Independent Study - Long Honors Project

Chapter 1 Market Efficiency and Real Estate Investment Trusts1.1 Introduction and Motivation The efficiency of the capital and real estate markets are considered in this study.The effici

Jonathan Matthew Long

A paper submitted in partial fulfillment of the requirements of the Honors Program

in the Department of Economics and Finance.

Examining Committee: Approved By:

_

Dr Robert Burrus Dr Edward Graham Faculty Supervisor _

Dr Christopher Dumas

_

Dr William Atwill

_ Department Chair

_

Honors Council Representative

Director of the Honors Scholars Program

The University of North Carolina at Wilmington

Wilmington, North Carolina

April 2004

Market Efficiency and Real Estate Investment Trusts

as a publicly-traded stockholder-owned company, but enjoys special tax treatment andhas accounting requirements peculiar to the real estate industry A REIT share representsownership in real estate – an asset far different than a share of stock – although it istraded in the same fashion as stock As a result, the REIT share “enjoys” some of thesame efficiencies as the stock market, while directly representing ownership in realestate, a far less efficient market These relationships, and publicly-traded REITcompanies, are considered at length in this study

I would like to give credit to a number of people and institutions for helping me in mystudy First of all, I would like to like Dr Edward Graham from the Economics andFinance department of the Cameron School of Business (CSB) He was my facultysupervisor and mentor for this project He spent numerous hours of his past twosemesters meeting and working on my project with me Dr Graham was the inspirationfor the research conducted, and he provided me with guidance and direction throughoutthe entire study Without his help I feel I would never have been able to accomplish what

I did

Among the other people I would like to thank include Gene Houghtaling from theCSB Once Morningstar’s Principia product was obtained he was an invaluable resourcefor accessing the data and installing it in the computer lab in Cameron Hall My thanksalso go out to Dr Burrus, Dr Dumas, and Dr Atwill for being a part of the reviewingcommittee for my thesis

A number of institutions also helped make this project a success I need to thank theresearch firm, Morningstar, for their most generous donation of their Principia dataprogram to UNCW I would also like to thank the Cameron School of Business and theEconomics/Finance Department for use of their computer lab and the help I receivedfrom the many professors Last of all, I would like to thank the Honors ScholarsProgram Because of this program, I have had this opportunity to differentiate myself as

a student through this project The skills and experience I have gained from this projectwill serve me well as I transition towards a career in business, and as I consider myoptions for graduate study

Chapter 1 Market Efficiency and Real Estate Investment Trusts

1.1 Introduction and Motivation

The efficiency of the capital and real estate markets are considered in this study.The efficient market hypothesis is introduced and contrasted with the behavior of thesetwo markets Comparisons between capital and real estate market efficiency help tohighlight possible inefficiencies in the real estate market In the real estate market,consideration will be given especially to the REIT (Real Estate Investment Trust) sectorand the efficiency of that component of the real estate market

The efficient market hypothesis holds that market prices fully reflect all availableand relevant information, and that it is typically unprofitable for investors to try to “beatthe market.” This is intuitive: If all traders in a given market have access to the same set

of information, and no onerous “frictions” (high commissions, taxes, regulations, etc)preclude a buyer or seller acting on their “new” positive (for the buyer) or negative (forthe seller) information, then trading profits are theoretically eliminated with the first fewtrades after the arrival of “new” information One can quickly envision the securitiesmarkets being relatively efficient (with stock prices quickly responding to news of greatearnings or the arrest of the firm’s chief executive) and the real estate market being farless efficient Real estate just does not “trade” in the same fashion as shares of stock

The semi-strong form of this theory holds true in the capital markets, particularlythe US equity market The semi-strong form of this theory suggests that prices reflectpublicly, but not privately, available information The strong form, maintaining thatprices reflect all information – both public and private – does not, by legal mandate, hold

It is generally against securities laws for individuals to trade based on their privateinformation, and thus that information is not typically “imbedded” in securities prices.The rapid and dramatic response of stock prices to new and significant news is strongevidence both that the strong form does not hold and that investors, despite the jadedremarks of the popular press, generally do not trade on inside information.

In the real estate market, conditions are less “perfect,” than in the capital markets

A perfect market is one where there are no costly “frictions.” Costly frictions includetaxes, transaction costs (commissions), government regulations, abbreviated informationflows, heterogeneous products and a limited number of buyers and sellers Real estateitself is broadly considered an inefficient and imperfect market, with prices beingrequired to overcome copious and costly frictions The introduction of REIT’s – asecuritized ownership form for real estate – was designed in part to overcome theseinefficiencies and imperfections Given the greater costliness to a buyer or sellerdelivering good or bad information to the market with his real estate trade, trades often donot take place, and prices do not reflect “available and relevant” information Forexample, it may be attractive to an investor to trade on a 10% pricing disparity in thestock market, but such a “spread” often does not even cover the cost of the trade in realestate

1.2 The Efficient Market Hypothesis

The foundation of the EMH is that all available information is quicklyincorporated into a company’s stock price Fox (2002) explains that this efficient markets(EMH) theory, first offered by Samuelson in 1965 and then expanded by many others,states that security price movements are random because information impacting the value

of a given security is already reflected in its price Prices change only in response tonews, which by definition is unpredictable The theory holds that the random nature ofthe market is what makes the market “unbeatable” by even the most practiced investors.

