REITs and Idiosyncratic Risk

1
REITs and Idiosyncratic Risk

• Mukesh K. Chaudhry
• Indiana University of Pennsylvania
• Suneel Maheshwari
• Marshall University
• James R. Webb
• Cleveland State University

2
Objectives

• Analyze whether some of the accounting
  characteristics of (Real Estate Investment Trust)
  REITs are related to its idiosyncratic risk

3
Motivation for the Study

• Understanding the REITS important for portfolio
  managers
• Traditionally, REITS provided significant
  diversification benefits in 80s
• Structural changes and diminished diversification
  benefits in 90s.
• REITS, like bonds and stocks, have predictable
  component.

4
Methodology

• Isolate the idiosyncratic risk of the individual
  firms
• Identify the variables of interest Size,
  financial leverage, performance, liquidity, and
  earnings variability
• Identify the different time periods
• Analyze whether the characteristics are related
  to idiosyncratic risk

5
Model

• Return for REITS can be decomposed into two
  components a market aggregate and a
  firm-specific residual.
• The firm specific residual is the idiosyncratic
  risk and is the dependent variable.

6
Model for Idiosyncratic Risk

• The excess return on individual stocks would be
  expressed as
• rit rjt- rft
• j - individual REIT stocks
• m - the market aggregate for REITs
• rft - is the risk-free rate

7
Model for Idiosyncratic Risk

• The excess market return is
• rmt ?i wit rit and ?i wit 1
• rmt - market risk premium

8
Model for Idiosyncratic Risk

• The CAPM model can be written as
• rjt - rft ?j ?jm rmt ?jt (1)
• rit ?im rmt ?it (2)

9
Independent Variables

• Size
• larger a REIT is, the more likely it is that it
  would be geographically diversified
• smaller REITs are more likely to be impacted by
  the idiosyncratic component of the risk
• Financial Leverage
• higher levels of borrowing are likely to magnify
  or leverage the earnings of REITs
• expected to be positively correlated with the
  idiosyncratic risk

10
Variables

• Performance Measures
• measure incorporates funds from operations (FFO)
  or Earnings Before Interest and Taxes (EBIT)/Book
  Value of Stockholders Equity
• EBIT/Market Value of Stockholders Equity
• Hypothesized to have an inverse (negative)
  relationship with idiosyncratic risk
• Liquidity Risk
• Cash and marketable securities divided by total
  assets
• expected to be negatively correlated with
  idiosyncratic risk

11
Variables

• Capital Risk
• The higher the capital risk ratio, the lower
  would be the riskiness of REIT
• Earnings Variability Risk
• The higher the variability of earning the more
  positively significant the coefficient would be
  when regressed against the idiosyncratic risk
  measures

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Empirical Model

• Idiosyncratic Risk
• ?2 (?it) ?0 ?1Size ?2Leverage ?3
  Performance I ?4Liquidity ?5 Capital ?6
  Earnings ?t (8)
•  
• ?2 (?it) ?0 ?1Size ?2Leverage ?3
  Performance II ?4Liquidity ?5 Capital ?6
  Earnings ?t (9)
• Total Risk
• ?2 (rit) ?0 ?1Size ?2Leverage ?3
  Performance ?4Liquidity ?5 Capital ?6
  Earnings ?t (10)

