REIT Stock Price Volatility and the Effects of Leverage

This article sheds light on several puzzling empirical observations. We examine the volatility implications of equity Real Estate Investment Trust (REIT) stock returns over the sample period from January 1985 through October 2012. We find a negative “leverage effect” in the pre‐ and post‐Greenspan era, but not during the Greenspan era (circa 1994–2006). We argue that the positive elasticity of variance with respect to the value of equity during the Greenspan era can be explained by a decline in the spread between the yield on commercial mortgages and 10‐year Treasuries, which triggered a wealth transfer from REIT equity holders to REIT debt holders. We also argue that the declining commercial‐mortgage‐10‐year‐Treasury yield spread during the Greenspan era allowed REITs to take on far more risk than most people realized. We then document that average REIT stock return volatility increased significantly in the 2007–2010 period in the midst of a historic decline in REIT stock prices. The results have significant implications for the good deal of interest and debate in the media over the status of REITs and whether equity REITs have become excessively risky relative to the returns they generate.     

Privately Versus Publicly Held Asset Investment Performance

Classic asset pricing is problematic as a method to assess privately held asset investment performance. We propose an alternative approach that involves adjusting the characteristics of assets constituting an index or portfolio to match the asset characteristics of a reference index or portfolio. This approach is applied to commercial real estate, where we create an index of REIT returns to compare to the NCREIF index. To enhance comparability, return indices are adjusted for partial-year financial data, leverage, asset mix and fees. Adjusted results over a 1980–1998 sample period show general convergence between the indices, although an annual return difference of over three percentage points remains in favor of public market asset ownership. Possible causes of the investment performance gap include liquidity and geography as missing risk factor adjustments, an unrepresentative sample period, and the form in which commercial real estate assets are held.     

Correlation Dynamics and Determinants in International Securitized Real Estate Markets

We find the correlation movements among eight developed securitized real estate markets and among their stock markets are quite synchronized over the period from 1995 through 2012. There is a high degree of correlation dependence with many of the realized correlation series subject to regime switching. Moreover, international correlations of public property returns could be significantly explained by five real estate variables that include global real estate securities market volatility, co‐existence of real estate investment trust (REIT) influence, underlying direct real estate return performance differential, real estate securities volatility differential and real estate securities market size differential after controlling for macroeconomic influence and stock market effect. The importance of the control and real estate variables in explaining the return correlations varies across the economies examined.     

A Measure of Fundamental Volatility in the Commercial Property Market

The low level of volatility observed in appraisal-based commercial property indices relative to other asset classes has been frequently noted and extensively commented on in the real estate finance literature. However, the volatility of such commercial property indices is only one source of information on the second moment of commercial property returns. The volatility of securitized property returns forms another potential source of information, though there is some uncertainty about how closely the volatility of securitized returns may match the volatility of the underlying asset. Each measure of volatility has a potential source of noise associated with it. This paper proposes a fundamental measure of volatility for the commercial property market by using a stochastic volatility model to filter out the signal in the different sources of volatility information. This allows for different measures of volatility to be decomposed into transitory noise and unobserved fundamental volatility. The suitability of such an approach and the properties of the underlying fundamental volatility series are analyzed using data from the U.K. property market.     

Do Common Risk Factors in the Returns on Stocks and Bonds Explain Returns on REITs?

The monthly returns on equity and mortgage real estate investment trusts (REITs) are analyzed over the period July 1976 to December 1992. The results indicate that risk premiums on equity REITs are significantly related to risk premiums on a market portfolio of stocks as well as to the returns on mimicking portfolios for size and book-to-market equity factors in common stock returns. Mortgage REIT risk premiums are significantly related to the three stock market factors and two bond market factors in returns. Also, mortgage REIT shares underperform by an average of 6.8% per year.     

The Dynamics of Appraisal Smoothing

We investigate the dynamics of appraisal smoothing in the National Council of Real Estate Investment Fiduciaries (NCREIF) index return using time‐varying asset pricing models. We find that smoothing is on average close to zero but varies substantially over time. From the inception of the NCREIF index in 1978 until the mid‐1990s, there was little evidence of smoothing. Smoothing has increased significantly since the mid‐1990s to the end of 2010. Smoothing increases when property prices or uncertainty increases. However, it decreases when sentiment in the property market is high or during recession periods. The substantial variation in the level of smoothing indicates that the volatility of unsmoothed appraisal‐based property returns would be significantly over‐ or under‐estimated for different periods if unsmoothed with a long‐run average smoothing.     