The idea of an efficient market operates on several assumptions Rattiner (2002)explains that in order for a market to be efficient it must first satisfy four conditions: 1) Alarge number of contending participants who are actively analyzing securities; 2)information arrives to the market fresh and in a random manner; 3) investors adjust tonew information quickly in an unbiased manner; and 4) expected returns implicitlyinclude risk In the capital market of stocks and bonds, theses conditions for an efficientmarket are generally met, allowing the semi-strong form of the EMH to hold true in mostcases

As implied above, the EMH was eventually broken down into three differentlevels of efficiency, weak form, semi-strong form, and strong form The weak form ofthe EMH states that stock prices reflect all available past share price data, and anyinformation about future price movements contained in past movements is alreadyincorporated into the current share price; the chartist or technician looking for predictivepower in past pricing and volume data – attaching importance to levels of pricing

“resistance” – is wasting his time Rattiner (2002) explains that the weak form assumesthe independence of security returns, and that the correlation between stock prices overtime is “virtually nothing” Under the weak form, technical analysis of past stock pricemovement provides no competitive advantage

The semi-strong form of the EMH holds that stock prices fully reflect all publicinformation; therefore fundamental analysis of a stock provides no benefit to the investor

Under this theory, past share price information and any beneficial fundamentalinformation about a company is already discounted in the share price Findlay andWilliams (2000) note that any hunt for a second or “true” value to compare with thecurrent market price in order to find a stock that is “cheap” or “dear” is pointless.However, the semi-strong form does not contend that no one can achieve superiorreturns; it holds only that higher returns should not be expected (Rattiner 2002)

The final version of the efficient market hypothesis is the strong form This formstates that all possible information about a stock price is considered in the price,including inside information With this form, even insiders with information unknown tothe rest of the investment world cannot beat the market Rattiner (2002) elaborates on theweak form saying that even if investors beat the market with inside information, they willmore than likely fail in other attempts, preventing them from achieving consistentsuperior returns The strong form advocates a lack of necessity for investment managers

since analysis of all possible information offers no advantage to an investor.

The level of market efficiency increases from the weak form of the EMH to thestrong form Each form also holds the previous form to be true so the strong form is thehighest level of efficiency a market can operate under according to the EMH A keyfactor in market efficiency is the flow of information In order for a share price tocurrently reflect all available information, this information must be able to flow quicklyand accurately, through a large and active market free of costly frictions There are manyparticipants in the market, each having access to a wealth of this “information.” Investorsgather information through investment firms, brokers, newspapers, magazines, and ofcourse, the Internet The Internet has allowed investors to gain access to an even larger

measure of information with speed and ease unrivaled by most any other source Theability of participants quickly to take advantage of this information allows markets tobehave efficiently New information is discounted into share price appropriately,precluding the market’s “missing” the correct price Therefore, it is generally too late toprofit on news by the time one hears of it (Findlay 2000)

The US equity market is one of the most highly analyzed markets in the worldand many investors employ techniques every year to “beat the market.” The efficientmarket hypothesis has led many investors to believe in the efficiency of the market andthe futileness of market timing and other techniques Fox (2002) points out how the logic

of the EMH has led to the creation of many index funds that aim to “mimic” the market,rather than to try and outperform it There are many ideas about the effectiveness of theEfficient Market Hypothesis, particularly about the US equity market and its efficiencyunder the theory’s provisions An entirely different set of trading beliefs populate the realestate community, and these beliefs manifest themselves in the trading behavior of thereal estate market; seeking to emulate the efficiency of the securities markets, the REITwas introduced to allow the more efficient trading of real estate

The introduction of REITs to the market has improved efficiency with a morehomogeneous, liquid product; however, research still shows that the real estate market ismuch less efficient than the capital markets It is towards a better understanding of thisresearch that the following pages are dedicated We consider the extant literature onREITs and examine an exhaustive REIT data set towards that “better understanding.”

Chapter 2

A Review of Capital and Real Estate Market Efficiency:

A Look at the REIT Market

2.1 Objectives of Chapter Two

In this chapter, the efficiency of the equity markets is re-introduced, and selectedresearch on the EMH is considered The efficiency of the real estate market is thenexamined; it is contrasted with the securities markets and patterns of increasing efficiency

in the real estate markets are reviewed Much of this “pattern of increased efficiency”can be attributed to the trading of shares of REIT’s; these shares, their introduction andelements of the research on REIT’s are considered as the chapter comes to a close with areview of the performance of REIT’s and their contribution to the investmentenvironment in the United States

2.2 US Equity Market and the EMH

The U.S equity market operates at a certain level of efficiency The three forms

of efficiency provided by the EMH are considered below in order to underscore thisefficiency Studies by Brock et al (1992), extended by Bessembinder and Chan (1998),look at the implications of technical analysis and the strength of weak form efficiency Inaddition, Malkiel and Radisisch (2001) examine the performance of index funds incomparison with actively managed funds to investigate the semi – strong form ofefficiency The strong form of efficiency is a more problematical concept to research due

to the illegality of “insider trading” Adequate data for such research is difficult to find,though actions to “uncover” strong form efficiency, with adjacent prosecutions, are beingmade New York’s attorney general, Eliot Spitzer, is unearthing more and more tradingscandals In terms of the general consensus on the Efficient Market Hypothesis and the

US equity market, investors tend to feel that the weak form holds true, semi – strong formholds fairly true, and that strong form efficiency does not hold.

