Relief for Beaten-Down Investments

Income Investing

Relief for Beaten-Down Investments

The Federal Reserve's surprise rate cut breathed life back into REITS and business development companies. Regional banks should benefit, too.

Who'd a thunk it? The Federal Reserve Board slashes interest rates three-quarters of a percentage point in an extraordinary rush, if not a panic, while U.S. banks and securities markets are closed for the Martin Luther King holiday. (The Fed trimmed the cost of borrowing another half-point on January 30).

Usually this drastic action would add to the fear that all income investments other than government debt are perilous. Instead, the Fed's surprise rate cut has rescued some slumping high-income investments.

Start with real estate investment trusts, which rallied dramatically since the Fed's January 22 rate cut.

The four largest REITs as measured by total stock market value -- Simon (symbol SPG), ProLogis (PLD), Vornado (VNO) and Public Storage (PSA) -- are all in different REIT segments, yet each stock is up more than 10% since the Fed's intervention. This isn't a random catch-up. Even health-care oriented REITs, the best REIT group during last year's sweeping real-estate stock downturn, have enjoyed strong gains since the news of the Fed's easing.


One reason so many REITs are reacting so favorably is that their bosses saw the recent commercial real-estate boom as an opportunity to borrow and become developers -- not just investors and property managers. This added to the REIT boom but magnified last year's slump. Lower interest rates are helping the most-leveraged REITS improve their cash flow and prospects for delivering stable or growing dividends.

For example, Duke Realty is a credit story as much as an economic one. This office and industrial warehouse REIT doubled its debt load from 2005 to 2007 to buy land for some large-scale projects. Duke's land is prime, but as the economic and credit news got worse, the stock plunged from $47 in February 2007 to $21 in January 2008, much harder than the average REIT loss in 2007.

Duke hasn't cut dividends -- now $1.92 a year for a 7.6% yield -- even though cash from operations hasn't covered the dividend bill since 2005. But with lower debt costs -- some of Duke's debt is tied to LIBOR, a global benchmark short-term rate that also is falling in 2008 -- pressure on the stock and the dividend eases. Its shares (DRE) are up 17% since January 22, to $25. It still looks cheap. You find similar stories all over REITland.

Business development companies, which I've often written about because of their diversified investment holdings and history of high dividends, are another beaten-down stock group that stands to get relief from credit easing. Shares of BDCs, which include American Capital Strategies (ACAS), Allied Capital (ALD), MCG Capital (MCGC) and TICC Capital (TICC), all tumbled in 2007 and fell some more at the start of 2008 until the aforementioned Fed meeting.


Since then, all are up more than 10% yet are still priced to yield from 11% to 15% on their current dividend rates. (BDCs, like REITs, are required to distribute almost all of their net income as dividends).

Some of this recovery rests on the hope that easier credit will recharge the economy and cause fewer BDC customers to fall behind on their loans. But BDC share prices also benefit because their own lower borrowing costs go directly into earnings and dividends.

Allied, American Capital and MCG Capital each have revolving credit lines tied to LIBOR or to the federal funds rate (the actual rate the Federal Reserve controls and is cutting), so they should save substantial interest bills. When the economy expanded between 2003 and 2007, BDCs benefited from a wide spread between their own borrowing costs and the rates on their loans. This spread tends to get wider when short-term rates fall outside of a recession.

Other investments benefit from falling short-term rates. Most banks' profits are driven by the spread between the rates they pay on savings, CDs and other deposits (which go down as short-term rates do) and the rates they charge on loans, which depend not only on the Federal Reserve but also on how many borrowers fall behind. That, in turn, varies with the economy.


Banks should do poorly when the economy is ailing. But when the worst is over -- you'll be able to sense this by checking indicators like the percentage of loans that are in arrears (this is reported every quarter) -- it's generally time to buy the local and regional banks that are unscathed by the subprime mortgage mess.

You don't have to buy these stocks right as the Fed eases rates. BB&T (BBT) did gain 19% in the five days after the three-quarter-point cut and U.S. Bancorp (USB) rose 11%. But you'll get even more growth from these banks to go with their reliably high dividends if the economy avoids a recession.

REITs, business lenders and regional banks aren't exciting, but eight or nine years out of ten, you'll want to own their shares. We just had one of the exceptions in 2007. I think you catch my drift.