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Performance Evaluation of Finite-Life Real Estate

Performance Evaluation of Finite-Life Real Estate - THE...

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Unformatted text preview: THE JOURNAL OF REAL ESTATE RESEARCH Performance Evaluation Paul R. Goebel" of Finite-Life ‘Real Estate Kee 5- Kim“ Investment Trusts Abstract. This study analyzes the investment performance of real estate invest- ment trusts, comparing the finite-life trusts (FREIT) with traditional REITs and stock returns. The results indicate that the FREITs performed more poorly than the REITs, with both the FREITs and REITs underperforming the market index over the period studied. It was also found that while portfolio risk diversification benefits may exist for the REITs and FREITs, it is not clear that the reduced risk is warranted by the large reduction in returns. Finally, this research shows that little total or unanticipated inflation hedging capability exists for the REITs or FREITs over the period studied, although anticipated inflation hedging capabilities were found. Introduction Investment in real estate, and specifically real estate investment trusts (REITs), has re- ceived wide attention in recent academic research. Several studies [7, 22, 23] have compared the performance of REITs to stocks and bonds, while other studies [1, 9, 15, 19] have ex- amined commingled real estate funds (CREFs) or real estate limited partnerships (RELPs) in terms of their inflation hedging ability and diversification benefits. REIT returns have been examined quite extensively, including being analyzed within the framework of market equi- librium models [4, 14, 24]. But very little attention has been given to the performance of finite-life real estate investment trusts (FREITs) in the research literature. The REIT industry has been growing and providing strong returns to investors since a near disastrous period in the mid—19705. Industry sources report that total REIT assets were over $17.5 billion as of January 1987, with $5.2 billion added since 1984 [16]. The increase in REIT market activities has prompted renewed research interest both in terms of performance of REIT stocks and portfolio considerations. The traditional REIT has tended to sell at a discount from its underlying asset value, supposedly due to the uncertainty surrounding the liquidation and realization of value be- ing so far in the future. With the market discounting the liquidation value heavily, the result is that REITs trade very similar to common stocks, with dividend payments constituting a —____________—__.___—-—————-—————— "College of Business Administration, Box 4320, Texas Tech University, Lubbock, Texas 79409. "College of Business Administration, Southwest Missouri State University, Springfield, Missouri 65802. Date Revised—July 1989; Accepted—August 1989. —___—__—_____—____.__.—————-——— 57 58 THE JOURNAL OF REAL ESTATE RESEARCH larger portion of the current market value of the REIT stock. FREIT stocks, while a subset of the REIT industry, are considered quite different in nature given their finite maturity. The first FREIT was offered in 1975, with only seven FREITs offered prior to 1983. Since 1983, 38 FREITs have been placed in the market, where FREITs now account for 28% of the total 138 tax-qualified REITs [17]. Since FREITs have a finite maturity, their value should reflect the liquidation component as well as the dividends, although the liquidation portion would be the lesser of the two in the early years. But as the FREIT approaches its liquidation, assuming appreciation of the underlying real estate held or invested in by the trust, the price of the stock should rise to reflect the value of the real estate. Further, while FREITs have definite deadlines for liquidation, the trustees often have the option of liquidating sooner if market conditions warrant it. This should provide a positive impact on the price of the stock since presumably the trustees could lock into a satisfactory yield prior to liquidation in a favorable market. As a result of these factors, FREITs should be considered less risky to investors, and should provide significant portfolio diversification effects. This paper analyzes the investment performance of FREITs relative to REITs, while also examining the ability of diversification for both classes of trust. The REITs and FREITs will initially be categorized by type, being an Equity, Mortgage or Hybrid trust, with their indi— vidual performances analyzed within the framework of risk and return. Following a review ‘of current literature, the data source, models and empirical results will be presented. The paper will conclude with a summary of the implications of the research. Current Literature Revisited In reviewing previous literature, it is helpful to look at representative studies that examine the return or diversification benefits of REITs relative to other types of investments. It is also of interest to review studies that illustrate the