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Introduction

The strong relative performance of REITs in the first quarter of 1994 came as a

surprise to many yield-oriented investors who had assumed that REIT prices would move

in lockstep with bond prices as interest rates rose. Many people have also felt that REITs

are similar to utility stocks due to their high dividend yields and concluded that REITs

would have the same type of interest-rate sensitivity in their pricing as utility stocks. This

Literature Review

A number of authors have analyzed the effects of different economic variables on

REIT prices. Chen and Tzang looked at the sensitivity of REITs to interest rates and

inflation using a regression model with Merton’s intertemporal capital asset pricing

model. The study used a small sample of mortgage and equity REITs with the time

period 1973–1979 and 1980–1985. They found that equity REITs were not sensitive to

interest rates, but only to changes in expected inflation, while mortgage REITs were

sensitive to both changes in expected inflation and changes in real interest rates. Park,

Mullineaux and Chew studied the inflation hedging ability of REITs and found them to

strategy. This model used the percentage growth rate in industrial production and the

current cap rate along with a number of financial market variables (such as T-bill yields

THE JOURNAL OF REAL ESTATE RESEARCH 319

319

Glenn R. Mueller*

Keith R. Pauley**

The Effect of Interest-Rate

Movements on Real Estate

Investment Trusts

*National Director of Real Estate Research, Price Waterhouse, LLP, Baltimore, Maryland 21090, and faculty

of The Berman Real Estate Institute at Johns Hopkins University.

analyzes the movement of REIT price changes during past interest-rate cycles. The results

indicate that REIT price movements have a low correlation with changes in interest rates

and a lower correlation with interest rates than with movements in the stock market as a

whole. The findings lead to a call for research into other areas in order to ascertain the

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and spreads, and S&P statistics) to predict future returns for the allocation model. They

found that an active strategy (without transaction costs) outperformed a passive strategy

by 250 basis points. This leads to the assumption that some capital market factors affect

real estate returns. Gyourko and Keim studied REIT returns and compared them to the

NCREIF appraisal-based index. This study showed the correlation between equity

REITs and long bonds to be .43 and the correlation with the S&P 500 to be .65 in the

time period 1978 to 1990. Their study found that REIT returns during the year were a

significant predictor of year-end appraisal movements in the NCREIF index. They

conclude that important information about real estate fundamentals is incorporated in

equity REIT returns, especially when controlled for stock market factors. Jacob and

Zisler stated that real estate returns have been positively correlated with interest rates in

many instances due to the tight supply of space that allowed rents to rise, offsetting a

drop in value caused by rising interest rates. They also hypothesized that during interest-

Monthly changes in interest rates, as measured by price data from federal government

three-month Treasury bills, ten-year bonds, and long-term government bonds, are

compared to monthly changes in the S&P 500 Price Index, the S&P 40 Utilities Index,

the NAREIT Price Index (which includes healthcare REITs), and the Wilshire Real

Estate Index (which includes equity REITs and publicly traded real estate operating

companies). Exhibit 1 shows the correlations between these different indices from 1972

to 1993.

This matrix shows that the NAREIT Equity Index had a low negative correlation with

interest-rate movements over the time period studied. This was true for short-, medium-

and long-term interest rates as the correlations were low and negative for all. Because we