After Fed Chair Jerome Powell’s speech at the Jackson Hole symposium last month, odds of a rate cut at the upcoming Federal Open Market Committee (FOMC) meeting have risen. The question markets are now asking is not whether the Fed will cut rates, but by how much.
While most believe that the Fed will start its loosening cycle with a 25-basis point cut, the clamor for a 50-basis point rate cut has also risen from many quarters. Fed rate cuts are generally positive for stocks – even as a 25-basis point cut for September now seems baked into stock prices.
Dividend stocks could also see traction if the Fed’s rate cut cycle turns out to be as aggressive as its tightening.
REITs Could Be a Good Bet Amid Fed Rate Cuts
The real estate sector, which bore the brunt of multi-year high interest rates, could be among the biggest beneficiaries of the Fed’s rate cuts. Real estate investment trusts (REITs) offer prospects of good dividend yields and capital appreciation as the Fed works towards normalizing interest rates.
Lower interest rates are positive for REITs in more than one way. These include:
- Lower refinancing costs: Rate cuts will lead to lower refinancing costs for REITs, which leads to lower interest expenses - and by extension improves their margins and cash flows.
- Higher property prices: In theory, lower interest rates are positive for property prices, as they spur demand for real estate.
- Better valuations: As lower interest rates diminish the appeal of other fixed-income instruments, REITs – especially those with high dividend yields – could regain some popularity with investors, thereby leading to higher valuation multiples.
But the relationship between interest rates and REITs is not always straightforward, and contrary to the above points, REITs have occasionally outperformed during periods of rising interest rates.
While research is inconclusive on the correlation between the two, arguably REITs have outperformed during previous high-rate regimes due to the accompanying strong economy. Also, inflation is often high during periods of rising interest rates, which usually implies high rental yields and thereby better earnings for REITs. On the other hand, when the Fed cuts rates, the economy is generally sloping downwards - as it is now - which negatively impacts rental yields, as well as occupancy levels.
To sum it up, the causal relationship seems to be more between REITs and the broader economy, rather than REITs and interest rates – which are ultimately the Fed’s reaction to the macroeconomy. In a nutshell, high-yielding REITs can be a good proposition if a recession or a severe downturn does not accompany the rate cuts.
Looking at the current scenario, while the U.S. economy is certainly slowing down, a recession does not look like a likely possibility, and the Fed’s rate cuts should help to spur growth in the world’s largest economy. Given that argument, REITs could be a good proposition, and in that space, I find Kilroy Realty Corp. (KRC) to be a good bet.
Kilroy Reality’s Dividend Yield Is Over 6%
Kilroy Reality is an office REIT with a dividend yield of over 6%. It has 121 office properties and 1,001 residential units. At the end of June, its stabilized portfolio was 85.4% leased, which is arguably on the lower side.
Kilroy’s business was negatively impacted when many enterprises – and especially tech companies, which are a major client set for Kilroy, along with life sciences companies - let their employees work from home, which led to lower demand for office space. While many thought that the “work from home” mandate was here to stay for good, many companies (including some of Kilroy’s clients) have since mandated that employees start working from offices.
This would suggest that the slowdown that Kilroy witnessed over the last few years should subside. During Kilroy’s Q2 earnings call, CEO Angela Aman said, “While this recovery will, at times be uneven, we are seeing encouraging signs in all of our markets that reinforce our conviction that the trend line is moving in the right direction.”
That said, the back half of the year looks a bit challenging for Kilroy, as it anticipates three large moveouts from Salesforce (CRM), Microsoft (MSFT), and Capital One (COF), impacting 350,000 square feet. However, it expects 2025 to be a relatively stable year, with no individual lease expirations above 100,000 square feet. The Fed's rate cuts should also have a positive impact on the U.S. economy, and leasing activity should pick up in 2025, leading to better business prospects for Kilroy.
KRC Stock Looks Cheap Here
KRC stock is down over 13% in 2024, and has been a long-term underperformer, losing 41% of its value over the last 10 years.
However, amid the dismal price action, the stock’s valuations look quite cheap. During their Q2 earnings call, Kilroy gave a 2024 fund flow from operations (FFO) guidance of between $4.21-$4.31 per share. At the midpoint of the guidance ($4.26), we get a price-to-FFO of 8.1x, which looks quite attractive. Kilroy's price-to-book multiple of 0.73x also signals undervaluation.
Importantly, the company’s dividend looks quite safe, as the annual payout of $2.16 is just over half of the expected FFO this year. Wall Street analysts have rated KRC stock as a “Moderate Buy,” and its mean target price of $39.14 is 14.1% higher than current prices.
Overall, given its tepid valuations, high dividend yield, and the expected recovery in the underlying business, I find KRC stock to be a good buy – especially for investors craving fat dividend yields.
On the date of publication, Mohit Oberoi had a position in: MSFT . All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
