Review of REITs Volatility Factors

2.2 Review of REITs Volatility Factors

There are many factors affecting REITs price volatility, and we divide these factors into two parts, the macroeconomy and real estate markets. In this chapter, we will discuss the relationship and impact between these two markets and REITs.

2.2.1 REITs and Macroeconomy

The nature of REITs is mutual funds, and it is similar to macroeconomic markets.

Therefore, there are plenty of researches about the relationship between REITs and macroeconomic variables. Besides the legal and institutional side, most of the subjects focus on relationship between REITs returns and volatility and macroeconomic variables such as stock price, inflation rate and interest rate. This chapter reviews the relevant studies of these three variables.

(1) REITs and Stock Markets

In the past, people use linear regression model to discuss the relationship between REITs and other markets. In the relation among REITs, macroeconomy and real estate markets, stock markets can affect real estate markets through the wealth effect; that is, the investors’ wealth increase when stock prices go up. Under the consideration of increasing consumption and risk diversification, investors will transfer part of the funds from the stock markets to the real estate markets, influencing the real estate prices.

Giliberto (1990) applied correlations and regression model to explore the relations between equity REITs, stock markets and real estate markets, and he found that when the impact of the bond market and stock market effects are removed, REITs returns are significantly correlated to the traditional real estate investment returns, which implies that there is a common factor (or factors) that affects both REITs and real estate market. The study also found that real estate market has lower volatility and is negatively correlated to EREITs returns. In addition, EREIT’s correlation with the stock market has declined over time and their correlation with bond returns has increased.

Liu and Mei (1992) stated that while previous studies have found that EREIT returns resemble large cap stocks, they found that returns on EREITs move more

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closely with small cap stocks. Moreover, they found that real estate market conditions influence small cap stocks in addition to EREITs. Lee (1992) suggested that stock returns appear prior to Granger-Causal and help explain a substantial fraction of the variance in real activity, and is positively correlated to shocks in stock returns. Myer and Webb (1994) further explain that there is a positive contemporaneous relationship between retail stocks and retail REITs after controlling the market returns. However, no positive evidence is found for a relationship between retail real estate and either retail REITs or retail stocks, which does not support the previous conclusion about the existence of a stronger relationship between retail REITs and retail real estate. He expected that the differences between the results could be due to the presence of overage rents and perhaps other common factors.

Liu, Hartzell, Greig and Grissom (1990) intended to explore whether the commercial non-form real estate market is segmented from the stock market in U.S.

for the period from June 1978 through September 1986 using Capital Asset Pricing Model (CAPM). In general, the results are consistent with the hypothesis that the commercial real estate market is segmented from the stock market as a result of indirect constraints, but commercial real estate market appears to be integrated with the stock market when the tests of integration are performed. Therefore, equity REITs are integrated with the stock market even though the commercial real estate which underlies the equity REITs is segmented from the stock market. They show that indirect barriers such as the cost, amount, and quality of information are the major source of segmentation. Peterson and Hsieh (1997) find EREIT returns significantly related to three stock market factors, whereas MREIT returns are related to the three stock market factors and two bond market factors in return.

From the above literatures, whether we are discussing from the perspective of total REITs and individual REITs or from the perspective of equity REITs and mortgage REITs, the results both occur REITs and stock market are under certain correlation. However, stock market is not the only factor, factors such as bond market and indirect barriers such as cost may also affect REITs performance and reward.

(2) REITs and Inflation Rate

The discussion about whether REITs can act as inflation hedging products, the past researches have not reached the same conclusion. Fama and Schwert (1977) find

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that changes in returns on private residential real estate are positively related to changes in inflation, suggesting that such real estate is a hedge against inflation. Park, Mullineaux and Chew (1990) further examine the hedging ability of REITs and stock market based on the conclusion drawn by Fama and Schwert, and they find that for the most part, REITs are perverse inflation hedges just as stocks. Larsen and Mcqueen (1995) state that according to Fisher, real estate products can act as an effective hedge against inflation; however, the follow-up studies show the opposite result. They indirectly use the relation between gold and gold stocks to explore REITs’ hedging ability. The results turn out that gold is shown to hedge inflation whereas its securi- tized form, gold stocks, is shown to be a poor hedge against expected inflation.

Therefore, the study from the gold market suggests that conclusions about real estate's ability to hedge inflation should not be drawn from equity REIT studies.

Yobaccio, Rubens and Ketcham (1995) use autoregression model to do the time-series predictions, and the results indicate that REITs only act as a poor hedge against inflation. The results also indicate that REITs, at best, act as a partial hedge against expected inflation and a perverse hedge against unexpected inflation. Studies that have shown the real estate’s ability to act as a partial inflation hedge may be the result of well-documented appraisal basis, rather than real estate’s innate ability to be an effective hedge. Simpson et al (2007) point that EREIT returns do display a negative relationship with inflation, but only when inflation itself is going down. This result indicates that EREIT returns are shown to rise when inflation goes up and also rises when inflation decreases, and this involves other market mechanisms and fiscal policies. Lu and So (2001), Glascoca et al (2002) conclude that the negative relationship observed between REIT returns and inflation is partially derived from the interaction between monetary policies and inflation.

To sum up, based on the researches about REITs and inflation rate we still can’t conclude whether REITs can act as an effective hedge against inflation because the result may change with the time and scope of the research data selection. However, if REITs can be hedged against inflation in the long-run, it implies that there is a long-run relationship between REITs and inflation.

