By Brad Case

Quick Bio: James R. Webb is a professor of finance in the Nance College of Business at Cleveland State University and director of its center for real estate brokerages and markets. During his 28-year academic career, he has authored more than 20 papers on REITs and more than 150 papers on other real estate topics.

Portfolio: Some investors assume that the relationship between interest rates and REIT values is straightforward, but what have you discovered?
Webb: Property prices usually decline in a rising interest rate environment due to higher capitalization rates. However, the relationship between REIT returns and interest rates is not so straightforward.

Rising interest rates, usually because of rising inflation, will increase the costs of REITs, thus affecting returns. The impact will be stronger for REITs that employ high debt levels in their capital structure, especially if loan commitments are on a floating rate basis or if they have not hedged their interest costs. Often, REITs are viewed as quasi-bonds by the general public because of their yields.

However, a rising interest rate environment can mean good economic performance in the market. This translates into strong fundamentals, which increase the demand to real estate space and, therefore, increase rental revenue.

Another effect of rising interest rates is that funds may be drawn out of the securitized real estate market, since the REIT industry may find it difficult to keep up with the rising yield expectations.

Portfolio: In one study, you found that the long-term relationship between stocks and real estate is weakly negative, implying that real estate diversifies a stock portfolio. What is the role of REITs in the optimal mixed-asset portfolio?
Webb: REITs play an important role in portfolio risk diversification. REITs were traditionally regarded as a defensive stock due to their passive nature, but this has changed in more recent years. Many of the internally managed REITs have taken on a more entrepreneurial character to create value for shareholders. Hence, besides the stable income story, REITs also have offered high capital growth, particularly in the past few years.

Portfolio: Are equity REITs an inflation hedge?
Webb: Yes and no. As the securitized form of a real asset, it often acts as at least a partial hedge, at least over the long-term. However, it is more complicated, since you have the wise—or, sometimes, unwise—decisions of management confounding the general economic relationships.

Portfolio: How should pension funds and other institutional investors use REITs in their investment portfolios?
Webb: REIT investment has advantages over direct property investment, particularly in terms of overcoming both liquidity and the proactive management requirement associated with direct property ownership. REITs also facilitate easier cross-border fund flow, and their transparency and tighter corporate governance should be appealing to pension funds and other institutional investors. Additionally, the “hands on” management problem, which can be very time consuming, is eliminated.

While REIT returns go through cycles of ups and downs, real estate investment should yield somewhat superior and countercyclical returns in the long-term. This should be attractive to pension funds and institutional investors, which have longer investment horizons.

Joseph Ooi, University of Singapore, contributed to these answers.

Brad Case is NAREIT's vice president, research & industry information.