Technical analysis of the U.S equity market is a widespread and daily pursuit byinvestors Many different strategies to outperform the market are based on technicalanalysis of past price returns and movements These actions violate the weak formefficiency of the EMH, yet still much research has been done on technical analysis ofsecurities Bessembinder and Chan (1998) follow up on a 1992 study by Brock et al.dealing with findings of simple forms of technical analysis containing significant forecastpower for U.S equity returns They confirm the results found in the study; however theyprovide that the forecast power is not exclusively due to return measurement errors fromnonsynchronous trading, and that this evidence can “co-exist” with the idea of marketefficiency Bessembinder and Chan conclude that there is little basis to the data provided

by Brock et al as proof of market inefficiencies, and that the evidence of this technicalforecast power can be consistent with the weak form efficiency In general, despite manystudies examining possible inefficiencies found with technical analysis, the U.S equitymarkets appear weak form efficient

Another aspect of securities that is often scrutinized is the fundamental data of acompany Many investors investigate the financials of a company and its businessoperations in order to assess the future performance of their stock The semi-strong form

of efficiency and research showing a large number of investors unable to consistentlyoutperform the market has led to the rise of index funds Market enthusiasts are turning tothe Efficient Market Hypothesis that provides that the market is far better “equipped” toassess the U.S companies than any analyst (Fox 2002) The performance of market

imitators is examined in a study by Malkiel and Radisisch (2001) Their researchprovided that even if the market weren’t entirely efficient, active management as a wholecannot ensure dependable returns above the market, and therefore active managers willtypically under-perform the indexes by the amount of their “expense and transaction costdisadvantage.” Malkiel and Radisisch conclude that the variance between theperformance of index funds and active managers is completely explained by the extramanagement costs and transaction costs associated with active management Theyconstitute that the success of indexing is due to the overall efficiency of our stock market.Managers still use fundamental analysis as a tool when comparing securities andsometimes gain a competitive advantage in doing so However, research tends to provethat in the long run, active managers are unable to consistently achieve returns greaterthan the market, holding the semi strong form of efficiency to be true.

The most difficult feature of the Efficient Market Hypothesis is the strong form,stating that all private or “insider information” is already reflected in the stock price.Most investors find this form of efficiency to fall short, since insider trading can and hasgiven traders an advantage in predicting stock price movements Trading scandalsinvolving Martha Stewart, large mutual funds, and other companies are being preventedwith tighter regulations and higher levels of inspection Legal restraints and tradingrestrictions, if effective, present the security markets from ever being strong-formefficient

In 2003, New York’s attorney general Eliot Spitzer “tore” into the mutual fundindustry for allowing high-dollar clients to make trades that ordinary investors weren’t

able to (Kosova 2004) Fervent actions taken by Spitzer and the SEC (SecuritiesExchange Commission) are helping to eradicate insider trading

The U.S equity market may, in general, be deemed an efficient market, but eventhe most avid supporter of the Efficient Market Hypothesis will admit that the marketdoes have its moments of inefficiency Shleifer (2000) sums up the U.S equity market’sefficiency by pointing out that not only individual investors trail the benchmarks like the

S & P 500 by 2-3% a year Most all the mutual and pension funds also fail to regularlyoutperform the market Shleifer alludes to a particular example involving the pricing ofRoyal Dutch Shell He concludes that the inefficiency in the pricing of Shell showsdeviations from market efficiency can be significant He notes that in an inefficient,market, active management of investments is worthwhile in the long run, as value stockshave in fact brought greater returns than growth stocks over longer time periods

Fox (2002) points out an interesting aspect of the EMH, which is that for a market

to sustain efficiency there must be many rational investors who believe enough in theinefficiencies of the market to spend their careers trying to outperform it He introduces

an evolving new theory in finance - behavioral finance Fox explains that behavioralfinance recognizes that stock market investors are sometimes irrational, that future pricemovements are in some ways predictable, and that close examination of past trends andfinancial reports can give investors an edge Even in a market that is deemed overall as

“efficient,” anomalies do occur, and investors may be able to exploit possibleinefficiencies in the U.S equity market and elsewhere

2.3 Real Estate Market Efficiency

Real estate is not so efficiently situated as the securities markets in the UnitedStates It is becoming an asset that more and more investors are turning to when building

a portfolio This increased investor interest has led to many academic studies of thebehavior and performance of real estate Most of these studies examine thecharacteristics of real estate return in relation to real estate market efficiency Research

on market efficiency has focused on elements such as distribution of returns, returnpredictability, macroeconomic variables that influence returns, different methods ofcalculating risk and returns, and the returns of specific property types (Benjamin,Sirmans, Zietz (2001)

