In the 1960's, Real Estate Investment Trusts (or REIT's) were introduced to the capital markets. Literature on REIT's has been produced on a large scale, and the 3 key areas in which we can divide the literature are: -Investment -Financing and -Risk & Return compensation (Corgel). As a summary, REITs are closed-end funds (no. Of share positions are limited) which trade like public stocks. REITs trade as a sector ETF (Exchange traded fund) on the ASX. The primary motivation for investing in REITs over Real estate is that it allows investors to participate in Real Estate returns but also prefer the liquidity provided. Listing as REIT has certain prerequisites that must be met that dictate the percentage of the fund that must be held in Mortgages, Real Estate Equities and government securities. Other prerequisites encompass the percentage of income that must be distributed, and where the income is generated from. Once these criteria are met (which differ by country), the fund is permitted to list as a REIT.
We now examine the literature that can be broadly divided into 3 categories: -Investment -Financing and - Risk & Return compensation.
In the field of Investment Decision we look at the issue- Are REITs equities or real estate
There are various views taken on whether REITs are equities or real estate. Ross and Zisler (1987a, 1987b) found high volatility in the movement of REIT values. They concluded that REITs return lay between the return of securitized/unsecuritized indices but display the volatility of equities. Ennis and Burik (1991), take an opposing view, stating that REIT returns are true returns of Real estate if REIT markets are efficient. They go one to cite several studies along with empirical tests to confirm that REIT shares are efficiently priced and hence the returns are indicative of returns on Real Estate. Barkham and Geltner (1993) provide evidence that price changes in Real Estate Markets are followed by price changes in Securitized markets (REIT markets) within a year. Overall we draw the following conclusions: -Returns on REITs and Real Estate are highly positively correlated - REITs are significantly more volatile than Real Estate and seem to have variance patterns similar to that of equities.
The field of REIT financing has examined the following issues: - Payout (Dividend Policy) - Capital Structure - Agency Costs
From the 80s to the 90s, REITs were far more liquid while private firms were far from liquid. This created a demand for REIT investment a growth in the sector that increased in size by greater than 11 times from 1992 to 1999. Hott and Yi (2005) find that (i) REITs are financed by outside debt and equity for investment; (ii) financing policy stabilized over time (iii) REIT capital structures became increasingly complex. We can question at this point whether investing in REITs adds firm value. By examining M&M theory with optimal capital structure, this complex capital structure seems to increase firm value. As capital structure stabilizes we expect the REIT to operate at the optimal capital structure where Marginal Distress Costs equals the Marginal Gain from borrowing (M&M 1963). According to Jensen's (Jensen 1986) free cash flow theory, higher dividend payouts should reduce agency costs. In the case of REITs, there are special requirements in certain countries whereupon 95% of taxable income must be declared as dividends. Lee and Kau (1987) test to see whether high dividend payouts in REITs affect market values, and they find higher payouts actually reduce the market value of the REITs because investors prefer to be taxed on capital gains rather than dividends. Maris and Elayan (1990) find that Capital Structure of REITs support leverage, and the use of Debt is relatively high for REITs. Agency problems also arise during Hostile takeovers where managers act selfishly. McIntosh (1991), examines 16 REITs performance after announcements of anti-takeover measures such as Golden parachutes, and milking dividend payouts; the result is very similar to that of equities, where REIT price declines significantly thus proving that managers act in their own interests in such times. However, increasing incentive based fees to managers increases the performance of REITs as found by Solt and Miller (1985).
Overall we can conclude that there are some similar aspects to Equity with regards to Agency costs, but there is some conflicting evidence with regards to capital structure and dividend payouts.
Finally examining the Risk and Return of REITs we look across a range of studies encompassing performance, volatility and trade-offs.
Liang, McIntosh and Webb (1992) find that REIT Portfolios experience shifts in their return distributions, also Coskewness is found to explain returns (Liu, Hartzell and Grissom 1992). Coskewness indicates that the first variable's probability distribution is skewed relative to the second variable's distribution. Han (1990) and Glasock (1991) find no excess return generated for a long holding period. Others such as Hartzell & Mengden (1987) report a 4% alpha for long holding periods. Glasock(1991) also finds that for short term investment there exist no abnormal returns. The majority of studies however seem to confirm that REITs either outperform/underperform the market over certain time periods; refer to Martin & Cook (1991). Several studies have been conducted regarding seasonality in REIT performance. Colwell and Park (1990) find that REIT returns are highest in January. The result is confirmed by Liu and Mei (1992a).
