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.
Highlights
Real Estate Investment Trusts (REITs) were firstly introduced in the United States in 1960, and they provide a liquid way for investors to gain real estate exposure
We found that default risk appears to be mispriced in the share prices of REITs
Default risk is negatively associated with the return of REITs, which is consistent with the common stock literature
Summary
Real Estate Investment Trusts (REITs) were firstly introduced in the United States in 1960, and they provide a liquid way for investors to gain real estate exposure. REITs experienced a sharp fall in values in the Global Financial Crisis (GFC) between 2007 and 2009, the National Association of Real Estate Investment Trusts (NAREIT) index fell 67% (Sun et al, 2015). Chung et al (2016) argue that REITs are exposed to high default risk during periods of financial market turmoil. This is because REITs typically have high leverage ratios and low cash holdings. Some REITs eventually file for bankruptcy, default and delist due to business failure (see Appendix A for details). These cases are, as one would expect concentrated in periods of economic recession and financial crisis. REITs generate relatively stable cash flows and are predominantly comprised of tangible assets that have high recovery rates, implying that the actual extent of loss from default may be less than for the average public company
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