Returns and Information Transmission Dynamics in Public and Private Real Estate Markets

This paper examines U.S. public and private commercial real estate returns at the aggregate level and by the four major property types over the 1994–2012 time period. Returns are carefully adjusted for differences between public and private markets in financial leverage, property type focus and management fees. Unconditionally, we find that passive portfolios of unlevered core real estate investment trusts (REITs) outperformed their private market benchmark by 49 basis points (annualized) over the 1994–2012 sample period. Our baseline vector autoregression results suggest that REIT returns do not embed additional commercial real‐estate‐specific information useful in predicting private market returns. These results strongly suggest that equity REIT returns react to fundamental (latent) asset pricing information more quickly than private market returns given their greater liquidity and price revelation. REITs therefore serve as a fundamental information transmission channel to private market returns when asset pricing variables are omitted.     

Geographic Portfolio Allocations,Property Selection and Performance Attribution in Public and Private Real Estate Markets

This article examines the effects of geographic portfolio concentrations on the return performance of U.S. public real estate investment trusts versus private commercial real estate over the 1996–2013 time period. Adjusting private market returns for differences in geographic concentrations with public markets, we find that core private market performance falls. Using return performance attribution analysis, we find that the geographic allocation effect constitutes only a small portion of the total return difference between listed and private market returns, whereas individual property selection within geographic locations explains, in part, the documented outperformance of listed versus private real estate market returns.     

Housing Price Volatility Changes and Their Effects

We examine significant volatility shifts in regional housing price changes, adapting a method of Haugen, Talmor and Torous (1991) independent of predefined sampling blocks. We identify 36 volatility events, most of which are purely regional, but three of which are national. We find significant associations of volatility events and economic conditions, especially national and regional income growth, inflation, and interest rates. During an initial adjustment period after a volatility shift, realized housing returns move opposite to volatility. We find evidence of significant interregional diffusion of volatility increases, but not of decreases. New insights on links between economic conditions and housing volatility and returns should be of value to household investors and mortgage investors.     

Mortgage Borrower Repayment Behavior: A Microeconomic Analysis with Canadian Adjustable Rate Mortgage Data

In this paper we estimate a model of mortgage borrower behavior using micro-level data on Canadian borrowers with rollover mortgages—a form of adjustable-rate mortgage. Our results suggest that the probability of default rises with a decrease in housing equity and an increase in the mortgage contract rate; however the size of these changes is relatively small. They also show that partial prepayment is sensitive to fluctuations in the rates of return from investing in housing versus other assets. For the United States experience, our results suggest that, relative to fixed-rate mortgage borrowers, adjustable-rate mortgage borrowers are more likely to default and less likely to prepay.     

Errors in Variables, Links between Variables and Recovery of Volatility Information in Appraisal-Based Real Estate Return Indexes

The present article proposes a multivariate approach to unsmoothing appraisal-based real estate return indexes to recover the true market volatility information in real estate returns. It scrutinizes the role played by errors in variables, in conjunction with an analysis of other economic activities relevant to real estate returns, to exploit the functional relationship and the mechanism of interactions between real estate returns and these economic activities. Appraisal smoothing can therefore be detected and corrected properly and efficiently, without presuming a weakly efficient real estate market. The approach is then applied to U.K. real estate indexes as empirical examples. The results suggest a reasonable volatility in U.K. real estate investment that is close to reality. It is found that the volatility of the true market return on real estate is 1.5404–1.9282 times that of the return on the appraisal-based indexes, in contrast to figures of 2.4862–5.8720 produced by the fully unsmoothing procedure.     

REIT Stock Market Volatility and Expected Returns

We study the relation between REIT stock volatility and future returns, focusing particularly on the financial crisis period of 2007–2009. There is ongoing debate about whether stock volatility can forecast future returns. Our findings suggest that REIT‐implied volatility is negatively related to contemporaneous stock returns; there is a significant positive relationship between REIT implied volatility and future stock volatility; and there is a significant negative relation between REIT implied volatility and future stock returns. Lastly, we develop trading rules based on REIT implied volatility to test whether these relationships are exploitable. The result suggests a potentially profitable trading strategy.     

Return Risk and Cash Flow Risk with Long-term Riskless Leases in Commercial Real Estate

This paper presents a conceptual analysis of some of the key fundamentals that underlie the risk characteristics of commercial real estate returns. In particular, the relationship between the property's return risk and its cash flow risk is explored. This relationship is important because it is the return risk that should matter most to investors, yet it is the cash flow risk or market risk about which we may have the most objective information and the most intuition. This is because real estate assets are generally unsecuritized and trade too infrequently to observe time series of returns (including appreciation) that could be used to directly study the risk characteristics of the returns. By explicitly incorporating the possibility of cash flows governed by riskless long-term leases, this paper also explores the relationship between lease term and both cash flow risk and return risk.     

Valuing the Defeasance Option in Securitized Commercial Mortgages

To protect the interests of investors, commercial mortgage loans pooled for the issuance of commercial mortgage-backed securities (CMBS) have restrictive covenants that discourage the borrower from refinancing. Such restrictions limit the borrower's ability to access any accumulated equity. The predominant means of accessing this equity today is defeasance. By defeasing a loan, the borrower substitutes the commercial mortgage with U.S. Treasury or agency obligations whose payments match those of the defeased mortgage. Therefore, defeasance is an exchange option whereby the borrower gives up the portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits arising from accessing the accumulated equity in the underlying property. The value of the option to defease is shown to depend critically on the rate of return that can be earned on the released equity, prevailing interest rate conditions, as well as the option's contractual features.     