Overall, the real estate markets are much less efficient than the market for stocksand bonds Graham (2003) classifies seven different areas where real estate marketimperfections lead to inefficiencies First, information flows in real estate are much moreconstrained and infrequent than in the capital market In a study comparing real estateinvestment trusts to the stock market, Wang, Erickson and Chan (1995) note that the realestate market does not provide the same level of services such as information distribution,activity monitoring, and pricing processes as the capital markets

The second area with market imperfections leading to inefficiencies that Graham(2003) points out is the government regulation arena in real estate He notes that thereare many more regulations and restrictions regarding real estate and its transactions Thisadds constraints to the market, causing inefficiencies Transaction costs in the real estatemarket are the third element in which imperfections exist There are much higher feesand more extensive transaction costs when acquiring real estate when compared tobuying stocks and bonds A fourth cause of market inefficiency in real estate is the much

smaller number of buyers and sellers in this market The large number of investorsactively trading in the capital market is a leading factor for keeping the market

“efficient,” so the fewer participants and smaller transactions in the real estate marketlimit its efficiency

A fifth imperfection in the real estate market is the lack of homogeneity in realestate assets Stocks are a much more homogeneous product, allowing investors to valuesecurities quickly and accurately Pieces of real estate are unique, retaining differentvalues even when properties are very similar Real Estate Investment Trusts haveimproved this area of inefficiency by providing more homogenous investments that aretraded like stock However, Miles (1998) points out that even the assets of REITs cannot

be viewed in general since the industry is now made up of many heterogeneous firms thatvary in size, property type, focus, and other characteristics This non-homogeneousnature of the real estate market compared to the capital market plays an important role intheir efficiency differences

A sixth area of imperfection for the real estate market causing reduced efficiency

is the illiquid nature of real estate Buying and selling traditional real estate is not nearly

as easy as trading stock in the capital market Real estate investment can be an involvedprocess, dealing with appraisals, leases, brokers, zoning, closings, and more The ability

of an investor to quickly turn real estate into cash is limited when compared toinvestment vehicles like stocks and bonds REITs have greatly improved thisimperfection by allowing a much more liquid way for investors to participate in the realestate market

The final area of imperfection is the overall fixed nature of real estate Real estate

is, by definition, an immobile asset, set to remain in one location International realestate investment is even more complex as the asset is located abroad An investor caninvest internationally in the capital markets simply by purchasing foreign stock

In general, the real estate market is seen to be much less perfect than the capitalmarkets To summarize, the imperfections leading to inefficiencies in the real estatemarket can be classified in seven areas, as compared to the capital markets:

1 Information flows in real estate are much more constrained and infrequent

2 Government controls are more restrictive and numerous in the R/E market

3 Transaction costs in R/E include higher fees and more costs

4 There are fewer buyer and sellers of real estate on any given day, than there

are of securities on that same day

5 Real estate is a much more heterogeneous product than are stocks, makingvaluations and comparisons more involved and difficult

6 Real estate is far less liquid than capital market securities

7 Real estate is fixed and forever immobile

2.4 The REIT market

The financial markets experienced the introduction of real estate investment trusts(REITs) in 1960 Creation of REITs was made possible by federal legislation thatprescribed the “structural and dispositional” requirements under which they must operate(Zeitz, Sirmans and Friday, 2003) These investment vehicles allow investors toparticipate in the real estate market while enjoying the liquidity and marketability ofstock Since the introduction of REITs, much research has been done on the performance

of these investments Academics have empirically and theoretically examined REITs in

order to better understand their characteristics, finding many different results on thebehavior and performance of REITs

Zietz, Sirmans, and Friday (2003) offer an extensive review of the literaturedealing with REITs and the real estate market Their study examines and organizes themany different studies since 1995 on REITS in order to better understand the findings onthe REIT market This review uses their study as a guide to help better review the currentinformation about the REIT market

As REITs become a more widely used vehicle in the diversification of investmentportfolios, there is more research being done on whether REITs are more like real estate

or stock Public REITs, sharing the same structure as stock, are compared to private realestate investments in a study by Hartzell, Stivers, Ludgin, and Pire (1999) Their workexamines different levels of public and private real estate, considering four differentscenarios of risk and return conditions Mueller (1998) notes that if investors are lookingfor the long-term stable income and price appreciation characteristics of real estate bybuying REITs, then they should focus on active operating REITs to provide thesebenefits Mueller and Laposa (1996) question whether REITs are real estate or stock intheir study of different return characteristics for various property-type REITs Their workfound REIT property types moving very closely from 1972-1985, but since then returnsare digressing more across property types

Several studies have recently examined the REIT market and its relationship withother markets Wang, Erickson, Gau, and Chan (1995) find the level of institutionalinvestor participation in REIT stocks lower and that they are watched by fewer securityanalysts than the stock market in general Young (2000) finds that grouping Equity REIT

