Risk and Return in Real Estate: Evidence from a Real Estate Stock Index

Abstract

The continued growth of the equity REIT market depends critically on investors' belief that the stock market provides fair and accurate valuations of real estate. An index of real estate stocks traded on the New York and American stock exchanges reflects changes in real estate market fundamentals in a more timely fashion than a widely used appraisal-based system. The index includes equity real estate investment trusts (REITs), real estate operating companies not organized in trust form, land subdividers and commercial developers, and general contractors. A statistical examination of the relation between the stock-based and appraisal-based series finds that the lagged returns of the real estate stocks help explain the behavior of the current-period appraisal series. The stock market apparently impounds information about changes in real estate values in a more timely manner than appraisal-based series constrained by infrequent property appraisals. oth practitioners and academics have become increasingly interested in the risks and returns of real estate ownership. In the absence of a centralized exchange to record sales, appraisal-based data such as the Russell-NCREIF Property Index (RNPI) are often used to analyze real estate returns. Such appraisal-based series are imperfect proxies for actual market conditions, however, largely because property valuations occur infrequently (quarterly at best), so appraisal-based series contain stale prices.1 This shortcoming has been highlighted recently by the failure of appraisal-based return indexes to capture either the timing or the magnitude of the recent dramatic downturn in commercial real estate markets. This article presents and analyzes the return behavior of a stock-market-based index of real estate performance. The index is composed of real-estate-related equities traded on the New York and American stock exchanges (NYSE and Amex). The firms in the index include owner-operators of existing properties as well as developers. Previous real estate research has primarily examined the returns of equity real estate investment trusts (REITs). That work generated two findings of particular relevance to this article. First, there is no significant contemporaneous correlation between equity REIT and appraisal series returns. Second, equity REIT returns are significantly positively correlated with broader stock market returns such as the SP real estate stock prices more accurately captured the industry downturn in the late 1980s than the well-known RNPI series. Despite the lack of a contemporaneous relation between appraisal and stock series, we conclude that there is an important connection between the two. This conclusion is based on a statistically and economically significant relation between lagged real estate stock returns and current-period returns on the appraisalbased RNPI. The evidence indicates that the two series incorporate similar information about real estate fundamentals, but the stock-based index does so in a more timely manner.