Does default risk matter for investors in REITs
Abstract
We investigate the relationship between default risk and REIT stock returns. A default risk long-short investment strategy generates a return of 15% per annum. We also evaluate a large number of potential explanations for the negative relationship between default risk and subsequent stock returns. We do not find robust evidence that the default risk premium can be explained by firm size, book-to-market equity, asset growth and idiosyncratic volatility. However, CAPM beta shows some promise in explaining the default risk premium. Our results shed further light on the role of default risk in investment in REITs.
First published online 23 September 2020
Keyword : default risk, Real Estate Investment Trust (REIT), anomalies, distress puzzle, cross-sectional return, real estate investment
How to Cite
Sha, Y., Wang, Z., Bu, Z., & Mansley, N. (2020). Does default risk matter for investors in REITs. International Journal of Strategic Property Management, 24(5), 365-378. https://doi.org/10.3846/ijspm.2020.13504
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Anzinger, S. K., Ghosh, C., & Petrova, M. (2017). The other side of value: the effect of quality on price and return in real estate. The Journal of Real Estate Finance and Economics, 54(3), 429–457. https://doi.org/10.1007/s11146-016-9574-z
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Campbell, J. Y., Hilscher, J., & Szilagyi, J. (2008). In search of distress risk. The Journal of Finance, 63(6), 2899–2939.
https://doi.org/10.1111/j.1540-6261.2008.01416.x
Carhart, M. M. (1997). On persistence in mutual fund performance. The Journal of Finance, 52(1), 57–82.
https://doi.org/10.1111/j.1540-6261.1997.tb03808.x
Charitou, A., Dionysiou, D., Lambertides, N., & Trigeorgis, L. (2013). Alternative bankruptcy prediction models using option-pricing theory. Journal of Banking & Finance, 37(7), 2329–2341. https://doi.org/10.1016/j.jbankfin.2013.01.020
Chava, S., & Purnanandam, A. (2010). Is default risk negatively related to stock returns? Review of Financial Studies, 23(6), 2523–2559. https://doi.org/10.1093/rfs/hhp107
Chui, A. C. W., Titman, S., & Wei, K. C. J. (2003). The cross section of expected REIT returns. Real Estate Economics, 31(3), 451–479. https://doi.org/10.1111/1540-6229.00073
Chung, R., Fung, S., Shilling, J. D., & Simmons-Mosley, T. X. (2016). REIT stock market volatility and expected returns. Real Estate Economics, 44(4), 968–995.
https://doi.org/10.1111/1540-6229.12128
Cooper, M. J., Gulen, H., & Schill, M. J. (2008). Asset growth and the cross-section of stock returns. The Journal of Finance, 63(4), 1609–1651. https://doi.org/10.1111/j.1540-6261.2008.01370.x
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https://doi.org/10.1111/0022-1082.00209
DeLisle, J., Price, S. M., & Sirmans, C. F. (2013). Pricing of volatility risk in REITs. Journal of Real Estate Research, 35(2), 223–248. https://aresjournals.org/doi/pdf/10.5555/rees.35.2.92q1v49220220861
Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? The Journal of Finance, 53(3), 1131–1147.
https://doi.org/10.1111/0022-1082.00046
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(2), 427–465. https://doi.org/10.2307/2329112
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3–56. https://doi.org/10.1016/0304-405x(93)90023-5
Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing anomalies. The Journal of Finance, 51(1), 55–84. https://doi.org/10.1111/j.1540-6261.1996.tb05202.x
Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1–22.
https://doi.org/10.1016/j.jfineco.2014.10.010
Fama, E. F., & French, K. R. (2016). Dissecting anomalies with a five-factor model. Review of Financial Studies, 29(1), 69–103. https://doi.org/10.1093/rfs/hhv043
Feng, Z., Price, S. M., & Sirmans, C. F. (2011). An overview of equity real estate investment trusts (REITs): 1993–2009. Journal of Real Estate Literature, 19(2), 307–343.