Risk and Return in the U.S. Housing Market: A Cross-Sectional Asset-Pricing Approach

This article carries out an asset-pricing analysis of the U.S. metropolitan housing market. We use ZIP code–level housing data to study the cross-sectional role of volatility, price level, stock market risk and idiosyncratic volatility in explaining housing returns. While the related literature tends to focus on the dynamic role of volatility and housing returns within submarkets over time, our risk–return analysis is cross-sectional and covers the national U.S. metropolitan housing market. The study provides a number of important findings on the asset-pricing features of the U.S. housing market. Specifically, we find (i) a positive relation between housing returns and volatility, with returns rising by 2.48% annually for a 10% rise in volatility, (ii) a positive but diminishing price effect on returns and (iii) that stock market risk is priced directionally in the housing market. Our results on the return-volatility-price relation are robust to (i) metropolitan statistical area clustering effects and (ii) differences in socioeconomic characteristics among submarkets related to income, employment rate, managerial employment, owner-occupied housing, gross rent and population density.     

Pricing Efficiency in the Mortgage Market

Traditionally, the presence of serial correlation has been presumed to indicate an inefficient market for financial assets. As Latham [15] discusses, while the absence of serial correlation implies market efficiency, its mere presence does not imply inefficiency. Rather, market efficiency is a characteristic of security pricing. This study investigates pricing efficiency in the mortgage market. Using mortgage loan quotations for 343 institutions over a 71-week period, the empirical findings show that a wide variety of mortgage contracts are efficiently priced.     

Price Signaling and Return Chasing: International Evidence from Maturing REIT Markets

This article examines the liquidity of international real estate securities across 10 markets over the period 1990–2015. We apply and compare results for four different measures of liquidity, and find that while liquidity has increased consistently, wide variations still exist across markets, with the United States and Japan in the lead. Our results also suggest that the introduction of local REIT regimes did not have any pervasive effects on stock liquidity. When we study the relationship between liquidity and returns, we document new and consistent evidence for international return chasing behavior, whose pattern is a function of local market efficiency, listed real estate market maturity and stock ownership dispersion. The introduction of REIT regimes seems to weaken the importance of extra performance over and above general equity returns as investors tend to allocate funds to real estate securities within real estate rather than equity portfolios.     

Measurement of the Spreads Between Yields on Various Mortgage Contracts and Treasury Securities

Spreads between yields on different mortgage instruments and comparable maturity portfolios of Treasury securities have been computed and compared with quoted yields over the 1974–82 period for three different mortgage instruments: GNMA pass-throughs, FHLMC participation certificates, and conventional mortgage commitments. The methodology explicitly accounts for the expected timing of the payments on the mortgages and thus avoids the cash-flow timing problems noted in the literature.
Between late 1978 and 1981, the computed spreads rose by 30 to 40 basis points relative to those customarily quoted (the internal rate of return on a mortgage, assuming a twelve-year life, less the yield on near-par ten-year Treasuries). This increase can be attributed to the rise in the level of interest rates (the compounding error in quoted mortgage yields is larger at higher levels of rates) and the change in the slope of the yield curve from flat to downward sloping (the twelve-year prepayment date assumed in the computation of quoted GNMA and FHLMC PC yields seems to be too long).     

Transactions-Driven Commercial Real Estate Returns: The Panacea to Asset Allocation Models?

A transactions-driven commercial real estate return series is generated in this study to determine whether the reliance on appraised values in the estimation of real estate returns is the source of the reported underpricing of real estate relative to stocks, bonds, and bills when analyzed in a traditional mean-variance setting. The reported underpricing of commercial real estate would be rational if transactions-driven returns exhibit more variance than appraisal-driven returns. While we find that transactions-driven real estate returns have greater variance than appraisal-driven returns for individual properties, most of the individual property risk is idiosyncratic and diversified away at the portfolio level. Real estate continues to be a dominate asset class in mean-variance allocation models even when represented with transactions-driven indices.¹     

What Factors Determine International Real Estate Security Returns?

We use constrained cross-sectional regressions to disentangle the effects of various factors on international real estate security returns. Besides a common factor, pure country, property type, size and value/growth factors are considered. The value/growth measure that is used in this paper provides for each security the relative importance of the value and growth components, rather than a binary classification. The value/growth factor is found to be volatile and to have a substantial effect on returns over the period February 1990–April 2003. Country factors are the dominant factors, and size is shown to have a negative impact on returns. Statistical factors derived by means of cluster analysis explain about one third of specific returns on international real estate securities. The implication for portfolio managers is that failing to recognize the importance of the various factors leads to the portfolio being exposed to systematic risk.