(EREIT) portfolios by property type reveals increasing integration Li and Wang (1995)find that the REIT market is more integrated with the general stock market Whencomparing public real estate to the capital markets a positive correlation between REITsand U.S stocks was also found in a study by Mull and Soenen (1997) Ling and Naranjo(1999) research whether there is evidence of integration between direct real estate,REITs, and common stocks by employing multi-factor asset pricing techniques Theirstudy finds non real estate equities to be integrated with REITs; however, the direct realestate market provides no evidence of this relationship Oppenhiemer and Grissom(1998) find that REIT price movements are strongly influenced by Treasury debt andstock indices They provide evidence contrary to the popular idea of using REITs as ahedge against inflation, revealing strong co-movement of stock indices and REITs.However, a recent study by Chen (1999) finds that simple correlation statistics revealvirtually no systematic relation between new REITs and the S&P Mid-Cap Index Betas

of equity REITs tend to be generally low, suggesting that REITs are exposed to manydifferent risk factors and these factors differ from the ones that are at play in the rest ofthe stock market

Much of the research devoted to REITs compares return behavior to other assets.Marer (1999) notes the function of REITs as generators of stable long-term income.Liang and MacIntosh (1998) draw comparisons between the REIT markets and the otherinvestment markets, finding that REIT portfolios perform most like portfolios of 40%small capitalization stocks and bonds with 60% in Treasury bills Wang, Erickson, andChan (1995) disclose that the behavior of REITs reflects that of small and value stocksrather than growth stocks However, Li and Wang (1995) find REIT returns to be no more

predictable than stock returns in a study of equity and mortgage REITs over a 20-yearperiod ending in 1991

The behavior of REITs in comparison to other markets has changed over time.Chen and Peiser (1999) find that REITs in general did not perform like small firms inJanuary from 1978 to 1996 This study suggests that REITs are becoming less likeunknown small firms as more investors become interested in the REIT market Glassock,

Lu, and So (2000) remark that REITs have exhibited more stock like behavior since 1990and behave less like bonds He (1998) finds evidence supporting ideas that a causalrelationship exists from Equity REITs to Mortgage REITs, also ruling that the two sectorsshow evidence of cointegration Friday and Higgins (2000) research the timing effects

on the performance of REITs, finding that equity REITs behave like most other securitiesnear the weekend

Legislative changes involving REITs also play a role in whether REITs are morelike real estate or stock Mueller and Ainkeef (2001) comment on the 1999 REITModernization Act, which reduced the 95% required payout of REIT’s funds fromoperations to 90% This has freed up capital for many REITs to become more involved inoperating businesses other than renting real estate through new taxable REIT subsidiaries(TRS) In addition, a new Taxable REIT Subsidiary law became available in 2001,allowing even more freedom for combining ownership of real estate with operations.REITS combine “operations income with real estate rental income” after the legislation

of 1999 The research concludes that greater volatility in income results.Hotel and retailREITs’ returns were the most volatile and had lower risk adjusted returns The studyquestions some REITs as a replacement for direct property investments; showing that

REITs that add other operations income to their “bond like lease incomes” contain returncharacteristics that are bound to be more volatile The changing legislation on REITswill continue to have effects on their performance.

Seiler, Webb, and Myer (2001) examine EREITs performance Their researchfinds that replacing private real estate with EREITs to rebalance a private real estateportfolio has little balancing benefits The study holds that EREIT’s lower transactioncosts, higher liquidity, and public nature do not play enough of a role to effectivelyrebalance private real estate portfolios Instead, public real estate (EREITs) should beheld based solely on return and risk characteristics, analyzing them more as stock,government securities, or bonds would be viewed

2.4.1 Performance of REITs

Much of the research devoted to real estate examines the performance of differentassets As investors increase their participation in the real estate market, the changingperformance of REITs is becoming a highly studied topic Here many of the studiesdealing with the performance of REITs are examined For a period from 1993 –1997REIT stocks were outperformed by both the S&P 500 index and the S&P MidCap index(Chen and Pieser 1999) This study also showed that new REITs, created after 1993,performed better than old REITs while both carried similar risk characteristics Ghosh,Guttery, and Sirmans (1998) present a study of the contagious performance of REITsecurities in relation to real estate news about financial institutions’ real estate portfolios.The study finds that REIT stocks incur considerable “valuation losses” around theannouncement of falling real estate values Redman and Manakyan (1995) useCOMPUSTAT data to find that variables such as location of properties, financial ratios,

and types of real estate investments, are significant in establishing risk-adjusted REITreturns Their study also maintains that REIT returns cannot be explained by thefinancial variables specific to common stock and REIT size

Some studies on REITs look at the performance benefits of including REITs in aportfolio Jacobius (2203) explains how a recent study by Ibbotson Associates for theNational Association of Real Estate Investment Trusts found that combining direct realestate with REIT stocks equally could improve institutional portfolio performance by anaverage of 27 basis points This return is in comparison to portfolios holding only one orthe other of these real estate asset classes However, Glasscock, Lu and So (2000) affirmthat since 1992, the diversification benefits for REITs have declined

