Does Inflation Illusion Explain the Relation between REITs and Inflation?

Other studies include Wurtzebach et al. (1991), Miles and McCue (1982), and Sirmans and Sirmans (1987). For other countries, Newell (1996) finds that Australian private real estate only partially hedges both expected and unexpected inflation. Limmack and Ward (1988) report that U.K. property sectors hedge expected, but not unexpected, inflation. Hoesli et al. (1997) examine U.K. real estate, and they obtain the coefficients significantly less than one, with those relating to unexpected inflation being negatively signed. Barber et al. (1997) use a structural time series approach and find that U.K. real estate provides, at best, a weak hedge against changes in underlying inflation but no hedge against shocks that change price levels or against irregular price fluctuations. Stevenson and Murray (1999) examine the inflation hedging ability of the commercial real estate sector in the Republic of Ireland and do not find evidence to support the hypothesis that real estate acts as an effective inflation hedge over the period 1985 to 1996. Using Hong Kong data for 1998-2006, Glascock et al. (2008) find that real estate assets in Hong Kong are not a good hedge against inflation, in the short term or long term. Rosental (1999), using the data on single-family housing in Vancouver, British Columbia, shows that the implicit market for residential buildings is efficient and that any inefficiencies in the housing market must lie in the market for land itself.

Piazzesi and Schneider (2007) consider asset pricing in a general equilibrium model in which some, but not all, agents suffer from inflation illusion. (see also Suleyman and Yan 2010).

Mei and Saunders (1997) show that real estate investments by commercial banks and thrifts have largely been driven by past real estate and market returns rather than by future expected returns. This trend-chasing investment strategy offers an explanation for the poor performance of their real estate investments. Vincent (1999) examines the information content of alternative summary performance measures, using stock returns as the benchmark, for various REITs. Goetzmann and Peng (2006) analyze a bias in transaction-based price indexes due to the presence of seller reservation prices. Levitt and Syverson (2008) show that information asymmetry between real estate agents and sellers can contribute to distortions in housing prices.

As in Campbell and Shiller (1988b), we also assume E_t h_t = E_t r_t + c.

Falk and Lee (1998) decompose farmland price movements into movements attributable to fundamental factors (i.e., factors that influence the time paths of rents and interest rates) and movements attributable to nonfundamental factors in a trivariate model.

The latter case is emphasized by Brunnermeier and Julliard (2008) in examining potential mispricing in the housing market.

While Simpson et al. (2007) examine asymmetric responses of equity REIT to positive and negative inflation rates, we examine the effect of positive and negative inflation rates on the mispricing component of REIT prices. Applying a pooled estimation methodology to an expansive data set containing 195 publicly traded equity REITs for the period 1981–2002, Simpson et al. (2007) document a strong asymmetry in the response of equity REIT returns to inflation. Specifically, they find that equity REIT returns rise in response to both increases and decreases in inflation.

Hess and Lee (1999) provide a theoretical model showing that there are aggregate supply and aggregate demand shocks that affect the relation between stock returns and inflation. Falk and Lee (2004) develop and estimate a structural vector autoregressive model to examine the dynamic responses of the inventory and sales of new single family homes to transitory and permanent shocks.

The REIT Composite Index contains all the publicly traded U.S. REITs. The Index, which is further classified as equity, mortgage, and hybrid subcategories, also serves as the selection universe for the REITs. Equity REIT is a REIT that owns, or has an “equity interest” in, rental real estate (rather than making loans secured by real estate collateral). Hybrid REIT is a REIT that combines the investment strategies of both equity REITs and mortgage REITs. Mortgage REIT is a REIT that makes or owns loans and other obligations that are secured by real estate collateral.

Before we move on to the analysis of the mispricing components in REITs, we examine potential unit root and cointegration in REIT prices and dividends as another preliminary step. For both monthly and quarterly REIT returns, we find that nominal REIT prices (Pn) are a nonstationary, I(1), process. However, nominal dividends (Dn), real prices (P), and real dividends (D) are all stationary, I(0), processes without a unit root although there is some evidence that nominal dividends (Dn) may be marginally nonstationary according to the augmented Dickey-Fuller test with four lags. This is rather unusual in that for the general stock market, both stock prices and dividends tend to be nonstationary and cointegrated. This implies that, among others, the cointegration between real REIT prices and real REIT dividends is not a serious issue. As usual, we find that CPI series is nonstationary, while inflation rate is stationary. In addition, the linear combination of real REIT prices and dividends, S, is also stationary, as expected. Not surprisingly, when we implement the cointegration test, we find that the null of one cointegrating vector is rejected.

Estimation results using monthly REIT series are not reported partly because the results are very similar to those using quarterly series and to save space. The monthly results are available for authors.

Lee and Chiang (2004) extend Seck’s (1996) approach to investigate the substitutability between equity REITs and mortgage REITs. They find that the two types of real estate investment trusts are highly substitutable. An important implication of this study is that investors who believe they have superior forecasting abilities for a set of economic factors will be indifferent to invest in either equity REITs or mortgage REITs. Another implication is that REITs can be treated as a single asset class in constructing a diversified multi-asset portfolio.