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Discussion of Results
14
Table 1 REIT Descriptive Statistics Average for
1994-1998 (period I) and 1996 2000 (Period II)
Variables Number Mean
Standard Minimum Maximum Range of
Companies Deviation
__________________________________________________
___________________________ Period
I  Size 84 5.72 1.45 2.22 8.56 6.34  Leverage 84
0.49 0.21 0.02 1.09 1.070  Performance
I 84 0.28 0.19 -0.05 1.53 1.580  Performan
ce II 84 0.16 0.19 -0.002 1.58 1.582  Liqu
idity 84 0.04 0.09 0.001 0.72 0.719  Capital 84
0.47 0.21 -0.09 0.99 1.080  Earnings
84 0.035 0.09 0.0001 0.726 0.726 Variability
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Table 1 REIT Descriptive Statistics Average for
1994-1998 (period I) and 1996 2000 (Period II)
(cont.)
Variables Number Mean
Standard Minimum Maximum Range of
Companies Deviation _________________
__________________________________________________
____
Period II  Size 91 6.18 1.50 2.21 9.24 7.030 Leve
rage 91 0.53 0.21 0.0001 1.125 1.125 Performance
I 91 0.162 0.17 -0.01 1.65 1.660 Performance
II 91 0.426 0.40 -0.016 2.64 2.656 Liquidity 91 0
.041 0.106 0.001 0.919 0.920 Capital 91 0.429 0.1
99 -0.12 0.997 1.117  Earnings 91 1.22 1.04 0.07
2 5.81 5.741 Variability
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Table 2 Descriptive Statistics of Dollar Value
of REITs Assets and Liabilities and Income
Statements 1994-1998 (period I) and 1996 2000
(Period II). Amount in Millions
Variables Number Mean
Standard Minimum Maximum Range of
Companies Deviation _________________
__________________________________________________
____
Period I Total Assets 84 782.31 1109.55 9.18 6333.
85 6324.67   Cash and 84 17.798 53.05 0.03
460.2 460.17 Equivalents   Total
Debt 84 413.46 687.10 0.0001 4130.44 4130.44   To
tal Liabilities 84 482.31 823.65 0.02 5021.61 5021
.59   Equity 84 299.99 375.68 -24.60 2394.74 2419
.34 Book-Value Net Income/ 84 22.12 27.55 -16.80
127.71 144.51 Loss Sales (Net)
84 113.74 196.86 0.67 1486.8 1486.13   EBIT 84
50.10 64.91 9.03 396.41 387.38   Equity 84 46
0.14 569.57 5.99 2745.36 2739.37 Market Value
17
Table 2 Descriptive Statistics of Dollar Value
of REITs Assets and Liabilities and Income
Statements 1994-1998 (period I) and 1996
2000 (Period II). Amount in Millions (cont.)
Variables Number Mean
Standard Minimum Maximum Range of
Companies Deviation _________________
__________________________________________________
____
Period II Total Assets 91 1232.08 1788.70 9.19 109
99.35 10990.16   Cash and 91 23.51 62.92 0.04
544.0 543.06 Equivalents Total
Debt 91 642.59 1036.67 4.99 6846.18
6841.19   Total Liabilities 91 761.51 1251.29 0.43
8481.54 8481.11   Equity 91 472.33 690.78 3.1
1 4320.75 4317.64 Book-Value Net
Income/ 91 38.01 52.45 -28.66 293.50
322.16 Loss Sales (Net) 91 178.22 273.97 0.74
1657.6 1656.86   EBIT 91 83.01 113.88 0.09
396.41 396.32   Equity 91 614.73 844.34 3.13 43
99.08 4395.95 Market Value
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 Table 3 Hypothesized Relationship Between
Idiosyncratic Risk and the Balance Sheet
Variables
Variables Hypothesized Sign ______________
_______________________________   Size Negative
  Leverage Positive   Performance
I Negative   Performance II Negative   Liquidi
ty Negative   Capital Negative   Earnings
Variability Positive
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Table 4 REITs Idiosyncratic RisksTwo Factor
Regression Model with SP 500 Index and Mortgage
Rates Using Performance Measure I
Variables Coefficients Coefficients Period
I Period II ____________________________________
____________________________
Dependent Variable Idiosyncratic
Risk   Size -0.004 -0.0006 (-3.35) (-0
.29)   Leverage -0.115 -0.174 (-0.33) (
-2.03)   Performance I 0.131 0.072 (7.
08) (3.65)   Liquidity 0.004 0.092 (0.
14) (2.92)   Capital -0.026 -0.217 (-0.
75) (-2.47)   Earnings 0.191 0.235 Var
iability (5.73) (5.64)   F-Value 20.37
16.67   Adjusted R2 0.58 0.51 ______________
__________________________________________________
t-values are given in parentheses ,,
indicate significance at 10, 5, 1 levels,
respectively.
20
Table 5 REITs Idiosyncratic RisksTwo Factor
Regression Model with SP 500 Index and Mortgage
Rates Using Performance Measure II
Variables Coefficients Coefficients Period
I Period II ____________________________________
_________________________________
Dependent Variable Idiosyncratic
Risk   Size -0.001 -0.0002 (-0.72) (-1.16
)   Leverage 0.011 0.024 (0.28) (5.35)
  Performance II 0.072 0.002 (5.01)
(3.95)   Liquidity 0.094 -0.003 (3.27)
(-1.76)   Capital 0.002 -0.025 (0.06)
(-5.30)   Earnings 0.038 0.007 Variabi
lity (1.33) (2.13)   F-Value 13.84 7.63
  Adjusted R2 0.48 0.31 ___________________
__________________________________________________
t-values are given in parentheses ,,
indicate significance at 10, 5, 1 levels,
respectively.  
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Conclusion

• aggregate volatility may be important for
  understanding the risk and return relationships
  for a portfolio of stocks, because of special and
  unique characteristics for REITs, idiosyncratic
  risks are equally relevant

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Model for Idiosyncratic Risk

• ?2( rit) ?im2 ?2 (rmt) ?2 (?it) 2 Cov (rmt,
  ?it) (3)
• ?2( rit) ?im2 ?2 (rmt) ?2 (?it)
  (4)
• rit ?im rmt ?ik rkt ?it (5)
• ?2( rit) ?im2 ?2 (rmt) ?ik2?2 (rkt) ?2
  (?it)
• 2 Cov (rmt, rkt) 2 Cov (rmt, ?it) 2 Cov
  (rkt, ?it) (6)
• ?2( rit) ?im2 ?2 (rmt) ?ik?2 (rkt) ?2
  (?it) (7)