Liao and Mei (1998) find the predictability of expected excess returns of realestate-related securities greater than comparable returns of value-weighted stocks andbonds Friday and Peterson (1997) find that some tax-loss selling is attributed to theJanuary seasonal effect for REITs of all sizes and property types; however, REIT stocksthat have higher levels of investor interest and participation outperform other REITstocks Nelling and Gyourko (1998) evaluate the predictability of monthly returns ofequity REITS by running a time series regression with small- and mid-cap companies.Based on past performance, they find monthly equity REIT returns are predictable,though transaction costs still outweigh the possible benefits from this finding Research

by Goldstein and Nelling (1999) concludes that REITs provide a good way to reduceportfolio risk due to the lower betas of equity and mortgage REITs than those of othersecurities A study by Clayton and MacKinnon (2001) find EREIT returns to haveconsiderable sensitivity to bonds, small and large cap stocks, though this relationship

varies over time Graff and Young (1997) find that REIT returns are negatively influenced

by investor movement in and out of large REITs

Several studies examine the returns of REITs in relation to size, marketcapitalization, and property types Brounen, Eichholtz and Kanters (2000) look atproperty development in equity REITs, finding a high average market capitalization fordeveloping REITS This study also finds that on a risk-unadjusted basis, propertydeveloping REITS earned higher returns than the NAREIT index Mueller (1998)examines small-cap, mid-cap, large-cap, and mega-cap REITS and finds that throughproperty development and acquisition it is easier and less risky for all but the mega-captypes to produce higher earnings per share growth and returns Some studies look atREITs controlling commercial property Capozza and Lee (1995) look at retail andwarehouse/industrial REITs and discover that the average REIT trades below retail REITsand large REITs; while warehouse/industrial REITS trade at a discount to the averageREIT Their study employs two-way analysis of variance and finds that higher cash flowyields cannot be expected from these premiums and discounts from net asset values.Mueller and Anikeef (2001) use regression with several commercial property type returns

to find that hotel REITs have weak performance where rents are associated with hoteloperations Their study also indicates that lower risk-adjusted returns are found whereretail mall and outlet REITs have rents connected to sales Martin (1998) analyzes officeREIT stocks and finds that retail, warehouse, R&D and apartment stocks, due to the rapiddepreciation of new high-rise office properties, consistently outperform office REITreturns His study contends that office REIT stocks should be avoided in a portfolio

2.4.2 The Efficiency of the REIT Market

The REIT market is relatively new compared to other securities markets, and hasbeen growing rapidly since its creation Investor participation in REITs is still lowrelative to stocks and bonds There were few REIT stocks to trade until the 1990’s, with

a flurry of IPO’s and secondary offerings of REITs (Chen and Pieser 1999) There were

43 REIT IPO’s in 1993 with 38 REIT IPO’s in 1994 Since fewer security analystsmonitor REIT stocks, they not only have a lower level of institutional participation butalso have much lower turnover ratios (Zietz 2003)

Research on the nature of REITs has led to many questions about theirperformance characteristics Marer (1999) finds that most analysts feel the REIT markethas matured after some early difficulties, and REITs purchased for the right reasonsshould be able to weather the ups and downs better than the rest of the market Thisconsensus has led to much research on REITs, including the examination of possiblepricing-inefficiencies

Studies on the past behavior of REITs help to explain the efficiency of REITs inthe stock market Mueller (2000) point out that during falling REIT prices in 1998-1999analysts rationalized low prices as fundamentally driven, predicting that the “efficient”public market constantly forecasts private market behaviors However, during that timeperiod U.S real estate showed strong fundamentals, suggesting pricing inefficiencies inthe REIT market A study by Grobel and Ma (1993) considers the perception that REITstrade below their net asset values, suggesting price inefficiencies The study finds thatREITs trade at around 77% of their net asset values for the 1972-1992 period Anotherstudy by Kuhle and Alvayay (2000) finds evidence of inefficiency in REIT pricing, aswell They propose that new market information is slowly and inadequately included in

prices, with investors responding sluggishly to new information This subduedinformation processing allows only a small portion of the investment community tobenefit from the newly arriving data

Other evidence for the REIT market being inefficient is found in studiescomparing REITs with other financial markets Different conclusions have been made onhow changing interest rates influences real estate, and studies have been done on theeffects of monetary policy on REIT performance Research by Darrat and Glascock(1989) examines this potential correlation, finding a significant lagged relationshipbetween REIT returns and monetary policy Their study suggests a possible tradingstrategy based on past monetary data to exploit these patterns; questioning REIT marketefficiency Mueller and Pauley (1995) find a low correlation between REIT returns andchanging interest rates, with a higher correlation to the movements of the general stockmarket They conclude that interest rates do not have a significant impact on REITprices, making them as good of an investment as the stock market during periods of risinginterest rates

In contrast to evidence for inefficiencies in the REIT market, there is also muchresearch supporting a premise proposing an efficient REIT market A study of interest-rate effects on REITs supports the efficient market theory: Johnson and Jensen (1999)examine patterns between the Federal Reserve Monetary Policy and REIT returns Theirresearch finds return patterns between the two that are consistent with market efficiency.They find real estate to behave efficiently with changing monetary policy, sharing similarreturn characteristics with stocks and bonds Liang and Anderson (2001) find thatevidence for REITs trading at discount to their net asset values (NAV) is not significant

enough to develop a successful trading strategy based on this factor They find that bythe time an investor is actually able to trade the companies deemed “discount” to theirNAV, the price will have converged to or near its NAV Another study by Hun and Liang(1995) looks at REIT returns in comparison with the Security Market Line (SML) TheSML is the locus of points predicted by the Capital Asset Pricing Model, which pointsdescribe the risk-adjusted expected returns for any asset in the universe of risky assets.The research by Hun and Liang examines the long-term performance of REITs (1970-1993), paying close attention to their stability over this time period Performance of theREITs proved to be consistent with the SML, suggesting that in the long-run REITs areefficiently priced

