Stock markets are overreacting to the link between REIT performance and interest rates, and it is providing a rare instance of a market inefficiency that could be exploited. 

That is according to a recent note called Perception Becomes Reality by Green Street Advisors analysts Mike Kirby and Peter Rothemund.

They argue that until around 2011, the link between the movement in interest rates and the performance of U.S. REIT shares was fairly loose.

But from around 2012 on the two have been closely correlated, with REIT share prices highly sensitive to the movement in 10-year Treasury yields in particular. Since 2012, a 100 basis point upward move in 10-year Treasury yields has corresponded with a 1400 basis point underperformance by REITs against the S&P 500 index, and vice versa.

Why? One possibility has to do with supply. Rising interest rates clearly make the cost of debt higher for REITs, eroding returns. A benefit to rising rates for real estate often cited is the fact that it is a sign of an improving economy, so rents will rise. But with supply and rents both high, that is not likely this time around, the note argues.

More importantly, how to profit from this? Green Street points out that when rates rise sharply, it is the long-lease sectors, like net-lease REITs or healthcare REITs, which underperform most, and short-lease sectors like hotels are more resilient.

But more importantly, Kirby and Rothemund argue that the market overreacts to sharp rises in rates. If rates rise by 100 bps in a month then you see that 1400 bps underperformance by REIT shares. But in the month after that, the same shares outperformed the S&P by 400 bps, clawing back more than 25% of that underperformance. So buy in the month after a sharp rate rise.

“The traditional approach, based on forecasts of future rates, is only as good as those forecasts, and the historic record of rate forecasters is so woeful that it is a game best avoided,” Kirby and Rothermund wrote. “A strategy that instead assumes the market overreacts to big rate changes requires nothing more than yesterday’s newspaper, and it seems quite plausible that it will continue to pay off.”