By Richard Wollack

It happened yet again after Mr. Greenspan's November rate hikes (due to his inflation precaution … or is that paranoia?). Namely, REIT shares dropped for two or three days, despite many earnings reports that showed REITs beating the Street's expectations. Why? Simply, the "Chicken Little" expert commentators who cluck about how the sky is falling on interest rate sensitive stocks creating a panic among investors. Thus, when the interest rate wolf (read, The Fed) comes growling, just like the three little pigs, they run from their homes (or commercial property in this case) by selling their REIT shares.

Fairy Tales Don't Correlate With Reality

Well, those experts and investors ought to read the data before they cluck any more. Folks, let's get this right once and for all—REITs are NOT interest rate sensitive stocks. You see, the correlation between REITs and interest rates is not like that of bonds—which move in direct lockstep with changing rates. In fact, the correlation of REITs to interest rates has actually been non-existent, negative in fact (-.74), for the last five years and no correlation for the prior five years.

The key point to take out of these data is that a two or three-day reaction to interest rates, like we have seen with recent Fed rate increases, is solely due to the irrationality of investors who believe in fairy tales. Yet, when you look at the data on REIT interest rate correlation the conclusion is quite simple … not all high dividend stocks are interest rate sensitive.

So, if REITs aren't like bonds, why don't they act like other high paying dividend stocks that are interest rate sensitive? Well, unlike slow growth, high-dividend companies (like utilities) that pay dividends to support their stock prices and enable them to continue to finance their ability to raise capital, REIT dividend policies owe to a legislative requirement. REITs have high dividends because they must pay out annually at least 90 percent of their taxable income. Thus, they are dividend payers for a technical reason, not because they are mimicking bond-like companies. The interest rate correlation is not significant because REITs are unique equities that actually may benefit from high interest rates.

How High Interest Rates Help REITs

How can that be, you say? How do high interest rates help REITs, and why are REIT returns uncorrelated with bond returns or changes in interest rates? The answer is counter-intuitive to many (particularly those panic sellers), but clear when you first ask this question: What else is usually happening with the economy when interest rates are increasing or high? Here's the answer: history shows that some combination of three major forces are also at work, varying in their individual and cumulative impact depending on the exact point in time in any particular economic cycle. Those forces—and the cause and effect on REITs—are:

Strong Growth: Cause: Interest rates typically rise because the economy is growing and companies are seeking more debt to expand (and often the Fed is trying to slow the economy's growth so it does not get overheated).

Effect: If companies are growing, that means they need to hire more people; who fill up office space and produce more goods that need warehouse space. Then the now-employed people can rent apartments and travel, both for business and personal reasons, consequently filling hotel rooms. And, of course, with more people earning more money, it's off to the malls, which helps retailers ring up sales. In turn, retailers begin to pay higher percentage rents and decide to add store locations. And just who benefits from increased occupancy and higher rents? Score one for REITs.