging into how interest rates can impact financial stocks. Stick with us.

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9:29They're perhaps one of the most obvious industries that gets hit by interest rates. After all, when rates go up, interest income for these companies tend to rise. But at the same time, consumer credit costs rise and loan growth can stall. So for some of these companies that can turn into a double edged sword. Jason, do lower interest rates really benefit banks and other financial institutions given the possibility for those lower net interest margins? There's definitely a tension between interest rates and borrower demand. I think that's more important than anything else. Obviously, in the high end of the low end, higher rates don't matter if nobody can afford them.

10:03And rates that are too close to your capital costs. So for banks, what do you pay for depositors and interest bearing? And then you think about companies that borrow money, and then they lend money in some way, like you have to pay for it. There's a margin between it, right? So they just don't work if the math doesn't work. But small rate cuts, they can unlock some pent up demand for large purchases like homes and cars. And that new loan activity can be worth more than the risk of lower yields cutting your margins. I mean, think about it like this. If you can earn an extra$25 million in margin at a lower gross margin rate, you take the extra$25 million, right?

10:40So the dollars are what pays the bills. So I think that's the key. Your net interest income moving higher is what matter. The percentages matter on the margins, but if you can issue more loans at the lower rate, you take the larger amount of loans. Yeah, that's nicely said. It's more of a volume game as opposed to a pricing game for a lot of these companies. And even if it means that you end up getting a lower margin on the sales that you're making, if you're doing a larger volume of sales on a dollar basis, the bottom line still grows. Yes.

11:09David Meier:I will also say, in my experience, the rates that they charge for their loans may not fall as quickly as the rates that they get for the money they borrow. So you could, in a very, again, very short period of time, you could get a little incremental boost that way, because it might take some time for that signal to flow through the market that sets the rates for the consumer, for the buyer. Dave, I also want to talk to you a little bit about the fintech sector. You follow this industry, and I know that you see a lot of growth at a reasonable price opportunities with some potentially smaller cap companies in the space.

11:43But even big companies like PayPal, Block, and Affirm, they're all being impacted by higher rates. And management really likes to parrot that lower rates could reduce consumer borrowing costs. They could drive transactions higher. But again, in my experience, those lower rates tend to come at a time when the economy is showing weakening signs, which isn't typically great for consumer spending. And I think it'd be a headwind for some of these platforms. Where do you fall on that?

12:08David Meier:So typically you're right. When there is a slowdown in the economy, we see monetary policy move towards reducing rates. And the idea there is to try to prevent demand from falling too far. Demand is what drives GDP. That's what people think about when they buy things. So that's the idea, at least when the environment is poor. Lower rates, spur buying, let's keep the economy from shrinking too much. But there are obviously other factors at play, right? That control spendings, job security, consumer confidence, inflation. We could name a whole bunch more. What's interesting is today, I think the rate cut chatter is more about just trying to get the economy to grow faster.

12:53David Meier:And in the short term, that should be beneficial to much of the fintech sector via a bump in demand. What that means is more people wanting to buy stuff and having multiple options to pay for it. So, you named a few, right? I can use PayPal. If I want to do buy now, pay later, I could use Affirm, things like that. And so, it will be interesting to see how this all plays out. But I actually think in today's environment, a short-term cut is positive for that entire industry. Beautifully said. Up next, we're moving over to bond proxy stocks and how interest rates impact high-yield investments. We'll see you after the break.

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14:15These are companies that kind of act like a bond, some would argue, a lower risk, high yielding investment, things like utilities, telecom, and dividend players. Dave, in a high rate world, dividend stocks, they lose luster in some sense compared to treasuries, right? I mean, 3 % dividend yield sounds great until you're comparing it to a risk-free 5 % from the government. And then all of a sudden, And I'm not so interested in buying that company anymore. So we've actually seen a pretty substantial underperformance of dividend-paying stocks in recent years. How much of that is impacted by rate cuts?

14:47And do you think potential rate cuts could make these types of investments even more attractive?

14:52David Meier:So yeah, I think that's right. Actually, it's a little weird, but I think the rate cut could make them a little bit more attractive. So in a rate-cutting environment, the market tends to gravitate towards smaller companies and growthier ideas, right? So, what that could mean is that there is, quote-unquote, less demand for dividend payers. People just don't want them, right? There's something else that's going up. Let's chase that. But dividend payers really aren't really for outperforming the market, right? They're like bonds. They're more for protecting capital and getting a little cent back to you each year.