With regards to volatility several studies have been done. Mengden and Hartzell (1986) find that the average correlation between REIT returns and Stock Market returns is 0.75. Gyourko and Keim (1991) find that the correlation between REIT Returns and Stock returns is 0.65. Khoo, Hartzell and Hoesli (1993) find that the Standard deviation of REITs reduced throughout 1989, hypothesizing the reduction due to increased analyst coverage. Very relevant to our own case study, Bharati and Gupta (1992) build an optimal portfolio including REITs. The results suggest superior performance of including REITs, not solely because of diversification.
From the above studies we can see that in certain periods REITs have outperformed the market, and we believe strongly that the Australian Real Estate will continue to be in a bubble for a further 2 years that will provide inflated returns. Risk patterns are ever changing, but inclusion of REITs in a portfolio seems to improve returns.
Price discovery in American and British property markets
R Barkham, D Geltner - Real Estate Economics, 1995
Managerial incentives: implications for the financial performance of real estate investment trusts
ME Solt, NG Miller - Real Estate Economics, 1985
Dividend payment behavior and dividend policy on REITs
CF Lee, JB Kau - Quarterly Review of Economics and Business, 1987
An examination of the small-firm effect within the REIT industry
W McIntosh, Y Liang, DL Tompkins - Journal of Real Estate …, 1991
Capital structure and the cost of capital for untaxed firms: the case of REITs
BA Marts, FA Elayan - Real Estate Economics, 1990
The influence of non-risk factors on real estate holdings of pension funds
RM Ennis, P Burik - Financial Analysts Journal, 1991
Finance, Investment and Investment Performance: Evidence from the REIT Sector
Steven H Ott, Timothy J Riddiough, Ha-Chin Yi. Real Estate Economics. Bloomington: Spring 2005. Vol. 33, Iss. 1; pg. 203, 33 pgs
Intertemporal changes in the riskiness of REITs
Y Liang, WMI Prudential, JR Webb - Journal of Real Estate Research, 199
Managing Real Estate Portfolios Part 2: Risk and Return in Real Estate SA Ross, RC Zisler - Goldman Sachs Real Estate Research, 1987
Managing Real Estate Portfolios, Part 3: A Close Look at Equity Real Estate Risk
S Ross, R Zisler - Real Estate Research, 1987
Risk and return in real estate
SA Ross, RC Zisler - The Journal of Real Estate Finance and Economics, 1991 - Springer
Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers
Michael C. Jensen American Economic Review, Vol. 76, No. 2, May 1986
Modigliani, F.; Miller, M. (1963). "Corporate income taxes and the cost of capital: a correction". American Economic Review 53 (3): 433-443.
The role of co-skewness in the pricing of real estate
CH Liu, DJ Hartzell, TV Grissom - The Journal of Real Estate Finance and Economics
Did REITs Really Outperform the Stock Market Portfolio
J Han - Working Paper, 1990 - MIT
Market conditions, risk, and real estate portfolio returns: Some empirical evidence
JL Glascock - The Journal of Real Estate Finance and Economics, 1991
Equity Real Estate Investment Trusts-Are They Stocks or Real Estate'
D Hartzell, A Mengden - 1987 - Solomon Bros. Inc., New York, NY
A comparison of the recent performance of publicly traded real property portfolios and common stock
JD Martin, DO Cook - Real Estate Economics, 1991
Risk Characteristics of Real Estate Related Securities-An Extension of Liu and Mei (1992)
H Liao, J Mei - Journal of Real Estate Research, 1998
What does the stock market tell us about real estate returns?
J Gyourko, DB Keim - Real Estate Economics, 1992
An investigation of the change in real estate investment trust betas
T Khoo, D Hartzell, M Hoesli - Real Estate Economics, 1993
Asset allocation and predictability of real estate returns
R Bharati, M Gupta - Journal of Real Estate Research, 1992