Overall, the general consensus on whether REITS are efficient investmentvehicles is mixed Much of the research done on market efficiency has involved the stockand bond markets However, there are several studies examining the behavior of REITs inthe financial markets A lower level of investor-participation with REITs has led tolimited studies on REIT efficiency, making conclusions about current research difficult

Data examined in the above-mentioned studies include the measures considered inthe following chapter

Chapter 3 Fundamental Analysis of REITS on the NYSE

3.1 Outline and Objectives of Chapter 3

In this chapter a wealth of measures of such factors as asset values, returns toinvestors, employment and debt-use by real estate investment trusts are presented TheREITs are compared and contrasted to one-another and across industries A number ofconclusions are reached

The measures provided in Tables 1-9 are developed entirely with data donated tothe Cameron School as a direct result of this Honors Project The data are drawn fromthe Morningstar – Principia data sets; these data are ubiquitous in the financial press, andare widely regarded to be among the most reliable sets of data for financial analysis in theindustry The data’s acquisition, accomplished by the Department of Economics andFinance, is described in Appendix 1 In Appendix 2, an exhaustive set of data ispresented; it is from that data set in the second appendix that the measures in Tables 1-9are drawn

3.2 Table 1: NYSE REIT Asset Size by Industry Sector

All data provided in this study are gathered as of the end of January 2004 Details

on the data development are available from the author on request Measures are given forreal estate investment trusts traded on the New York Stock Exchange (NYSE) for whichadequate data are provided to generate the selected measures The first set of measuresgiven in Table 1 provides information on real estate investment trust asset sizes byindustrial sector Total assets are often looked at in context, and are most useful in

Table 1 NYSE REIT Asset Size by Sector, Jan 2004

Total Assets Qtr 1

Health Care $ 1,098.56 $ 142.00 $ 2,832.40 Retail $ 3,022.08 $ 391.50 $ 15,105.00 Industrial / Office $ 3,428.08 $ 126.60 $ 24,888.40 Lodging / Resort $ 2,246.75 $ 374.00 $ 8,332.00 Residential $ 3,165.98 $ 238.60 $ 11,990.10 Mortgage $ 6,267.98 $ 440.40 $ 17,287.40 Specialty / Storage $ 1,668.80 $ 279.60 $ 4,742.20 Diversified $ 3,837.49 $ 847.10 $ 9,077.30

Notes: Total Asset Qtr 1 based on Morningstar Principia data as of January 31, 2004.

Assets are in millions of dollars and shown for the most-recent quarter and the past two fiscal years, total assets are all company-owned resources that are expected to provide benefits to that company's business

conjunction with other measures, such as total liabilities (total assets – total liabilities =total equity or book value) Data in Table 1 shows that the smallest publicly-traded REIThas reported total assets of $126.6 million; the largest REIT reports total assets of $24.9billion Both the smallest and largest REITS, by asset size, are from the Industrial/Officesector This sector includes REITs owning office buildings, manufacturing plants,industrial parks, etc The Health Care sector includes REITs that own and/or operatehospitals, medical centers, nursing homes, assisted living facilities, etc Retail REITs ownand/or operate shopping centers, malls, retail outlets and supermarkets TheLodging/Resort sector involves primarily hotels, resorts, and other lodging facilities TheDiversified sector handles a combination of real estate property types, such as retail,office, and lodging Residential REITs handle properties such as apartment complexes,neighborhood developments, and homes The Specialty/Storage sector includes REITsowning commercial warehouses, storage centers, correctional facilities, and other uniqueproperties Mortgage REITs primarily handle mortgage-backed securities

3.3 Table 2: NYSE REIT Revenue by Sector

Table 2 NYSE REIT Revenue by Sector , Jan 2004

Revenue TTM

Health Care $ 149.86 $ - $ 396.20 Retail $ 438.58 $ 57.30 $ 2,327.90 Industrial / Office $ 497.07 $ 15.90 $ 3,361.50 Lodging / Resort $ 781.72 $ 90.50 $ 3,639.00 Residential $ 487.28 $ 51.70 $ 1,995.30 Mortgage $ 224.32 $ 67.80 $ 527.70 Specialty / Storage $ 438.26 $ 30.60 $ 1,115.80 Diversified $ 616.26 $ 110.10 $ 1,522.00

3.4 Table 3: NYSE REITs Market Capitalization and Average Trading

Table 3 NYSE REITs Market Capitalization / Average Trading

Volume by Sector , Jan 2004

Market Capitalization Avg Trading Volume

data as of January 31, 2004 Market capitalization is the current stock-market value

of a company's equity, in millions It is calculated by multiplying the current share

price by the number of shares outstanding as of the most recently completed

fiscal quarter Avg Trading Volume is the average daily trading volume of common

shares during the trailing 12 months This is expressed in unit shares.