(3) REITs and Interest Rate

In exploring the relationship between REITs and interest rates, Liu and Mei

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(1992), Liang and Webb (1995), and Peterson and Hsieh (1997) believe that REITs are sensitive to interest rate changes, so a multi-factor model would be better than a single-factor model. The results of how interest rate affects REITs are divided into two conclusions. The first part thinks that REITs are highly sensitive to interest rate changes (Allen, Madura and Springer, 2000; Chen and Tzang, 1988). The second part believes that the correlation between REITs returns and interest rate changes is relatively low (Park et al., 1990；Mueller and Pauley, 1995；Li and Wang, 1995).

However, those researches were not done under the same time frame, so interest rate volatility and the characteristics of REITs are not the same; thus, the relationship between REITs and interest rates still has room to be explored.

Allen, Madura and Springer (2000) find strong evidence to suggest that REITs returns are sensitive to long-term and short-term interest rate changes, but they cannot conclude that REITs can affect their exposure to interest rate changes through asset structure, financial leverage, management strategy, or degree of specialization. The results also show that REITs returns are more sensitive to stock market conditions than to interest rate changes, and there is evidence that individual REITs characteristics would affect REITs riskiness. Chen and Tzang (1988) point that during 1973-1979, both equity and mortgage REITs were sensitive to changes in the long-term interest rates and changes in expected inflation, and for the period 1980-1985, both equity and mortgage REITs were sensitive to short-term and long-term interest rate changes. Swanson, Theis and Casey (2002) indicate that although the particular time frame according to daily market data are unevenly dependent, interest rates still impact REITs. And it appears that the interest rate effects seem to have less explanations than in the time period as a whole, which is consistent with previous short versus long window analyses.

Mueller and Pauley (1995) indicate that REITs price movements have a low correlation with interest rates changes and a lower correlation with interest rates than with movements in the stock markets as a whole. The results of correlation and regression also show that the spontaneous relationship between interest rates changes and REIT price changes is very weak. In addition, the NAREIT Equity Index had a low negative correlation with interest rate movements during the period under study.

Although the correlation between REITs and interest rates were divided into two parts, we can ascertain that REITs and interest rates changes are still correlated.

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However, the results may show different degrees of relevance subject to the length of time frame and data sources selected. This study tries to find out whether there is a long-run relationship between REITs and interest rates, or interest rates changes only has a short-term impact on REITs.

2.2.2 REITs and Real Estate Markets

There are also many studies exploring the relationship between REITs and real estate markets. Myer and Webb (1993) analyze the causality between REITs and real estate markets, and show the REIT index is found to Granger-cause the real estate indices, but there is no evidence that the real estate indices Granger-cause the REITs indices. In a time series sense, equity REITs returns appear to be much more like the returns on common stocks and closed-end fund. In addition, REITs returns are much more strongly related to unsecuritized real estate returns than are the returns on stocks or closed-end funds.

Clayton and Mackinnon (2003) find that after 1980, the large-cap stock factors impact on REITs drop dramatically, and the small-cap stock factors impact also occured. Since 1992, the dramatic growth and maturation of the REITs led to claims that the link between REITs prices and real estate market fundamentals become much stronger. Damodaran and Liu (1993) find the second-hand information associated with real estate appraisal announcements does not influence REITs prices. Following the research by Damodaran and Liu, Downs, Guner, Hartzell and Torres (2001) show that REITs prices change is a result of the information content in Barron’s “The Ground Floor” column, and that the prices change more in the period following the REITs boom than during an earlier period.

Liang, Chatrath and McIntosh (1996) set up a hedged apartment REITs index by removing the return components of stocks in general and non-apartment equity REITs that invest in apartment real estate, and they use the index to analyze the relation between apartment REITs and apartment real estate. The results indicate that the

“double-hedged” apartment REITs index satisfactorily track the performance of appraisal-based apartment real estate. Therefore, the hedged apartment REITs index can be used as a proxy for apartment real estate when making mixed-asset portfolio decisions.

Ling and Naranjo (1997) use a standard multifactor asset pricing model to

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examine the macroeconomic factors that will affect real estate returns. This study identifies the growth rate in real per capita consumption, the real T-bill rate, the term structure of interest rates, and unexpected inflation as fundamental drivers or “state variables” that systematically affect real estate returns. The results show that previous findings of significant abnormal returns that have ignored consumption are potentially biased by omitting variables problem, and the dynamic asset allocation strategies involve the predictability of real estate returns using economic data.

Myer and Webb (1994) find there is a positive contemporaneous relationship between retail stocks and retail REITs even after controlling the market returns, and support the hypothesis that the presence of overage rents would tend to link the performance of retail real estate with the performance of retail tenants. Lee, Lee and Chiang (2008) find evidence suggesting that the real estate factor plays an important role in explaining quarterly equity REIT returns, which is consistent with the result explored by Giliberto (1990) that REITs returns reflect the performance of underlying real estate. Moreover, the sensitivity of big-cap REIT returns to lag supports the notion that institutional investors view REITs as potential substitutes for direct real estate investments and switch their capital between public and private real estate markets. Interestingly, when a more sophisticated investor based on the new REITs era improves information flow, a high degree of participation from institutional investors strengthens the linkage between REITs returns and private real estate returns.

Quan and Titman (1999) find a significant positive relation between stock returns and changes in commercial real estate values in contrast to earlier studies. One hypothesis is that real estate and stock prices are both driven up and down by changing expectations of future economic growth which is independent of current fundamentals, such as current rents and GDP. Moreover, they find that rental rates are strongly correlated with GDP growth rates as well as stock returns. The insignificance of the inflation rate coefficient and interest rate variables suggest that commercial real estate is a good long-term hedge against realized inflation, and that changes in anticipated inflation do not have long-term effects on commercial real estate values.

Regardless of using price index or rent as the object, real estate activities do have some influence on REITs volatility and returns, and sometimes REITs can act as a proxy of real estate markets, especially of commercial real estate markets. Therefore,

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there is a correlation between the performance of real estate markets and REITs volatility and returns.

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