Real Estate Investment Trusts, Small Stocks and Bid-Ask Spreads
Nelling, Edward F., Mahoney, James M., Hildebrand, Terry L., Goldstein, Michael A., Real Estate Economics
This paper examines the liquidity of real estate investment trusts (REITs). REITs provide investors the opportunity for equity investment in a portfolio of real estate properties or mortgages. Although a primary motivation for securitizing real estate claims through REITs is to increase the liquidity of an essentially illiquid asset, to date there has not been a study of REIT liquidity.(1) This paper uses the behavior of bid-ask spreads to examine REIT liquidity in the United States equity markets from 1986 to 1990.
Liquidity is a desirable property of any security. A liquid security is one that may be purchased or sold conveniently and with low transactions costs. Buyers and sellers of illiquid assets must exert a greater search and negotiation effort to find a willing trading partner. For securities that are publicly traded, market makers provide liquidity by standing ready to buy and sell securities at posted bid and ask prices. This difference between the bid and ask price is referred to as the "bid-ask spread" or simply the "spread." Black (1971) describes a narrow spread as one of the characteristics of a liquid market. If an investor trades at a dealer's quoted bid and ask prices, his cost of trading will increase as the magnitude of the spread increases. This relation also holds for REITs, as most of them trade in major U.S. markets such as the New York Stock Exchange (NYSE) or in an over-the-counter market such as the National Association of Securities Dealers Automated Quotation (NASDAQ) system. An analysis of REIT trading strategies or return behavior should therefore consider their bid-ask spreads.
Liquidity is an additional concern for REITs due to their somewhat turbulent history. In the early 1970s, many mortgage REITs failed. As a result, investors lost confidence in REITs as an investment vehicle. In addition, previous empirical research on REITs has documented differences between REITs and other common stocks. Wang, Chan and Gau (1992) cite some of these differences that suggest that real estate stocks are more difficult to value than stocks of industrial firms. Theoretical models of the bid-ask spread, such as Glosten and Milgrom (1985), suggest that if a market maker believes that some investors are more informed than himself about the true value of a stock, he may increase his quoted spread to protect himself against losses to informed traders. Thus if REITs are more difficult to value than other common stocks, they may have larger bid-ask spreads. Unlike other stocks, REITs are exempt from corporate taxes if they meet certain qualification rules, and some of these rules may affect REIT liquidity. Wang, Chan and Gau examine REIT initial public offerings (IPOs) and find that, contrary to IPOs of other common stocks, REIT IPOs are overpriced rather than underpriced. Furthermore, they find that REIT type, (equity, mortgage or hybrid), is a significant determinant of the magnitude of the overpricing. If the difference in IPO pricing among REIT asset types is due to different levels of uncertainty regarding their value, one might expect to find differences in spreads by REIT type.
We find that REIT spreads have increased over the period 1986-1990, are inversely related to market capitalization, and are similar in magnitude to spreads on other stocks of comparable size. If the ability to value REITs differs from that of other common stocks, such differential ability does not appear to manifest itself in the form of different bid-ask spreads. Multivariate regression results indicate that market capitalization is the primary determinant of REIT bid-ask spreads and spreads are larger for NASDAQ REITs than for NYSE REITs, even after adjusting for differences in firm size. The regression results also indicate that spreads are inversely related to the fraction of the REIT's shares held by institutional investors, and are lower for equity REITs than for mortgage or hybrid REITs. The similarity between REIT spreads and those of other common stocks holds in both bull and bear real estate markets and suggests that, from a liquidity perspective, REITs are similar to other common stocks. …