application of the CAPM, or other types of investment performance measures, to an analysis of REITs or other real estate returns. There have been a number of studies reported concerning the investment performance of real estate other than REITs. Brueggeman, et al. [1] analyzed two CREFs relative to invest- ment performance, inflation hedging attributes and diversification benefits. They concluded that real estate generally outperformed stocks and bonds, offered very good portfolio di- versification potential by reducing risk and increasing return, and provided a good hedge against inflation. Miles and McCue [14] analyzed the market returns for a large CREF and the empirical evaluation of the benefits of diversification among the commercial real estate opportunity set. The findings were similar to other studies that show a high correlation of commercial real estate returns with measures of inflation and anticipated inflation, although not with unanticipated inflation. They also found that over the period studied, commercial real estate offered higher risk-adjusted returns than stocks and bonds. One of the earliest papers analyzing REIT returns was by Smith and Shulman [24], where they applied the framework of the capital asset pricing model (CAPM) to REIT returns from 1963 to 1974. They found that REITs, although their return performance was very similar to that of the closed-end mutual funds, provided a significant diversification benefit when combined with other common stocks. A REIT study by Miles and McCue [14] used a sample of equity REIT portfolios to investigate various real estate return performances. Return estimates from 1972- 1978 were reported by property type, size and location. The REIT portfolios were also com- VOLUME 4, NUMBER 2 FlNITE-LIFE INVESTMENT TRUSTS 59 pared with a CREF portfolio in terms of diversification effects. The conclusion was that benefits from diversification by property type appear to exist. Davidson and Palmer [4] also used the CAPM to examine the performance of equity REITS, common stock, and stocks of homebuilding firms from 1972-1977. While they came to no overall conclusions concerning the performance of REITs, they did find that equity REITs had greater total risk than common stocks, and local market conditions may be more impor- tant than overall market conditions in determining the returns of income property. A study by Burns and Epley [2] examined REITs relative to their ability to enhance portfolio returns and diversification. Using an efficient frontier approach, they combined REITs with a di- versified common stock portfolio to find that a mixed portfolio was superior to one consist- ing of either single asset only. Burns and Epley concluded that REIT s offered portfolio di- versification benefits in comparison to common stock portfolios, due primarily to the low correlation of returns between REITs and common stocks. In a study assessing historical risks and returns of REITs and real estate assets, Zerbst and Cambon [26] reported that real estate aSSets showed returns similar to assets such as stocks and bonds since 1950. Further, they noted that real estate assets outperformed the other assets during periods of inflation, with risk levels of REITs similar to that of common stocks. A study by Kuhle, Walther and Wurtzebach [12] updated the performance evaluation of previous REIT studies by analyzing a sample of publicly traded REITs over the period Ian- uary 1973 to December 1985. They found that the performance of the REIT stocks either significantly under or overperformed the Standard and Poors 500 index (S&P 500) during the period studied. They further concluded that the REIT market is somewhat efficient. A study by Kuhle [11] examined the effects of diversification in the reduction of total portfolio risk in REITs, as well as comparing the overall performance between stock and REIT portfolios. The results indicated that REITs did not provide as great a reduction in risk as common stocks did, which is contrary to many of the other studies reported above. How- ever, the study did find that REIT portfolios are more efficient in a Markowitz sense, which the authors interpreted as indicating market inefficiencies in REIT pricing over the time period studied. Finally, the study indicated that the overall performance of mixed portfolios of common stock and REITs was not significantly different from that of portfolios of only common stock, again in contrast to the results of previous studies. Although there have been no studies reported on FREITs, these vehicles are often com- pared in concept to the RELPs. Three recent studies, by Kapplin and Schwartz [9, 10] and Rogers and Owers [19], have reported the returns earned by RELPs over the past decade. These studies basically indicate that RELP returns have not exceeded returns of common stocks or other real estate investments, although there is some evidence that income proper- ties can provide a favorable portfolio diversification effect. FREITs have an advantage over the RELPs given