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Contained in a generally positive year-to-date report from NAREIT earlier this month was the cloud behind the silver lining: although the FTSE NAREIT ALL REITs Index was up 13.08% on a total return basis for the first three quarters of the year, it declined 2.63% for Q3. That compared to a 1.13% quarterly increase for the S&P 500 Total Return Index, marking the REIT sector's worst quarterly performance in a year.

The Wall Street Journal offered an explanation for the poor showing. “Over the past month, REITs have taken a dive as interest rates have ticked up in anticipation of the Federal Reserve ending its bond-buying program, known as quantitative easing, in October,” the WSJ reported earlier this month. “Higher interest rates can dent demand for REITs because they provide investors with more alternatives to the yields they can collect from real estate.”

A rap that's often brought against the sector in times of impending interest rate increases is that it's vulnerable to such increases. That's not only because some investors liken REIT stocks to fixed-income vehicles such as bonds and sell them off when rates rise, but it's also due to the increasing cost of debt when those rates go up. In a recent report from Morningstar in Chicago, analyst Todd Lukasik writes, “We generally expect REIT prices to move inversely with changes in long-term government bond yields, and we would expect REITs to generally underperform in a rising interest-rate environment.”

Such rate-driven price sensitivity is a legitimate concern and therefore it's an understandable perception that REIT stocks are vulnerable, NAREIT's Calvin Schnure tells Real Estate Forum. However, the reality may be more nuanced.

“The market's worried because when something's based on future cash flows—whether they're dividend payments or coupons—it reduces the current value when you have a higher discount rate,” says Schnure, vice president of research and industry information at NAREIT in Washington, DC. Yet in the case of REITs, “we're in an environment where the future payments are rising an awful lot.”

In fact, a report from SNL Financial makes it clear that the quarterly decline in REIT performance reported for Q3 can be attributed largely to the sector's performance in the last few weeks of Q3, and not a three-month slump. Year-to-date through August 25, according to Charlottesville, VA-based SNL, the premium-to-NAV estimate for US equity REITs rose 10.3 percentage points. While at the end of 2013, the sector had a weighted average 6.1% discount to NAV, this had improved to a 4.2% premium to NAV by late August. Additionally, SNL reported, “All REIT sectors exhibited positive weighted average YTD increases in stock prices, resulting in a 17.5% overall price appreciation, and 10 of the 12 sectors had increased NAV estimates, resulting in an aggregate 5.6% increase in NAV estimates since Dec. 31, 2013.

Schnure cites the 36% increase in REIT dividend payments over the past four quarters, along with an economy that is “finally in a solid recovery phase.” He recalls that two years ago, employment gains averaging 170,000 jobs per month were seen as the new normal, yet stronger growth in 2014 is creating more demand for office buildings and apartments. “That's giving REITs the income they need to support the values,” he says.

At Newport Beach, CA-based Green Street Advisors, which provides research on the REIT sector, VP Jim Sullivan acknowledges that rising interests are “a headwind for any capital-intensive industry such as commercial real estate. But it's important to ask the question 'Why are interest rates rising?' If the answer is that rates are rising as the result of a robust economic recovery, then the negative impact of rising rates will be largely mitigated by rising rents and occupancies for landlords whose buildings are full and whose tenants are thriving.”

Schnure notes that in the minutes from the September meeting of the Federal Reserve Board's Federal Open Market Committee, “they talk about normalizing monetary policy. They don't talk about tightening monetary policy, but about getting back to a more normal level that will allow the economy to continue to grow.” That's distinct from the Fed tightening policy to cool an overheating economy, “which would hurt most stocks,” including those of REITs.

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He sees another indicator in the Treasury yield curve, for which the current expectation is that short-term rates will rise considerably over the next couple of years, long-term rates less so. “If you look at the implied forwards on the yield curve, the five-year forward is up 150 basis points and the 10-year is up only 75,” says Schnure. “So the expectation is that it will rise in the short rates and not in the long rates. And it's in the long rates where REITs get their funding.”

Combine that with the dominance that the Fed's quantitative easing program has exerted upon the Treasuries market over the past few years—a dominance that's coming to an end along with the program. “A lot of the increase in Treasury rates is just going to be accompanied by some narrowing of credit spreads, which really won't have a whole of impact on REITs' financing costs,” Schnure says.

When considering the effects of an increase in interest rates, it's important to remember where they are now: at historic lows. “Even if they go up by 50 bps, you can still do good business at these rates,” Schnure says. Given the kinds of rents that REITs are currently enjoying, “They can easily absorb a couple dozen basis points in higher debt financing costs. Their balance sheets are pretty well protected.”

Along with increasing their asking rents, REITs have plenty of other options for increasing profitability. Writing on the website Seeking Alpha, investor manager Mike Serebrennik notes that among other actions, REITs can repurpose existing properties to grow rents. “For example, an office can be repurposed into a restaurant,” he writes.

There's also the option of developing and redeveloping existing land. “Some REITs have unused or underused land as part of their holdings,” Serebrennik explains. “These REITs can build on vacant land or expand buildings as needed. This works better if the owned land is much more expensive than buildings or construction. Then, the added expense of development may be feasible with just (or mostly) the retained earnings.”