Giacomini, E., Ling, D. C., & Naranjo, A. (2015). Leverage and returns: a cross-country analysis of public real estate markets. The Journal of Real Estate Finance and Economics, 51(2), 125–159. https://doi.org/10.1007/s11146-014-9489-5
Giacomini, E., Ling, D. C., & Naranjo, A. (2017). REIT leverage and return performance: keep your eye on the target. Real Estate Economics, 45(4), 930–978.
https://doi.org/10.1111/1540-6229.12179
Guidolin, M., & Pedio, M. (2019). How smart is the real estate smart beta? Evidence from optimal style factor strategies for REITs (BAFFI CAREFIN Centre Research Paper No. 2019-117). https://doi.org/10.2139/ssrn.3458308
Hao, Y., Chu, H.-H., Ko, K.-C., & Lin, L. (2016). Momentum strategies and investor sentiment in the REIT market. International Review of Finance, 16(1), 41–71.
https://doi.org/10.1111/irfi.12060
Hillegeist, S. A., Keating, E. K., Cram, D. P., & Lundstedt, K. G. (2004). Assessing the probability of bankruptcy. Review of Accounting Studies, 9(1), 5–34.
https://doi.org/10.1023/b:rast.0000013627.90884.b7
Hou, K., Xue, C., & Zhang, L. (2015). Digesting anomalies: an investment approach. Review of Financial Studies, 28(3), 650–705. https://doi.org/10.1093/rfs/hhu068
Kawaguchi, Y., Sa-Aadu, J., & Shilling, J. D. (2017). REIT stock price volatility and the effects of leverage. Real Estate Economics, 45(2), 452–477. https://doi.org/10.1111/1540-6229.12153
Kumar, A. (2009). Who gambles in the stock market? The Journal of Finance, 64(4), 1889–1933. https://doi.org/10.1111/j.1540-6261.2009.01483.x
Lin, C. Y., Rahman, H., & Yung, K. (2009). Investor sentiment and REIT returns. The Journal of Real Estate Finance and Economics, 39(4), 450–471. https://doi.org/10.1007/s11146-008-9115-5
Ling, D. C., Ooi, J. T. L., & Xu, R. (2019). Asset growth and stock performance: evidence from REITs. Real Estate Economics, 47(3), 884–927. https://doi.org/10.1111/1540-6229.12186
Lintner, J. (1965). Security prices, risk, and maximal gains from diversification. The Journal of Finance, 20(4), 587–615. https://doi.org/10.2307/2977249
Merton, R. C. (1974). On the pricing of corporate debt: the risk structure of interest rates. The Journal of Finance, 29(2), 449– 470. https://doi.org/10.2307/2978814
Newey, W. K., & West, K. D. (1987). Hypothesis testing with efficient method of moments estimation. International Economic Review, 28(3), 777–787. https://doi.org/10.2307/2526578
Novy-Marx, R., & Velikov, M. (2015). A taxonomy of anomalies and their trading costs. Review of Financial Studies, 29(1), 104–147. https://doi.org/10.1093/rfs/hhv063
Ooi, J. T. L., Wang, J., & Webb, J. R. (2009). Idiosyncratic risk and REIT returns. The Journal of Real Estate Finance and Economics, 38(4), 420–442. https://doi.org/10.1007/s11146-007-9091-1
Pástor, Ľ., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns. Journal of Political Economy, 111(3), 642–685. https://doi.org/10.1086/374184
Sharpe, W. F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425–442. https://doi.org/10.2307/2977928
Stambaugh, R. F., Yu, J., & Yuan, Y. (2015). Arbitrage asymmetry and the idiosyncratic volatility puzzle. The Journal of Finance, 70(5), 1903–1948. https://doi.org/10.1111/jofi.12286
Sun, L., Titman, S. D., & Twite, G. J. (2015). REIT and commercial real estate returns: a postmortem of the financial crisis. Real Estate Economics, 43(1), 8–36.
https://doi.org/10.1111/1540-6229.12055
Vassalou, M., & Xing, Y. (2004). Default risk in equity returns. The Journal of Finance, 59(2), 831–868.
