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- [00:00]
A
Foreign we're breaking down the businesses that stand to benefit most when borrowing gets cheaper. Today on Motley Fool Money, I'm Emily Flippen, and today I'm joined by analysts Jason Ha and David Meyer to discuss the industries and businesses that are actually impacted by interest rates. After last week 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. Do you do you think that actually will come to fruition, especially given the other environmental impacts that we're seeing today?
- [01:05]
B
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. 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.
- [01:56]
C
One thing about homebuilders is 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.
- [02:10]
A
That's a good point, Jason, but I'll play devil's advocate here too, which is to say we still see affordability at all time lows. And 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 homebuilders sitting on the sideline waiting for interest rates to come down to build 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.
- [02:37]
C
That's exactly right.
- [02:38]
B
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 as in the negotiating table.
- [02:51]
A
I can understand why. Yeah. Jason, you've analyzed economic measures as part of your research process for years. I mean, housing accounts for nearly a of all the good 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 homebuilding. 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. So how should one think about that segment of the housing market within the context of rate changes?
- [03:25]
C
Yeah, 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 and in a bigger way than we realize, because the vast majority of commercial real estate is financed. So those rates are there. Walker and 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. So Walker Dunlop estimates there's about 400 billion in dry powder, so to speak, that's kind of 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, and 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.
- [04:59]
A
Fair point. But I have to ask, how does this all accrue to value for investors? Are there certain stocks or Industries, homebuilders, REITs? I mean there's so many different ways to play these trends.
- [05:08]
B
Yeah, I'll start. I have to wonder if Rocket companies Ticker R K T 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 it unfortunately the Rockets stock price is up pretty sharply off the April lows and perhaps some of that is in anticipation of rates falling. That that's been talked about for quite a while. But that's where I'd be looking for.
- [05:48]
C
Sure.
- [05:48]
B
For opportunities.
- [05:49]
C
Yeah. David, Another part of Rocket that sets a benefit is not just the writing of the mortgages, but the original but their servicing business which is set to get a lot bigger with another acquisition. That's, that's in the pipe there too. So I think that's, that's an interesting one. But I'll make the case for homebuilders if you're targeted, looking at the ones that are really good originators. In other words, so 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 pin up demand. Despite the lack of affordability for a lot of people. There'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. 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. And 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.
- [07:14]
B
So, Jason, with those two ideas, are you saying quality is not a function of the rate environment? Those are good, high quality businesses.
- [07:21]
C
That's the key, right? That's, that's exactly it. It's, it's, you know, 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.
- [07:39]
A
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. And 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.
- [08:06]
C
Yeah, that's exactly right.
- [08:07]
A
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.
- [08:18]
D
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- [08:49]
A
Financials. That's the segment of the market made up of companies like banks, insurance companies, even some fintech businesses. They'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.
- [09:17]
C
Interest margins, there's definitely a tension between interest rates and borrower demand that I think that's more important than anything else, obviously. And the high end and the low end, higher rates don't matter if nobody can afford them. And 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. So 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.
- [10:21]
A
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 low 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.
- [10:34]
C
Yes.
- [10:35]
B
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 it very, 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.
- [10:58]
A
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. But 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 could be a headwind for some of these platforms. Where do you fall in that?
- [11:34]
B
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 use Think about when they buy things. So that's the idea, at least when the environment is poor, lower rates spur buying. Let's, you know, keep the economy from shrinking too much. But there are obviously other factors at play, right, that control spending, 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. 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? Like I can use PayPal. I could, if I want to do buy now, pay later. I could use affirm, things like that. And so you know, it. 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.
- [12:54]
A
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.
- [13:03]
E
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- [13:33]
A
Now moving over to a segment of the market that many believe stands to benefit the most from rate cuts. Bond proxy stocks. These 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, you know, 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 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? And do you think potential rate cuts could make these types of investments even more attractive?
- [14:18]
B
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 the like bonds, they're more for protecting capital and getting a little sent back to you each year. And 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? Yeah, 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 it's think it's always difficult for dividend payers to outperform something like the S&P 500 index.
- [15:25]
A
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 Molly Fool Money which is that the number of dividend paying companies in the US markets has fallen substant. 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 like high yielding investments. What are your thoughts?
- [15:58]
C
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 like 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 kind of fed each other because the capital flowed into VC which was funding because there was no return to be earned in, in bonds really again coming out of the 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 dividend and dividends, you know, 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 kind of created one another. We're in a weird place now though because you go back to 20 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, than they did prior to that because you can get 5% risk free again. Right. So you see how this kind of comes full, 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 and extremely high levels of corporate profitability that we've never really seen before. And 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 that. But I think we started to see a little bit of a shift. But they're so interrelated, it's. It's hard to really say it's one thing or the other.
- [18:38]
A
Speaking 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. Don'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?
- [19:21]
C
That's right.
- [19:21]
A
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. There's 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 in 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 receive cash up front. These are businesses that in part generate a fair portion of profits just off interest income.
- [20:37]
C
Airbnb has float. Who would have thought it?
- [20:39]
A
Who would have thought it? Dave, what about you?
- [20:42]
B
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, all things being equal, I would definitely look within the small cap sector for opportunities when, when, when rates are falling.
- [21:19]
C
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? So I'll go from Munger to Peter lynch here who once wrote, roughly even a great company in a mediocre industry is still a mediocre company in recent decades. Besides Tesla, find me a massively market beating successful investment in the automaker space. You really can't they're very rare. It's a brutal price taker industry, very low margins capital, insensitive end user demand that's very cyclical. And even Tesla, the one success hasn't really been a great investment in recent years and what success it has had has been tied to the story things future bets around AI, autonomy and robotics, not the EV business. Let's be honest, it's kind of struggling right now. So I think any investments, any benefit investors see from falling rates in that industry, let me paraphrase Jerome Powell and say it's probably going to be transitory.
- [22:19]
A
I love that. Note to end on. I mean I think that summarizes the takeaway from today's show, which is that yeah, it's true, lower interest rates can lift a lot of boats, but for some, some certain stocks or some certain segments that actually can make or break the investment and for other businesses, maybe automakers in this case, where it can drive demand, it doesn't actually change the long term thesis for a lot of investments.
- [22:42]
C
That's right.
- [22:43]
A
Jason, Dave, thank you both so much for joining. As always, people on the program may have interest in the stocks they talk about in the Motley fool may have formal recommendations for Oregon so don't buy yourself stocks based solely on what you hear year all personal finance content follows Motley fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes For Jason Hall, Dave Meyer and the entire Motley fool money team, I'm Emily Flippin. We'll see you tomorrow.