According to the Wall Street Journal REITS Notch Biggest Gains in a Decade

Real-estate investment trusts were among the hottest stocks of the year, propelled to their biggest gains in nearly a decade by low interest rates and an improving economy.

REITs, which own properties as diverse as office buildings, apartments and warehouses, are sensitive to changes in interest rates because many investors see them as an alternative to fixed-income investments like bonds. When interest rates fall, REITs look more attractive and vice versa.

With most forecasters calling for the Federal Reserve to increase short-term rates from near-zero in 2015, history suggests REITs could be in for a tough year.

But many analysts are predicting REIT shares will continue to perform well, even if interest rates rise.

That is because shifts in interest rates alone don’t set the tone for REIT performance, and sometimes can be drowned out by other factors. In 2015, a stronger economy and increased mergers-and-acquisitions activity could overshadow rate rises, helping to power REIT returns, analysts predict.

If that turns out to be true, 2015 could be the first year since 2009 that REITs outperform the broader stock market even as rates rise.

For 2014, real-estate stocks have produced a total return of 32.3%, including dividends, according to the FTSE Nareit Equity REITs Index, which tracks 148 property companies. That is the highest total return since 2006, the year before real-estate values peaked, when REITs returned 35% to investors.

The broader S&P 500 stock index neared the end of the year with total returns of 14.9% as of Tuesday’s close. Several industries have outperformed REITs, including airlines and biotechnology, which have had total returns for the year of 93.7% and 35.5%, respectively, according to FactSet. By contrast, total returns have been 20.6% for the pharmaceutical industry, 10.9% for the tobacco industry and 9.5% for the textiles, apparel and luxury goods industry, according to FactSet.

Analysts and investors attributed the sector’s beefy gains mainly to an unexpected fall in interest rates. Yields on the 10-year Treasury note, a key benchmark for short-term interest rates, fell from 3% to 2.191% between the beginning of the year and Tuesday.

Most economists had forecast that interest rates would rise in 2014 as the economy showed signs of improvement.

“Exactly what everyone thought was going to happen this past year, the opposite happened,” said Samuel Sahn, who manages $700 million in REIT stocks for Timbercreek Asset Management.

The decline in rates made REITs attractive because they are required to pay out the bulk of their earnings to shareholders in the form of dividends.

Citigroup Inc. economists predict that the benchmark 10-year Treasury rate will rise to 2.95% by the end of 2015 from its current level near 2.2%. Still, they say REITs will produce a total return of between 5% and 15% for the year. That is because the rise in rates is expected to be accompanied by an improving economy, said Michael Bilerman, Citi’s head of real estate research. “If rates are rising because the economy is doing well…it means rents are rising, and landlords have more pricing power.”

Part of the reason for the optimism is that REIT earnings already have started to reflect an improving economy. Citi estimates that same-property net operating income, a common measure of REIT performance based on rent and expenses, has grown by about 4.5% in each of the last three quarters. In addition, occupancy rates across all REIT types reached a record 94.5% in the fourth quarter, Citi says.

One of the biggest beneficiaries of this growth has been the apartment sector, which produced an average total return of 41.9%, the best of any of the large REIT subsectors, according to the FTSE Nareit index.

“Apartments were the biggest surprise to everyone,” said Matt Werner, who manages $280 million for Chilton Capital Management LLC.

Residential rents have been rising primarily because of strong demand from people who are unable or unwilling to buy homes. Also, developers added very little new supply of apartments during the early years of the downturn.

Health-care properties were the second-best performing of the major property types, with returns of 35.5%, followed by regional malls at 34.9% and hotels and resorts at 34.8%. The subsectors with the smaller gains in 2014 were industrial properties with 22.9%, office properties with 27.8% and shopping centers with 32.3%.

To be sure, bullish predictions for next year are based on a gradual rise in rates.

All bets are off if interest rates spike, which would likely unleash a flood of capital from REITs into bonds. In May 2013, for example, after then-Fed Chairman Ben Bernanke made remarks suggesting that the Fed would reduce its bond-buying programs, interest rates jumped and the Dow Jones Equity All REIT Total Return Index fell 16% in three months.

Aside from REIT gains or losses tethered to rates, many investors are predicting an uptick in deal activity among REITs in 2015. The market value of acquisitions by REITs fell by nearly 25% to $122 billion in 2014, compared with a year earlier, and the value of REIT initial public offerings dropped by one-third to $14.1 billion this year, according to Dealogic.

Deal activity is expected to increase as more capital flows into the sector. With some REITs trading at record levels, companies are more willing to use their stock as currency to make acquisitions.

Also, numerous pension funds like California’s massive Calpers system have indicated they plan to increase their allocations to real estate.

Private-equity firms, meanwhile, had a record $742 billion of assets under management as of June, according to data firm Preqin. Blackstone Group LP, the world’s largest real-estate private equity firm, has said it’s looking for REITs to take private.

In November, office landlord Paramount Group raised $2.3 billion in the largest-ever IPO by a U.S. REIT.

“Last year at this time, it would be somewhat unthinkable for a fiduciary to take a real estate company public or list it on an exchange,” said Joseph Fisher, co-head of real estate securities at Deutsche Asset and Wealth Management. “Today, you can list a company at much closer to market value and it ends up being a much better result for shareholders.”

The top-performing REIT in 2014 was Winthrop Realty Trust , a Boston-based firm specializing in buying distressed office properties that announced in May that it planned to liquidate its assets. Its shares rose 68.3% this year.

AmREIT Inc., a Texas-based shopping-center owner, was the second-best performing REIT in 2014, producing total returns of 62.6%, according to FactSet, driven largely by news that it was being acquired by Edens, a privately-held competitor that is half owned by Blackstone.

“M&A has taken a more important place in the conversation this year, because it’s become a lot harder to grow by acquiring assets externally,” said Jason Yablon, global portfolio manager for Cohen & Steers, one of the largest investment firms dedicated to REIT stocks.

Write to Robbie Whelan at robbie.whelan@wsj.com