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Recycling capital, via selling non-core or underperforming properties to finance other projects, is another avenue for REITs. “Strong real estate markets that tend to accompany strong economies should make this easier,” writes Serebrennik.

For REITs with a strong European presence, this could be an opportune time to boost profits by focusing outside the US. Serebrennik notes that's especially true since the European Central Bank “seems interested in its own quantitative easing program, which should result in attractive borrowing costs.”

Still more possibilities exist in the form of managing other companies' real estate assets, and thereby collecting management fees, and returning capital to investors. “While only up to 10% of earnings will be available for share buybacks, these buybacks can be executed at attractive prices,” Serebrennik writes. “Also, if the cost of debt happens to be lower than the cost of equity, debt-financed buybacks may become an attractive option. This applies especially to underleveraged REITs.”

A white paper published this past spring by Altegris Advisors, based in La Jolla, CA, asked and answered the question of how much correlation there really is between rising interest rates and REIT share prices. Based on the historical record, there's less of a correlation than you might think.

The white paper looked at seven periods of rising interest rates between 1972 and 2007, taking into account the differences in the REIT sector of 30 or 40 years ago compared to the modern era. “Many of the REITs that existed in the 1980s and the early '90s were very much passive,” Burland East tells Forum. East is CEO of American Assets Capital Advisers LLC, which serves as the sub-adviser portfolio manager to the Altegris/AACA Real Estate Long Short Fund. “Somebody owned 10 shopping centers, and put them into a public vehicle.”

In those days of a smaller, less cohesive and less active REIT sector, rising interest rates appeared to have at least a 50/50 chance of hurting the companies' stock prices. Between 1972 and 1974, the federal funds rate rose from 3.3% to 12.9%, while REITs lost 39% of their value. “This, of course, corresponds to the 1974 bear market, which up until now, was the worst downturn since the Depression,” according to the Altegris white paper. However, between 1977 and 1981, during the era of the so-called Volcker Squeeze, the Fed funds rate increased from 4.6% to 19.1%, while REIT share prices surged ahead by 110%.

Fast-forward two years to 1983, and the Fed funds rate saw another increase from 8.5% to 11.6% over a 12-month period, while REITs gained 23%. Then between 1986 and 1989, the fed funds rate rose from 5.9% to 9.9%, while REITs lost 3.3%.

“The modern REIT era began in 1993 when the Umbrella Partnership (UPREIT) was codified, allowing large real estate companies with low-basis assets to access the public market in a tax-efficient fashion,” according to the white paper. “This unleashed the market we now see, with larger, vertically integrated, professionally managed real estate operating companies. These companies have more sophisticated capital raising and allocation models, and are typically more adaptable to changes in credit conditions.”

In fact, most of the publicly traded REITs around today did not exist before 1993. This era saw three distinct periods of rising Fed funds rates: between 1993 and 1995, in which the rate rose from 2.9% to 6.1%; between 1999 and 2000, when it rose from 4.9% to 6.5%, and between 2004 and 2007, when the rate rose from 1% to 5.3%. In all three periods, REITs experienced positive returns, most dramatically in the 2004 to 2007 era, which saw share prices increase 99% in three years.

“If you're actively running a company, when market conditions change you can adapt, modify your business plan and steer the ship in the right direction,” East explains. Modern, active companies have access to secured and unsecured debt as well as equity, and are able to add value to their properties by improving them. “That tends to completely offset the increase in interest rates.”

Altegris conducted its study, which did not examine REIT performance in periods of stable or declining interest rates, based on what occurred historically rather than on projections of future REIT performance. “Because nobody really knows what interest rates are going to do,” says East.

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These effects of interest rates on REIT performance don't just vary by period; individual REITs appear to be more or less affected. “At Green Street, we've gone back and looked at several points in time when interest rates rose abruptly, and there is no consistent pattern,” Sullivan tells Forum.

In theory, he says, “You would expect that REITs with more bond-like cash flow characteristics would get hit the hardest. These would include triple-net lease REITs, mall REITs and CBD office owners. And you'd expect short-lived leased property types such as hotels and apartments to fare better.” In practice, he says, “those patterns have played out in some instances when rates rose quickly, but did not every time. Why not? It goes back to 'why are rates rising?'”

Sullivan acknowledges that as interest rates begin to creep upward, there's a possibility that investors' anticipation of negative effects on REIT metrics will cause them to look elsewhere to place their money—including investment vehicles other than commercial real estate. “Investors are always looking for the best risk-adjusted returns,” he says. “Rising interest rates cause prices to reset across the capital markets. It would only be natural for REIT investors, particularly those who were attracted to REITs by their dividend yields, to take a look around at alternatives.” However, he points out that an investment's total return, and not just its current return, is where investors should focus.

And even if the interest rate horizon suggests the possibility of squalls ahead, Sullivan doesn't think REIT executives should be watching the skies. “One of the last things REIT management teams should be doing is forecasting interest rates,” he says. “Instead, they should focus on things in their control, including the operations of their existing properties, the prices they pay to acquire new properties, the decision to develop or not and the structure of their balance sheet. If I had a dollar for every REIT CEO and CFO who told me 'rates can't go lower' when the 10-year Treasury was at 4%, then 3.5%, then 3%, then 2.5%, I'd have quite a large pile of dollar bills.”