The irrational disconnect between the earnings performance of real estate investment trusts (REITs) and their share prices is occurring once again. As I have pointed out in past columns, many investors believed that the recovery of the general stock market could cause investors who had fled from traditional stocks to REITs — thereby driving up REIT share prices — to pull back, causing the REITs' share prices to plunge. The threat of an interest rate hike only exacerbated this possibility because low rates had increased the profitability of financing real estate with leverage.

This phenomenon has occurred dramatically since April 1. In just over a month, the National Association of Real Estate Investment Trusts (NAREIT) Composite Equity Index fell 14.4% from a high of 5,505 on April 1 to 4,712 on May 6. It may fall even further.

However, the index's percentage loss of 3.3% since Jan. 1 was very similar to the percentage declines of three other major stock indices in the same period, when the Dow Jones Industrial declined 3.2%, the Nasdaq Composite fell 4.26% and S&P 500 dropped 1.2%.

At the same time, market conditions underlying REIT performance have begun to improve — especially in the retail sector. Retail sales have been rising, and retail firms have expanded their operations. Yet retail REIT shares have fallen just as sharply as other types of REIT shares, though market conditions underlying most other types have not improved as much as those in retail.

Heightened Fears of Inflation

But the real irony is that overall real estate market conditions are improving along with the economy, and are likely to recover even further in the near future. Office and industrial vacancies have stabilized in many areas, as have rents. Demand seems to be rising slowly. So why have REIT shares plunged since April 1?

The most obvious cause is the expectation that interest rates will begin to rise very soon. Large employment increases in both March and April have fueled the belief that the economic recovery is finally under way. Also, the rapid growth of the Chinese economy is absorbing enough resources to stimulate prices in world commodity markets, raising fears that inflation may reappear. That would cause the Federal Reserve to raise interest rates significantly by the end of this year, or certainly after the presidential election.

Very low interest rates have benefited the profitability of almost all real estate transactions. Moreover, many experts believe speculators have been borrowing money at very low rates and buying REIT shares to get their relatively high dividends. Such “spread” or “carry” investing would be threatened by higher borrowing rates.

Finally, since early 2000 investors avoiding non-real estate stocks have diversified by pouring funds into REIT shares, increasing their prices sharply. Even after its recent decline, the NAREIT equity index on May 6 was 105% above its level on Jan. 1, 2000. In the same period, the Dow Jones Industrial index fell 11%, the S&P 500 index dropped 24.5% and the Nasdaq Composite index plunged 45.4%.

The prospects of rising interest rates and the recovery of the rest of the stock market seem to be causing institutional investors — the principal owners of REIT shares — to back away from REIT stocks. A similar phenomenon occurred between 1996 and 1999, when conditions in real property markets were actually very favorable to REITs, and their operating profits were strong.

But the tantalizing prospect of gaining huge profits from Internet and other high-tech stocks lured institutional money away from real estate. That led to the speculative excesses of 1999 and the crash of 2000 through 2002. That experience proved that many institutional investors behave with herd-like instincts and follow fads to irrational extremes.

A Favorable Climate for REITs

I do not think the costly experience of the late 1990s will be repeated this time for several reasons. First, much uncertainty remains over the strength of this general economic recovery, especially considering the problems the U.S. is encountering in Iraq and the large federal deficits looming ahead. Hence, prospects for a real stock market boom are not terribly convincing — at least not yet.

Second, there is no single technical innovation that promises super profits, as the Internet did in the late 1990s. Third, REIT dividends are still attractive for both pension funds and individual investors, especially those reaching retirement age.

Finally, even the most lemming-minded institutional investors remember how badly they got burned in the crash of 2000-2002, so they will not abandon their diversification into real estate. So even if REIT shares decline further, I do not believe they will collapse in value.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.