their marketability, as well as not having onerous net worth requirements for investors, limited liability given the corporate ownership format, and the necessity by law of the FREIT passing through any cash flow. However, RELPs could pass through tax shelter benefits prior to 1987, which REITs and FREITs could not do. The results of most studies reported concerning the return performance of REITs is that they often provide risk-adjusted returns greater or equal to other types of investments, while also providing diversification benefits and inflation hedging capabilities. This study not only provides additional evidence for REITs, but also provides an analysis and compari- son of FREIT returns and diversification benefits using methods of analysis similar to previ- ous research. 1989 60 THE JOURNAL OF REAL ESTATE RESEARCH Data and Methodology The data used in this study was obtained from the CompuServe Information Service, Columbus, Ohio, and consists of thirty-two public REITs and FRElTs that were traded on the New York Stock Exchange, the American Stock Exchange, or through the National Association of Securities Dealers Automated Quotation System (NASDAQ). These securities were selected based on several screens, basically being whether each randomly selected security traded during every month of the study period. Annualized monthly returns are calculated by measuring the change in prices between months, adjusting for stock splits and dividends. Portfolios are assembled for the various types of REITs and FREITS where the portfolio returns are then used in the subsequent analysis. Since a limited number of FREITs were traded prior to 1983, the study extends from December 1983 through December 1987. Both REITs and FREITs specialize in the type of investments they make as well as the types of properties in which they invest. A trust that holds at least 75% of its invested assets in the ownership of property or other equity interest is called an Equity (EQ) trust; those that hold at least 75% of its invested assets in mortgages including participating mortgages and interests in mortgage pools are called Mortgage (MO) trusts; while those combining owner- ship and lending so that it is neither an equity nor mortgage trust are called Hybrid (HY) trusts. Exhibit 1 includes a summary of the average annualized weighted portfolio return calculations for the different types of trusts within each class over the period studied. Data existed for all types of trusts over the study period except the Hybrid FREfTs, which only had data for twenty-seven periods. Exhibit 1 Annualized Monthly Returns in Percent January 1, 1984-December 31, 1987 Study Period ‘ (Months) Mean Std. Deviation REIT Equity 48 1.064 43.53 Mortgage 48 — 5.622 49.24 Hybrid 48 — 2.070 40.95 Combined 48 - 3.233 36.77 FREIT Equity 48 — 11.724 41.44 Mortgage 48 — 9.553 43.90 Hybrid 27 — 34.810 91.63 Combined 48 —11.896 36.84 Combined Pool Equity 48 — 5.329 37.01 Mortgage 48 — 10.825 51.87 Hybrid 48 — 7.588 , 36.45 Combined 48 — 5.861 34.87 Other Data S&P 500 Index 48 10.632 49.64 CPI Change 48 3.262 2.66 T-Bill 48 6.626 1.70 Source: Derived by the authors —_____________.—__—_.——-—————— VOLUME 4, NUMBER 2 FINITE-LIFE INVESTMENT TRUSTS 61 Also included in Exhibit 1 are the return calculations for the S&P 500 index, which will be the market return measure used in this study, the change in the CPI index over the study period, and the average one-month Treasury bill (T-bill) returns. As Exhibit 1 indicates, the returns for the FREITs are much lower than the REIT returns, and display greater variability. An initial comparison of both the REIT and FREIT trusts and the combined sample with the S&P 500 index shows that the market index substantially outperformed the trusts over the period studied.1 As can be seen from Exhibit 1, there appears to be a significant difference between the returns in each of the types of trusts. But given the magnitude of the variation of returns, this may not necessarily be the case. To test whether a statistically significant difference between means exists, a general procedure to make all possible comparisons among the different population means is applied. The procedure used is one proposed by Duncan [18] to detect significant differences among pairs of population means, It is a very powerful test that utilizes a comparisonwise error rate. The results of the Duncan multiple range test are provided in Exhibit 2. As these results indicate, there is a significant difference only between the Hybrid FRElT mean compared with the S&P 500 return, and all three REIT trusts. This test can also be interpreted to show that there is not a significant difference between any of the REIT means among themselves, as well as no statistically significant difference between the Equity and Mortgage FREITs among themselves or between any of the REITs. Also of particular interest is that there is a significant difference in the 5&P500 return only with the Hybrid FREIT, and not with any of the other trusts. There are