Investor Recognition and Expected Returns of EREITs

Abstract

Executive Summary. The Merton (1987) model suggeststhat investors demand a higher return when requiredto trade on the basis of incomplete information.This research tests if the prediction of the Merton modelcan be validated for EREITs. The results are broadlyconsistent with the predictions of the Merton model. Returnsincrease monotonically with shadow cost. However,an analysis of portfolios sorted by shadow cost and sizeevidences some nonlinearity in the return-shadow costrelationship. The Fama-Macbeth regression analysis illustratesthat shadow cost of incomplete information isa priced factor in the REIT return-generating processeven in the presence of other control variables. Theshadow cost is shown to be time varying, becoming increasinglysignificant as a return-generating factor in thepost 1991 period of REIT industry ownership and controlrestructuring. Finally, the simulation of zero-costtrading strategies shows that a long position in highshadow cost REITs and a short position in low shadowcost REITs results in positive net benefits on the average.