Interest rates have an outsize impact on the real estate sector. Companies and individuals typically borrow money to fund a significant portion of any real estate investment. As rates rise, they make borrowing money to fund new deals more expensive, and higher rates typically weigh on real estate values.
However, after keeping rates high in recent years to combat inflation, the Federal Reserve has started cutting the Federal Funds Rate. It currently expects to continue reducing rates in the coming months. While that should positively impact the entire real estate sector, some stocks could see an even bigger benefit from falling rates. One of them is EPR Properties (NYSE: EPR). Here's why the real estate investment trust (REIT) could be a winner if the Fed keeps cutting rates.
Battling headwinds in recent years
EPR Properties is a specialty REIT focused on owning experiential real estate, such as movie theaters, eat-and-play venues, and other attractions. That strategy had paid big dividends over the years. The REIT has delivered a more than 1,600% lifetime total return to its shareholders since it came public in 1997 by growing its portfolio, cash flow, and dividend payment.
However, the company has faced some headwinds in recent years that have impacted its ability to grow shareholder value. First, the pandemic had a meaningful impact on its tenants, most of which had to shut down their operations temporarily. That affected their ability to pay rent. As a result, the REIT had to suspend its dividend for a period before bringing it back at a lower level.
The pandemic had a lingering impact on its theater tenants. The parent company of one of its largest tenants filed for bankruptcy in 2022. The REIT was able to renegotiate its lease to cover 41 of the 57 theater properties it had leased to this tenant, which should recover about 96% of the pre-bankruptcy rent this year.
On top of all that, higher interest rates have increased the company's cost of capital. Its share price currently sits more than 35% below its pre-pandemic peak, which is why it offers such a high dividend yield of 7.5%, even though its dividend is much lower than before the pandemic. Given that high yield and higher borrowing costs, it's difficult for the REIT to make accretive acquisitions funded by issuing additional equity.
From a headwind to a tailwind
EPR Properties' higher cost of capital has limited its ability to grow in recent years to a level it can fund with internally generated free cash flow after paying dividends, capital recycling proceeds, and borrowings on its credit facility. For example, EPR Properties funded $269.4 million of new investments last year and is on pace to invest $225 million to $275 million this year. This investment rate is enough to deliver 3% to 4% annual growth in its funds from operations (FFO) per share. This pace also supports dividend growth in a similar range.
Given its cost of capital constraints, the REIT plans to continue limiting its growth in the near term to investments it can fund with internally generated cash and borrowings on its credit facility, which currently has only $169 million outstanding on the $1 billion facility. It's very disciplined right now, primarily focusing on high-return development and redevelopment projects.
However, falling interest rates should help reduce its cost of capital. Lower rates would decrease its borrowing costs and should lift its stock price. That should make it easier for the company to fund additional accretive deals in the future. For example, in 2019, the REIT invested $794.7 million into new property investments. Meanwhile, it initially expected to spend $1.6 billion to $1.8 billion in 2020 on new investments, including an anticipated $1 billion gaming venue acquisition it had secured, funded partly by $882 million in non-core asset sales, primarily educational properties, in 2019. Those deals would have enabled the REIT to continue growing its dividend, which was at a much higher level than it is today following its post-pandemic reset.
Strong total return potential
EPR Properties currently offers an appealing total return potential despite its cost of capital headwinds. With a dividend yield above 7.5% and its cash flow and payout growing by 3% to 4% per year, the REIT should generate double-digit total returns from here. That assumes its stock price only rises in line with its earnings growth rate.
However, it could be an even bigger winner with additional rate cuts. They would help lower its cost of capital by reducing borrowing costs. Its stock price should also rise as real estate values increase. That catalyst would also enable the REIT to ramp up its investment volume and grow its FFO and dividend even faster in the future, further enhancing its total return potential.
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Matt DiLallo has positions in EPR Properties. The Motley Fool recommends EPR Properties. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
