The Federal Reserve gave borrowers some good news last month. Not only did it elect to keep interest rates steady, but it also indicated cuts to the all-important federal funds rate. The median estimate calls for three rate cuts by the end of 2024.
The federal funds rate is the rate at which banks lend each other money, and it's the biggest determinant of rates for just about every type of loan from a government bond to a home mortgage. The Federal Reserve is in charge of setting that rate, and by extension the cost to borrow for everyone from the government to consumers to businesses.
While the Fed forecasts just three interest rate cuts, Wall Street is more optimistic. The average futures trader expects six rate cuts by the end of the year, bringing the top end of the Fed funds target rate from 5.5% to just 4%.
Many businesses have been hit hard by high interest rates. But a few could see tremendous relief from lower costs to borrow that could fuel their earnings and, by extension, their stock prices much higher. Here are three stocks to buy today, before the Fed cuts interest rates.
Image source: Getty Images.
1. Realty Income
Real estate investment trusts (REITs) were hit particularly hard by rising interest rates.
A couple of factors punished shares of REITs. First, and most obvious, higher interest rates increase the cost of borrowing, which is essential for most REITs. A higher interest expense on the books means lower funds from operation, which means less cash to pass on to shareholders.
But the bigger impact of the increased interest rates is that investors now discount the future cash flows of a REIT at a much higher rate.
The REITs most affected by changes in interest rates are those with steady cash flow from long-term leases. Realty Income (O -0.17%) is the poster child for steadily growing free cash flow with its portfolio of retail storefronts concentrated in defensive sectors. As a triple-net lease operator, it's not responsible for rising taxes, insurance, or maintenance on its properties (the tenants are), which makes it far less risky than other REITs. But with such predictable free cash flow, it was also easiest to discount amid rising interest rates.
While shares of Realty Income already got a boost after the last Federal Open Market Committee meeting in December indicated forthcoming rate cuts, it could still move higher based on Wall Street's expectations for even more rate cuts than indicated by the Fed. Shares still trade for less than 15 times management's expectations for 2023 adjusted funds from operations. That's a better-than-fair price to pay for the REIT.
2. Zillow Group
If you've been trying to buy a house recently, you're probably familiar with Zillow Group (Z 1.68%) (ZG 1.70%). The online real estate listing company is the leading destination for home searchers. You'll also probably know there aren't many houses for sale.
Management noted new listing volumes are as low as they've ever been since 2010. There's a clear reason for that. Many homeowners have locked in record-low mortgage rates in 2020 and 2021. Meanwhile, new buyers have seen their buying power diminish as a result of higher mortgage rates, further reducing the number of available buyers.
Zillow generates its revenue from rental listings, mortgage origination, and home sale listing tools for agents. While the rental market has helped prop up its results in 2023, the challenging environment for new home sales has led to overall revenue declines for Zillow. But as interest rates decline, more homeowners are willing to move, and more people are able to afford new homes, Zillow should see strong growth.
Management expects rate cuts to provide a massive boon to its top line. Its long-term forecast in early 2022 called for $5 billion in annual revenue with a 45% earnings before interest, taxes, depreciation, and amortization (EBITDA) margin by the end of 2025. That would be phenomenal growth considering its 2023 outlook calls for $1.9 billion. Still, even half that growth, fueled by an expanding portfolio of services and a little help from the Federal Reserve, could make the stock a buy. Analysts currently expect just 9.4% sales growth for 2024, so a resurgence in the housing market could enable strong outperformance for Zillow.
3. NextEra Energy Partners
NextEra Energy Partners (NEP -0.89%) got hit hard by the rise in interest rates. The company relied on convertible equity portfolio financing (CEPF) to buy assets from its parent company, NextEra Energy (NEE -1.36%), as well as from third-party sellers. Those notes are convertible to shares based on the price of NextEra Energy Partners' shares.
When interest rates rose, NextEra Energy Partners' financing costs increased too. That put pressure on its stock price as a result, which became a double whammy for the company, as it now has to provide more shares to convert its maturing CEPFs. It was forced to find new funding, and it did so in the sale of some of its assets. It recently agreed to sell its STX Midstream business to Kinder Morgan for $1.8 billion, and it'll use a portion of the proceeds to pay off its debt.
Another challenge of the increased interest rates was that NextEra Energy Partners is now unable to acquire as many assets to fuel its growth. It's instead focusing on organic growth, such as repowering existing wind farms. However, that will result in significantly slower growth than it was experiencing before the shift in strategy. As a result, management cut its dividend growth outlook in half, which sent the share price down further (putting further pressure on management to extinguish the CEPFs).
However, a turnaround in interest rates could alleviate a lot of the pressure on NextEra Energy Partners. With $1.35 billion in debt maturing this year and an additional $700 million coming due next year, lower interest rates will enable it to refinance without as big a hit to its interest expense. With the shares yielding 11.4% on its dividend with management's target to keep growing the dividend at a 6% rate, it's worth buying shares of the high-yield MLP.