https://doi.org/10.1111/j.1540-6261.2004.00650.x
Zhang, A. J. (2012). Distress risk premia in expected stock and bond returns. Journal of Banking & Finance, 36(1), 225–238. https://doi.org/10.1016/j.jbankfin.2011.07.007
Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The crosssection of volatility and expected returns. The Journal of Finance, 61(1), 259–299. https://doi.org/10.1111/j.1540-6261.2006.00836.x
Anzinger, S. K., Ghosh, C., & Petrova, M. (2017). The other side of value: the effect of quality on price and return in real estate. The Journal of Real Estate Finance and Economics, 54(3), 429–457. https://doi.org/10.1007/s11146-016-9574-z
Bharath, S. T., & Shumway, T. (2008). Forecasting default with the Merton distance to default model. Review of Financial Studies, 21(3), 1339–1369. https://doi.org/10.1093/rfs/hhn044
Bond, S., & Xue, C. (2017). The cross section of expected real estate returns: insights from investment-based asset pricing. The Journal of Real Estate Finance and Economics, 54(3), 403–428. https://doi.org/10.1007/s11146-016-9573-0
Cakici, N., Erol, I., & Tirtiroglu, D. (2014). Tracking the evolution of idiosyncratic risk and cross-sectional expected returns for US REITs. The Journal of Real Estate Finance and Economics, 48(3), 415–440. https://doi.org/10.1007/s11146-013-9410-7
Campbell, J. Y., Hilscher, J., & Szilagyi, J. (2008). In search of distress risk. The Journal of Finance, 63(6), 2899–2939.
https://doi.org/10.1111/j.1540-6261.2008.01416.x
Carhart, M. M. (1997). On persistence in mutual fund performance. The Journal of Finance, 52(1), 57–82.
https://doi.org/10.1111/j.1540-6261.1997.tb03808.x
Charitou, A., Dionysiou, D., Lambertides, N., & Trigeorgis, L. (2013). Alternative bankruptcy prediction models using option-pricing theory. Journal of Banking & Finance, 37(7), 2329–2341. https://doi.org/10.1016/j.jbankfin.2013.01.020
Chava, S., & Purnanandam, A. (2010). Is default risk negatively related to stock returns? Review of Financial Studies, 23(6), 2523–2559. https://doi.org/10.1093/rfs/hhp107
Chui, A. C. W., Titman, S., & Wei, K. C. J. (2003). The cross section of expected REIT returns. Real Estate Economics, 31(3), 451–479. https://doi.org/10.1111/1540-6229.00073
Chung, R., Fung, S., Shilling, J. D., & Simmons-Mosley, T. X. (2016). REIT stock market volatility and expected returns. Real Estate Economics, 44(4), 968–995.
https://doi.org/10.1111/1540-6229.12128
Cooper, M. J., Gulen, H., & Schill, M. J. (2008). Asset growth and the cross-section of stock returns. The Journal of Finance, 63(4), 1609–1651. https://doi.org/10.1111/j.1540-6261.2008.01370.x
Daniel, K., & Titman, S. (1997). Evidence on the characteristics of cross sectional variation in stock returns. The Journal of Finance, 52(1), 1–33. https://doi.org/10.1111/j.1540-6261.1997.tb03806.x
Davis, J. L., Fama, E. F., & French, K. R. (2000). Characteristics, covariances, and average returns: 1929 to 1997. The Journal of Finance, 55(1), 389–406.
https://doi.org/10.1111/0022-1082.00209
DeLisle, J., Price, S. M., & Sirmans, C. F. (2013). Pricing of volatility risk in REITs. Journal of Real Estate Research, 35(2), 223–248. https://aresjournals.org/doi/pdf/10.5555/rees.35.2.92q1v49220220861
Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? The Journal of Finance, 53(3), 1131–1147.
https://doi.org/10.1111/0022-1082.00046
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(2), 427–465. https://doi.org/10.2307/2329112
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3–56. https://doi.org/10.1016/0304-405x(93)90023-5
Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing anomalies. The Journal of Finance, 51(1), 55–84. https://doi.org/10.1111/j.1540-6261.1996.tb05202.x
Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1–22.
https://doi.org/10.1016/j.jfineco.2014.10.010
Fama, E. F., & French, K. R. (2016). Dissecting anomalies with a five-factor model. Review of Financial Studies, 29(1), 69–103. https://doi.org/10.1093/rfs/hhv043
Feng, Z., Price, S. M., & Sirmans, C. F. (2011). An overview of equity real estate investment trusts (REITs): 1993–2009. Journal of Real Estate Literature, 19(2), 307–343.
