Academic journal article Real Estate Economics

Systematic Risk and Diversification in the Equity REIT Market

Academic journal article Real Estate Economics

Systematic Risk and Diversification in the Equity REIT Market

Article excerpt

This paper examines the relations between the types and locations of properties owned by equity real estate investment trusts (REITs) and market-based measures of systematic risk and diversification. Almost all previous analyses of these issues employ appraisal-based series such as the Russell-NCREIF Property Index (RNPI).(1) The burgeoning interest in the equity REIT market in general, accompanied by the recent passage of "look through" provisions for institutional investors in REITs, warrants an analysis of risk and diversification issues with stock market-based data.

Two important findings about systematic risk and diversification in the equity REIT market arise from this study. First, systematic risk appears to vary across firms depending on the types of properties they own. In particular, a REIT owning only retail properties tends to have a beta almost 50% larger than that of a REIT specializing in industrial properties. This finding has important implications for investors and for pension plan consultants. Investors clearly should interpret with caution the higher returns on retail properties over recent years, as part of the return appears to be compensation for greater systematic risk. For institutional investor consultants responsible for evaluating real estate advisor performance, the finding suggests that care should be taken so that advisors are rewarded only for added return per unit of systematic risk. Advisors should not be rewarded solely because they recommend relatively high return property types if the recommendation also brings more systematic risk to the portfolio. Second, there is no evidence that diversification across property type or geographic region is related to a market-based measure of diversification - the [R.sup.2] from a simple market model regression. This evidence supports some critics' views that such diversification strategies are indeed "naive." Additionally, no meaningful impact for diversification across economic regions was found in the stock market data. However, data limitations make it premature to conclude that this particular strategy is also naive.

The remainder of the paper is organized as follows. The underlying data used in the analysis are described in the next section. Section three examines the relation between a REIT's property ownership and a market-based measure of diversification. Section four examines the determinants of systematic risk for REITs. A brief conclusion summarizes the paper.

Data Description

The data sample consists of tax-qualified, publicly traded equity REITs listed in the REIT Sourcebook, published by the National Association of Real Estate Investment Trusts (NAREIT). The REIT Sourcebook also provides the investment cost of the firms' properties as well as describes the types of properties owned and the states in which they are located.

Each firm's investments are divided into one of six possible property type categories: Health Care, Industrial/Warehouse, Office, Residential, Retail and Other. The Other category includes hotels, land and specialty properties such as resorts.

State-level data on individual REIT investments are aggregated in one of two ways in order to analyze geographic diversification. The first is into the four Russell-NCREIF Property Index regions - East, Midwest, South and West. The other aggregation is based on the eight economic regions identified by Hartzell, Shulman and Wurtzebach (1989). These authors suggest that there is no a priori reason for investors to expect true economic diversification to be determined by broad geographic breakdowns. Hartzell et al. (1989) argue that, sometimes even within a single state (e.g., California), business activity is systematically different enough across subregions that some diversification benefits could be achieved just by spreading investment dollars across the different regions of the state. Their analysis led them to divide the nation into eight economic regions: New England, the Mid-Atlantic Corridor, the Old South, the Industrial Midwest, the Farmbelt, the Mineral Extraction region, Southern California and Northern California. …

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