Will real estate values plummet in line with the REIT roller coaster ride? Stephanie Schwartz investigates.

It's a truism that real estate investment trusts (REITs) are a leading indicator for US property values. Since they've just been through a turbulent time, does that mean that real estate is in for a roller coaster ride?

Although REITs have rallied since their 12% sell-off at the end of May, the market is still shaken by their dramatic fall, triggered by US Federal Reserve statements signalling the end of quantitative easing measures.

"There was a pretty sharp correction in REIT prices," says Alexander Goldfarb, managing director and REIT analyst at Sandler O'Neill and Partners. "Then there was a rebound, and that was expected."

What Goldfarb and other analysts do not expect is that real estate values will plummet in line with the REIT roller coaster ride. And there are a couple of reasons for this.

One is that REIT markets had become uncoupled from private real estate valuations before the Fed statements and the sharp rise in interest rates that followed.

With their pricing, REIT investors were signalling that real estate was priced very cheaply versus other fixed income yields, before the interest rate rises triggered the pricing correction, says Jason Moore of Green Street Advisors. In fact, had interest rates remained constant, Green Street was predicting that property prices were due to increase by as much as 10%. Today, however, property pricing looks fair compared with other fixed income pricing.

According to Moore, "everything has reverted to historical norms". He says: "This tells us real estate is priced fairly versus other yield alternatives." In addition, REITS are now trading at parity to net asset value (NAV), which indicates investors are aligned with private-market real estate values. "Real estate seemed cheap before – that's why REITs were trading at a premium," he says. "With this correction, it seems fairly valued now."

So if real estate is fairly valued, and if REITs have returned to their place in the world, and the REIT market is not looking as cheap as it was, how do REIT investors respond? "It's more important now to pick the right REIT," says Moore.

And the REIT sector has a lot going for it, notes an analysis from Sandler O'Neill: while REITs are trading at a discount to historical relative valuations, as a sector, they also rank 15th out of 24 in terms of earnings growth prospects.

"The pullback of quantitative easing will be done at a moderate pace," Goldfarb says. The housing recovery, while real, is still fragile, and the recent rise in mortgage rates, combined with a 12% increase in the average home price, makes it more difficult for many people to buy homes. Any disruption could curtail recovery in the crucial housing sector.

Goldfarb anticipates that if any sector will show the after-effects of the REIT pricing shock, it will be multifamily, which is more sensitive to prevailing trends. But he noted that, "considering the length of time it takes for property transactions to occur, it will take time for it all to work out". However, Sandler O'Neill does not expect much change in other property types. Industrial and retail are buoyed by steadily growing demand and a shortage of supply.

"The world is still starved for total return," says Goldfarb. "Real estate offers that, at the same time as there is limited new supply."