<prompt> Human: Basically the title.Arent higher interest rates usually indicative of a stronger market, thus increasing real estate prices?The reason I ask is because theres a lot of advice saying to not buy an REITs right now because of the potential for them to drop if the Fed raises interest rates. Is there any truth to this?  <response>: Im a financial analyst, have worked in commercial mortgage lending, as well have done some analysis and valuation of REITs. To understand why they are somewhat negatively correlated with interest rates, you have to understand how the valuation of REITs work. A bit long, but it should cover most of the moving parts.Despite being an equity position, the payout requirements of REITs reflect the characteristics of a fixed-income security, like a bond, which people invest into for a yield. If we take a look at why bond prices are negatively correlated to interest rates, we can start to get a sense as to why REITs are too.For example, if we have a 100 bond issued with a 1 interest rate, it will pay 1 a year. As long as investors continue to be happy with a 1 interest rate, the bond will trade at 100, as it pays out 1 a year. However if market suddenly decides 2 is the appropriate yield for the same security, but this bond pays 1, the price of the bond has to change so the 1 is 2. So while new bonds would be issued at 100 paying 2, this bond paying 1 will adjust its price to 50, so they have the same yield. Note: before anyone jumps on me, Im aware of the massive oversimplification, this is just for example.Now, with REITs collecting rent monthly, and required to pay out specific portion of their income, they too follow somewhat of a predictable payout pattern. However, there is more risk of uncertainty involved in this payout pattern than a bond cant rent out all rooms, people not paying rent, building needs renovations, etc., so investors want to earn a premium on top of what they would get for owning a bond. This is often referred to as a spread in the bond world.For example, if a government bond, which is the definition of risk-free, is paying 2 a year, investors may demand 2 3 risk premium 5 from the REIT or any yield-type security that is riskier than the government for the additional risk they take.So for a REIT, what we do is take the expected payout, divide it by the interest rate including the risk premium, and we have our valuation of the REIT. If the REIT is going to pay out 10, and we require 5, we would value the REIT at 10 0.05 200 200. This 5 in the real-estate world is called the capitalization rate, which is the rate of return real-estate investors believe properties should currently be earning.Now when interest rates rise, so too will these capitalization rates. As outlined earlier, investors require a premium on top of the current interest rate, so if we previously required 2 3 risk premium 5, we may now require 3 3 risk premium 6. If we did not adjust the capitalization rate, there would be no incentive to own the riskier security, as we are not being compensated more for doing so.So as you can guess, if we take the same payout, and divide it by a larger number, we ultimately result in a lower result 10 0.06 166.66.Another factor to take into account is that REITs employ high amounts of debt as most property purchases are made with the use of mortgages. Its not uncommon for REITs to have 50 or more of their asset values financed by debt. When interest rates go up, so too will the interest portion of the mortgage payment, and ultimately have higher expenses. So while the denominator in our valuation example grew larger, the numerator will also slightly shrink as well, which both result in a lower valuation.These are largely the reasons as to why REIT prices move inversely to interest rates. However, as they are an equity position, there are other factors that come into play as well. Superb management with the ability to grow net income, and ultimately higher payouts, increases the numerator in our valuation equation, and results in a higher valuation. This is why REITs have a negative, but low correlation to interest rates; interest rates arent the only factor dictating how much a REIT pays out.Hope this helps. I typed this up quickly for you so if there are any mistakes or you need clarification, let me know! 