Are Real Estate Investment Trusts (REITs) an Inflation Hedge?

Abstract

Given the recent debate on the empirical validity of the inflation illusion hypothesis, recent implosion of REIT prices combined with potential inflationary pressure, and a significant role of the real estate market in the recent financial market meltdown, we examine whether the observed negative relations between REIT returns and inflation can be explained by the inflation illusion. We identify the mispricing component in the REIT prices based on present value models, both linear and loglinear, and then we investigate whether inflation can explain the mispricing component. We find some evidence of the inflation illusion hypothesis for the REIT return-inflation relation for the linear models with a constant interest rate in that the inflation rates explain some fraction of mispricing components and their effect on mispricing is negative. However, when we allow for time-varying interest rates, inflation does not explain the REIT mispricing component anymore. Further, when we take into account a potential asymmetric effect of positive and negative inflation on the mispricing components in REIT prices, which is an important implication of the inflation illusion hypothesis, we find that REIT prices are not easily compatible with the inflation illusion hypothesis. Therefore, we find only very limited evidence for the inflation illusion hypothesis. To see whether behavioral factors such as consumer sentiment can better explain the mispricing components in REIT prices, we use the consumer sentiment index in lieu of inflation in the regression of the mispricing components. We find that when we include both the inflation rate and the consumer sentiment index in the regression of the mispricing components, the consumer sentiments tend to explain the mispricing component while inflation loses its explanatory power. Therefore, we find some evidence that behavioral factors such as consumer sentiment could have contributed to the mispricing in the REIT prices.