In Table 3, the market capitalization and average daily trading volume arepresented Market capitalization is an often-used indicator of a company’s size.Companies with market caps of less than $1 billion are often referred to as small-capstocks, while market caps of more than $5 billion generally denote large-cap stocks.Trading volume is also used when examining securities A stock with a high dailyvolume is a stock that is widely recognized by the market, or, in some cases, was oncehighly valued and has experienced a fall in value resulting in a high number of sell-offs.Conversely, a stock with a low average daily volume is likely to be a stock in which there

is little interest Relative size or lack of name recognition may also contribute to a lowaverage daily volume The set of measures in Table 3 provides information about bothmarket capitalization and trading volume

The Diversified sector had the largest capitalization average of $2.406 billion,with the Mortgage sector showing the smallest of $898 million Mean and median

Table 4 NYSE REIT Financial Leverage by Sector , Jan 2004

3.5 Table 4 NYSE REIT Financial Leverage

In Table 4, financial leverage data is given in Table 4 Financial leverage measuresthe extent to which a company’s assets are financed by debt Here the leverage measureconsists of a company’s total assets divided by total shareholder’s equity Data in Table 4shows the most highly levered REIT to be from the Mortgage sector with a 13.7 financialleverage value, while many REITs from the Health Care, Retail, Industrial / Office, andResidential sectors exhibit no financial leverage measures The Mortgage sector ofREITs holds the highest average leverage value of 8.433 and the Health Care sectorreports the lowest average financial leverage of 1.973 assets to equity

A mean measure in the Health Care sector of 1.973 suggests the average firm inthat sector uses $1.97 in assets for each $1 of book-value equity

3.6 Table 5 NYSE REIT Payout Ratio

Table 5 NYSE REIT Payout Ratio by Sector , Jan 2004

Notes: Payout Ratio based on Morningstar Principia data as of January 31, 2004.

Payout ratio is defined as the dividends per share for the trailing twelve months divided

by the earnings per share TTM

Data in Table 5 provides information about the payout ratios for the REITs Thehigher the payout ratio, the more of its earnings a company pays out as dividends As acompany matures, it tends to run out of attractive investment opportunities, so you canexpect it to pay out the bulk of its earnings as dividends rather than plow the profits backinto its business However, tax legislation for REIT’s require that 90% of all funds fromoperations for the company be paid out to investors in the form of dividends, so payoutratios are considerably higher for REITs than other industries

The highest payout ratio of 9.871 belongs to a REIT from the Residential sector.That payout ratio suggests the firm has paid out, over the TTM, a “dividend” equal to 9.9times the funds from operations for that same period Federal tax legislation allowing notaxation of REITs at the corporate level requires a payout of only 9, so firms are not

Table 6 NYSE REIT Dividend Yield by Sector , Jan 2004

Notes: Dividend Yield based on Morningstar Principia data as of January 31, 2004

This Dividend Yield % is calculated by dividing total dividends by the current price and

multiplying by 100 The total dividends are as of the most recent month-end.

required to and cannot, by definition, long sustain payout ratios greater than one Notealso that dividends from REITs are specifically excluded from the special 15% taxtreatment included in the recent tax reduction package

Over time, all the REIT sectors are expected to have payout ratios of “around” 9,and data in Table 5 imply that this requirement is likely met by the listed firms Thehighest current payout is in the Health Care sector and the lowest payout is seen in theMortgage sector

3.7 Table 6 NYSE REIT Dividend Yield

Table 6 provides data on the varying dividend yields for each real estate investment

trust sector Dividend yield shows the percentage of its stock price a company pays out

as dividends High dividend yields are often indicative of value stocks or of companiesthat are distressed However, as earlier stated, REITs are required to pay out 90% oftaxable income in dividends so higher dividend yields must not always be interpreted as awarning sign Data in Table 6 reveals that the highest dividend yield % of 10.90 belongs

to a REIT from the Mortgage, with both the Industrial / Office and Lodging/ Resortsectors having REITs with no dividend yields Likewise, Mortgage REITs hold thehighest average dividend yield % of 7.08 and Lodging / Resort REITs carry the lowestaverage dividend yield percentage of 3.26

Table 7 NYSE REIT P/E and PEG ratios by Sector , Jan 2004

P/E Ratio PEG Ratio

by the mean EPS estimate for the current fiscal year The denominator is the average

estimate of long-term EPS growth, derived from all polled analysts' estimates.

P/E : current price divided by earnings per share

3.8 Table 7 NYSE REIT P/E and PEG ratios by Sector , Jan 2004

Table 7 presents data on both the current Price/Earnings (PE) and Projected EarningsGrowth (PEG) measures By comparing the industry’s average P/E to the current P/E,you can quickly tell whether a company is currently valued above or below the industryaverage P/E PEG gives an indication of how cheap or expensive a stock is comparedwith its forecasted growth rate Because it is ratio of P/E to earnings growth, PEG allowsinvestors to compare companies with different growth rates Data from Table 7 showsthat the highest average P/E ratio of 38.59 is in the Diversified sector of REITs, while thelowest average P/E of 8.95 belongs to the Lodging/Resort sector The highest averageprojected earnings growth figure of 4.09 is found in the Health Care sector MortgageREITs exhibit the lowest average PEG ratio of 1.43 The expectation, met in Table 7, isthat the P/E measure is “smoothed” when an allowance is made for growth