15:32David Meier:But for some, that actually might be more attractive than treasuries because those stocks could actually get a little bit of capital appreciation. So, you might get a little boost in all of this, right? You might get a little less yield, but you could get a little more capital appreciation. So, it's possible to outperform what they were doing before, but I think it's always difficult for dividend payers to outperform something like the S &P 500 index. It's a good thing that we don't have Matt and Ant here listening because they might have a bone to pick with it. But Jason, I mean, I know this is something that I've talked about with Matt and Ant previously on Motley Fool Money, which is that the number of dividend paying companies in the US markets has fallen substantially.

16:16And you can make the argument that this is a potential impact of rate changes and just dividends being less attractive to investors, or if there's just a broader changing appetite from investors for high-yielding investments. What are your thoughts? I think it's a combination of two things that are very interrelated. If you look at what's happened, really, it's really worth a couple of decades in. But in terms of the investor win, really coming out of the financial crisis, this explosive growth of technology companies, software as a service, along with low interest rates. And those things fed each other because the capital flowed into VC, which was funding because there was no return to be earned in bonds.

17:01Really, again, coming out of a great financial crisis. So, we talk about this within the context of the pandemic. We need to go back another decade to really tell the full story of this low interest rate environment. So, all this money flowed into VC and VC became very institutionalized. We're talking massive amounts of money that would normally have maybe been in bonds or other income investments that went to VC that stayed there for decades. This funded so many of these software companies that have made the corporate world more efficient and more profitable and have unlocked other growth opportunities for those businesses, which have allocated their capital towards those growth opportunities instead of returning money back to dividends.

17:46dividends. Share repurchases have continued to happen at very high levels. But the dividends, like you said, have really, really largely gone down. So, those two things created one another. We're in a weird place now, though, because you go back to end of 2021, then 2022, when interest rates really skyrocketed. What's happened since then? VC and private equity, they're having a lot more trouble raising capital than they did prior to that. Because you can get 5 % risk-free again, right? So you see how this kind of comes full circle. So I think that 20 teens like Cambrian explosion of software as a service, and now we have AI, guys, that's software, it's all kind of funding the same thing and driving this growth in extremely high levels of corporate profitability that we've never really seen before.

18:33And it's just changed the environment. The last thing I'll add to that is we have an entire, because of this, we have an entire generation of retail investors who made their money on stocks and saw bonds as this not worth it thing to invest in. So now we have hundreds of billions of dollars of capital, even for people that are retired, that made their money in stocks that are not interested in shifting to fixed income. So it's this kind of weird dichotomy that we're dealing with. But I think we started to see a little bit of a shift, but they're so interrelated, it's hard to really say it's one thing or the other.

19:12Speaking anecdotally, I think I'm part of that generation of investors. I'm 30 years old. And if I have dividend paying stocks in my portfolio, it's by sheer accidents, not through any sort of conscious capital allocation on my part. I've always looked down on companies that pay dividends in some sense, because in my mind, it's effectively like saying, I can't figure out a better place to put this money to work. So we're giving it back to you and you can figure it out. I want my management and my leadership team for companies to have ideas about where great places to invest are. That's why I gave them my money in the first place.

19:44Don't send it back to me. But clearly, maybe the interest rate regime will change my opinion on that no longer when I'm, you know, not looking at a 5 % risk-free, right? That's right. As we sign off here, let's do one last quick lightning round on other stocks or segments that really care about interest rates that we didn't get to today. I'll start and I'll say companies that hold client cash. And I think this is such a big risk for investors because it's unrelated to their core business. Using Tesla just as a quick example, they have a lot of these auto regulatory credits that come and generate basically tons of net profit for the company that's unrelated to the manufacturer, production, and sale of electric vehicles.

20:24There are software companies that effectively do the same thing, except for instead of dealing with regulatory credits, they're dealing that with client cash. And Airbnb is perhaps the most salient example. Lots of people pay upfront when they get an Airbnb. Airbnb holds on to that cash and they earn returns and net interest on the cash that they're holding for clients. And over the course of 2024, the interest income from client cash generated around 30 % of their total profits for the year. And that's unrelated to their core platform offering, right? And that's the sort of risk that I think some investors don't factor in when considering lower interest rates is that Airbnb, Paycom, other software services that receive cash up front, these are businesses that in part generate a fair portion of profits just off interest income.

21:11Airbnb has float. Who would have thought it? Who would have thought it? Dave, what about you?

21:16David Meier:Small caps. Smaller companies face lots of challenges on their way to trying to become bigger companies by growing their revenue and cash flow. Lower rates makes capital, which is just way more crucial to a smaller company than a larger company, a little less expensive. So what that can mean, perhaps they can fund a project or make an improvement to a product that helps them grow that they didn't think they could fund before. So all things being equal, I would definitely look within the small cap sector for opportunities when rates are falling. I'm going to invert this a little bit. I'm going to do my best Charlie Munger and say, What are industries that can be heavily affected by this in positive ways that don't necessarily become more investable?