Giacomini, E., Ling, D. C., & Naranjo, A. (2015). Leverage and returns: a cross-country analysis of public real estate markets. The Journal of Real Estate Finance and Economics, 51(2), 125–159. https://doi.org/10.1007/s11146-014-9489-5
Giacomini, E., Ling, D. C., & Naranjo, A. (2017). REIT leverage and return performance: keep your eye on the target. Real Estate Economics, 45(4), 930–978.
https://doi.org/10.1111/1540-6229.12179
Guidolin, M., & Pedio, M. (2019). How smart is the real estate smart beta? Evidence from optimal style factor strategies for REITs (BAFFI CAREFIN Centre Research Paper No. 2019-117). https://doi.org/10.2139/ssrn.3458308
Hao, Y., Chu, H.-H., Ko, K.-C., & Lin, L. (2016). Momentum strategies and investor sentiment in the REIT market. International Review of Finance, 16(1), 41–71.
https://doi.org/10.1111/irfi.12060
Hillegeist, S. A., Keating, E. K., Cram, D. P., & Lundstedt, K. G. (2004). Assessing the probability of bankruptcy. Review of Accounting Studies, 9(1), 5–34.
https://doi.org/10.1023/b:rast.0000013627.90884.b7
Hou, K., Xue, C., & Zhang, L. (2015). Digesting anomalies: an investment approach. Review of Financial Studies, 28(3), 650–705. https://doi.org/10.1093/rfs/hhu068
Kawaguchi, Y., Sa-Aadu, J., & Shilling, J. D. (2017). REIT stock price volatility and the effects of leverage. Real Estate Economics, 45(2), 452–477. https://doi.org/10.1111/1540-6229.12153
Kumar, A. (2009). Who gambles in the stock market? The Journal of Finance, 64(4), 1889–1933. https://doi.org/10.1111/j.1540-6261.2009.01483.x
Lin, C. Y., Rahman, H., & Yung, K. (2009). Investor sentiment and REIT returns. The Journal of Real Estate Finance and Economics, 39(4), 450–471. https://doi.org/10.1007/s11146-008-9115-5
Ling, D. C., Ooi, J. T. L., & Xu, R. (2019). Asset growth and stock performance: evidence from REITs. Real Estate Economics, 47(3), 884–927. https://doi.org/10.1111/1540-6229.12186
Lintner, J. (1965). Security prices, risk, and maximal gains from diversification. The Journal of Finance, 20(4), 587–615. https://doi.org/10.2307/2977249
Merton, R. C. (1974). On the pricing of corporate debt: the risk structure of interest rates. The Journal of Finance, 29(2), 449– 470. https://doi.org/10.2307/2978814
Newey, W. K., & West, K. D. (1987). Hypothesis testing with efficient method of moments estimation. International Economic Review, 28(3), 777–787. https://doi.org/10.2307/2526578
Novy-Marx, R., & Velikov, M. (2015). A taxonomy of anomalies and their trading costs. Review of Financial Studies, 29(1), 104–147. https://doi.org/10.1093/rfs/hhv063
Ooi, J. T. L., Wang, J., & Webb, J. R. (2009). Idiosyncratic risk and REIT returns. The Journal of Real Estate Finance and Economics, 38(4), 420–442. https://doi.org/10.1007/s11146-007-9091-1
Pástor, Ľ., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns. Journal of Political Economy, 111(3), 642–685. https://doi.org/10.1086/374184
Sharpe, W. F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425–442. https://doi.org/10.2307/2977928
Stambaugh, R. F., Yu, J., & Yuan, Y. (2015). Arbitrage asymmetry and the idiosyncratic volatility puzzle. The Journal of Finance, 70(5), 1903–1948. https://doi.org/10.1111/jofi.12286
Sun, L., Titman, S. D., & Twite, G. J. (2015). REIT and commercial real estate returns: a postmortem of the financial crisis. Real Estate Economics, 43(1), 8–36.
https://doi.org/10.1111/1540-6229.12055
Vassalou, M., & Xing, Y. (2004). Default risk in equity returns. The Journal of Finance, 59(2), 831–868.
https://doi.org/10.1111/j.1540-6261.2004.00650.x
Zhang, A. J. (2012). Distress risk premia in expected stock and bond returns. Journal of Banking & Finance, 36(1), 225–238. https://doi.org/10.1016/j.jbankfin.2011.07.007