several interesting relationships suggested in the correlation matrix presented in Exhibit 3. There is not a statistically significant relationship between all of the REIT s and FREITs. The strongest significant relationships exist with the Equity and Mortgage RElTs and FREITs, and the Hybrid REIT. The Hybrid FREIT is not significantly correlated with any of the other trusts. All of the trusts are significantly, positively correlated to the market index over the period studied except the Hybrid and the Mortgage FREITs. The only trusts signif- icantly correlated to the change in CPI are the Hybrid FREIT, with a positive correlation, and the Mortgage REIT, with a negative correlation. Although there is a negative correlation between the rate of inflation and the common stock index, the correlation is not statistically significant. This does not coincide with other studies [7, 10] which find a negative correlation Exhibit 2 Duncan's Multiple Range Test for Mean Differences Type of Return N ' Mean _ érohaing’ MP 500 4g ' " .0088! ' A. ' " Equity REIT 4a 00069 A Hybrid REIT 49 —.00173 A Mortgage REIT 48 —.09468 A Mortgage FREIT 48 — .09796 A B. Equity FREIT 48 — .0097? A B Hybrid FREIT 27 —.02901 B Alpha = .05 DF = 308 MSE = .002124 *Means with the same letter are not significantly different from each other within that grouping. Source: Derived by the authors 1989 62 THE JOURNAL OF REAL ESTATE RESEARCH _______________—__———————————————-— Exhibit 3 Pearson Correlation Coefficients Prob > |R| Under Ho.- Rho = 0 _—_—_—___-____._._.__.—.—_—-———-———— EQ-FR EQ-RE HY-FR HY-RE MO-FR MO-FlE S&P500 CPI T-BILL EQ-FR 1.00000 .0000 EQ-FlE .51763 1.0000 .0002 .0000 HY-FR .21259 .05172 1.00000 .2871 .7978 .0000 HY-RE .51655 .70317 .11441 1.00000 .0002 .0001 .5699 .0000 MO-FR .37435 .52449 — .001 18 .53016 1.00000 .0088 .0001 .9954 .0001 .0000 MO-RE .21 107 .49025 — .22625 .56666 .22254 1 .00000 .1499 .0004 .2565 .0001 .1284 .0000 S&P 500 .36527 .49969 .12789 .43553 .21068 .44622 1.00000 .0107 .0003 .5250 .0020 .1506 .0015 .0000 CPI —.05208 .03109 .46858 —.20583 -.17764 —.38377 —.01082 1.00000 .7252 .8338 .0137 .1605 .2271 .0071 .9418 .0000 T-BILL .25110 .16831 — .01926 .24173 .12071 .25383 — .02228 .09906 1.00000 .0852 .2528 .9240 .0979 .4138 .0817 .8805 .5030 .0000 Source: Derived by the authors between the rate of inflation and common stock prices and a positive correlation between the rate of inflation and real estate returns. While a number of studies that have examined returns on real estate have used an internal rate of return (IRR) methodology [9, 19, 23], this is not appropriate for analyzing REIT re- turns given the data problems of not being able to accurately assess cash flows and reversion values of ther'underlying properties in the trusts. Thus the CAPM has been adapted in several studies that have analyzed the performance of REITs [1, 4, 12, 24]. An extension of the CAPM was"iadvanced by Jensen [8] that allows the evaluation of investment perfor- mance, and has been used in other studies analyzing real estate returns (see [1] for example). The Jensen performance index model is also applied in this study given its ability to evaluate the risk-adjusted performance of investments relative to a market measure. Using the Jensen model allows us to assess the systematic risk associated with the individ— ual securities or portfolios. In this research, Jensen’s alpha (co-measures are calculated to see if the REIT and FREIT portfolios provide excess returns above the equilibrium rates allowed in the market. This u-measure is designed to evaluate investment performance of securities (or portfolios) within the two-parameter equilibrium model by evaluating ex-post risk pre- miums of individual investment vehicles: let = 0‘} + Bf ,mt + if: (1) where R',-, = excess rate of return (Ry: — R”) on portfolio j in period t; R’m, = excess rate of return (Rm, — Rfl) on the market portfolio in period t; — intercept and slope terms, respectively, of the least squares regression line; — random error term with E(e,~,) = 0 :9 m w? ll VOLUME 4, NUMBER 2 FINITE-LIFE INVESTMENT TRUSTS 63 and R), = rate of return on portfolio j in period t; Rm, = rate of return on the market portfolio in period t; Rf, = risk-free rate of return in period t. The rate of return on the market portfolio is represented here by the S&P 500 index. Given the limited number of EQ, MO and I-IY types in each class of REIT and FREIT, the total sample of the REIT, FREIT and combined trusts are used as the portfolios in the subsequent analysis. As mentioned, the risk-free rate of return is measured by the one-month T-bill rate. The alpha (or) in equation (1) is the Jensen performance index and the beta (B) indicates the systematic risk of the portfolio. A negative alpha would indicate an inferior performance of the portfolio relative to an unmanaged portfolio of similar market risk, where a positive alpha would indicate a superior performance of a trust portfolio given the portfol...
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