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Review of Quantitative Finance and Accounting

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01-01-2016 | Original Research

REITs and market friction

Authors: Benjamin Blau, Jared F. Egginton, Matthew Hill

Published in: Review of Quantitative Finance and Accounting | Issue 1/2016

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Abstract

We examine differences in price delay for a sample of real estate investment trust (REIT) and non-REIT matched pairs. Results suggest an economically and statistically higher level of price delay for REIT securities, which implies heightened frictions that increase the time needed for new information to be impounded into the prices of REIT shares. The primary drivers for the observed delay differential include differences in idiosyncratic volatility, market risk, and the number of days traded. Within-REIT determinants of delay confirm findings for the pooled sample of matched pairs. Importantly, we infer find that REIT investors are not compensated for restricted information flow, as excess returns are unrelated to the price delay.

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Trading costs further compound the adverse selection problem by impeding price discovery (Choy and Zhang 2010).

For brevity, we refer to our sample of equity REITs as REITs.

REIT share price reactions represent a growing area of research. Recent studies by Doran et al. (2011) and Price et al. (2010) examine the information content of earnings conference calls and post-earnings announcement drift, respectively.

For several decades U.S. REITs have been sampled for studies in economics and finance. Lu et al. (2013) argue that samples of international REITs will increasingly be used in such studies.

A REIT must meet four main provisions to maintain their tax-exempt status. First, five-or-fewer shareholders may not hold more than fifty percent of the REIT’s stock. Second, at least 75 % of the total assets of the REIT must consist of real estate, mortgages, cash, or federal government securities, and a minimum of 75 % of the REIT’s gross annual income must be derived from the ownership of real estate properties. Third, REITs must derive their income from passive sources such as rents and mortgage interest and not from the short-term trading or sale of property assets. Last, REITs must pay out a minimum of ninety percent of taxable income via dividends. Prior to 2001, the dividend requirement was 95 % of taxable earnings.

Also, Wang et al. (1993), Bradley et al. (1998), Ghosh and Sirmans (2006), Feng et al. (2007a), Hardin and Hill (2008) and Chou et al. (2013) discuss that REITs pay out greater dividends than is mandated, which further restricts capital accumulation.

Specifically, Dolvin and Pyles (2009) show REIT initial public offerings are associated with lower levels of underpricing and smaller price revisions than those for non-REITs and attribute these findings to reduced uncertainty in pricing REIT securities. Meanwhile, Blau et al. (2011) find less short selling activity for REITs and that REIT short sellers are less able to predict negative future stock returns, relative to non-REITs.

Transparency is positively related to liquidity (Hendershott and Jones 2005; Harris and Piwowar 2006; Bessembinder et al. 2006). Thus, results suggesting increased market frictions for REITs may also imply that they are less transparent.

Other papers that have examined the illiquidity of REITs relative to non-REITs include Nelling et al. (1995), Bhasin et al. (1997), Clayton and MacKinnon (2000), Bertin et al. (2005) and Danielsen and Harrison (2007).

Interestingly, Lu et al. (2013) find improved liquidity for REITs with lower debt levels.

Common Stocks are obtained from CRSP with a share code of 10 or 11.

We also match control stocks to the listing sample of stocks that are traded on the same exchange (NYSE or NASDAQ). That is, we match the control sample to the listing sample based on the three stock attributes that are similarly listed by the NYSE or NASDAQ.

The REIT Modernization Act (RMA) was passed in 1999 but went into effect in 2001. This legislation greatly altered the REIT operating environment. See Chan et al. (2003) for a full discussion of the RMA’s lasting impact. .

The dataset runs through 2008 because we collected the dataset while one of the co-authors was affiliated with an institution with subscriptions to both Thompson Reuters and I/B/E/S (the data sources for the institutional investment and analyst coverage variables).

Hou and Moskowitz (2005) use Wednesday-to-Wednesday returns to control for autocorrelations that are apparent in Friday-to-Friday returns and Monday-to-Monday returns (Chordia and Swaminathan 2000).

We use CRSP value-weighted market returns as the market index throughout the analysis.

We assume that weekly risk-free rates are equal to zero in our estimation of the CAPM beta.

We note that the negative correlation coefficients on CAPMβ and #Anlst are opposite of that reported by Hou and Moskowitz (2005). However, our sample consists of REITs and a control sample of non-REITs that are matched based on turnover, a measure of volatility, and market cap. The fact that some of the reported correlations in Table 3 are opposite findings in Hou and Moskowitz (2005) might simply be due to differences in our samples. Our sample firms are much smaller than those studied by Hou and Moskowitz (2005).

We recognize that the distribution of Delay is much higher for REITs than for the sample in Hou and Moskowitz (2005). It could be attributed to the lack of liquidity in REITs during this time period. For instance, Hou and Moskowitz (2005) show that stocks in the top 20 % based on Delay had typical price delay exceeding 0.196. The distribution of REIT Delay might be explained by lower levels of liquidity for REIT securities.

We also note that similar inferences are made when we examine median home prices obtained from the U.S. Census.

We find similar results when controlling for error clustering across securities and years.

This approach parallels Greene’s (2007) “general to simple” model building strategy (pp. 136–137). Due to the tradeoff between bias and efficiency, Greene (2007) suggests a top–down approach, wherein the model is systematically scaled back to a more parsimonious version. Thus, this approach places a greater emphasis on providing unbiased results. Accordingly, we emphasize results from the full models.

The difference-in-difference approach is specified as

$$\begin{aligned} Diff\_Delay_{i,t} & = \beta_{1} Diff\_MktCap_{i,t} + \beta_{2} Diff\_IdioVolt_{i,t} + \beta_{3} Diff\_CAPM\beta_{i,t} \\ & \quad + \beta_{4} Diff\_B/M_{i,t} + {\rm B}_{5} Diff\_Ret_{t - 12,t - 2} + \beta_{6} Diff\_InstOwn_{i,t} \\ & \quad + \beta_{7} Diff\_\# Anlst_{i,t} + \beta_{8} Diff\_Illiq_{i,t} + \beta_{9} Diff\_Turn_{i,t} \\ & \quad + \beta_{10} Diff\_Vol\$_{i,t} + \beta_{11} Diff\_Price_{i,t} + \beta_{12} Diff\_Days_{i,t} + \beta_{0} + \varepsilon_{i,t.} \\ \end{aligned}$$

With operating partnerships, or more specifically, umbrella partnerships (UPREITs), the limited partnership owns the properties while the REIT owns a controlling interest in the partnership. Subsequently, Han (2006) argues that partnerships cause conflicts of interest between common shareholders and operating partners because of differences in marginal tax rates. Chou et al. (2013) show that the market values discretionary dividends paid by REITs utilizing the operating partnership structure, relative to REITs not in a partnership.

Our evidence is not directly comparable to Danielsen and Harrison’s (2007) examination of differences in liquidity across property focus. This is because their sample consists of mortgage and equity REITs.

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Title: REITs and market friction
Authors: Benjamin Blau
Jared F. Egginton
Matthew Hill
Publication date: 01-01-2016
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 1/2016
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-014-0459-z

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