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Market Efficiency and Real Estate Investment Trusts

By

Jonathan Matthew Long

A paper submitted in partial fulfillment of the requirements of the Honors Program in the Department of Economics and Finance.

Examining Committee: Approved By:

_______________________ ____________________

Dr. Robert Burrus Dr. Edward Graham

Faculty Supervisor

_______________________

Dr. Christopher Dumas

_______________________

Dr. William Atwill

_____________________

Department Chair

_________________________________

Honors Council Representative

____________________________________

Director of the Honors Scholars Program

The University of North Carolina at Wilmington

Wilmington, North Carolina

April 2004

Market Efficiency and Real Estate Investment Trusts

Abstract

An efficient market is one in which prices quickly reflect information relevant to the goods or services traded in that market. Few markets are efficient; securities markets in the United States are relatively efficient, and real estate markets – though less efficient than the securities markets – are becoming more efficient. A wealth of research exists that considers the efficiency of securities markets; a much narrower literature considers the relative inefficiency of the real estate market. Only a modest volume of research contrasts the efficiency of securities and real estate markets; that research is supplemented with this study. Real Estate Investment Trusts or REIT’s, provide a unique link between the securities and real estate markets. A REIT is traded in the same fashion as a publicly-traded stockholder-owned company, but enjoys special tax treatment and has accounting requirements peculiar to the real estate industry. A REIT share represents ownership in real estate – an asset far different than a share of stock – although it is traded in the same fashion as stock. As a result, the REIT share “enjoys” some of the same efficiencies as the stock market, while directly representing ownership in real estate, a far less efficient market. These relationships, and publicly-traded REIT companies, are considered at length in this study.

Acknowledgements

I would like to give credit to a number of people and institutions for helping me in my study. First of all, I would like to like Dr. Edward Graham from the Economics and Finance department of the Cameron School of Business (CSB). He was my faculty supervisor and mentor for this project. He spent numerous hours of his past two semesters meeting and working on my project with me. Dr. Graham was the inspiration for the research conducted, and he provided me with guidance and direction throughout the entire study. Without his help I feel I would never have been able to accomplish what I did.

Among the other people I would like to thank include Gene Houghtaling from the CSB. Once Morningstar’s Principia product was obtained he was an invaluable resource for accessing the data and installing it in the computer lab in Cameron Hall. My thanks also go out to Dr. Burrus, Dr. Dumas, and Dr. Atwill for being a part of the reviewing committee for my thesis.

A number of institutions also helped make this project a success. I need to thank the research firm, Morningstar, for their most generous donation of their Principia data program to UNCW. I would also like to thank the Cameron School of Business and the Economics/Finance Department for use of their computer lab and the help I received from the many professors. Last of all, I would like to thank the Honors Scholars Program. Because of this program, I have had this opportunity to differentiate myself as a student through this project. The skills and experience I have gained from this project will serve me well as I transition towards a career in business, and as I consider my options for graduate study.

Chapter 1

Market Efficiency and Real Estate Investment Trusts

1.1 Introduction and Motivation

The efficiency of the capital and real estate markets are considered in this study. The efficient market hypothesis is introduced and contrasted with the behavior of these two markets. Comparisons between capital and real estate market efficiency help to highlight possible inefficiencies in the real estate market. In the real estate market, consideration will be given especially to the REIT (Real Estate Investment Trust) sector and the efficiency of that component of the real estate market.

The efficient market hypothesis holds that market prices fully reflect all available and relevant information, and that it is typically unprofitable for investors to try to “beat the market.” This is intuitive: If all traders in a given market have access to the same set of information, and no onerous “frictions” (high commissions, taxes, regulations, etc) preclude a buyer or seller acting on their “new” positive (for the buyer) or negative (for the seller) information, then trading profits are theoretically eliminated with the first few trades after the arrival of “new” information. One can quickly envision the securities markets being relatively efficient (with stock prices quickly responding to news of great earnings or the arrest of the firm’s chief executive) and the real estate market being far less efficient. Real estate just does not “trade” in the same fashion as shares of stock.

The semi-strong form of this theory holds true in the capital markets, particularly the US equity market. The semi-strong form of this theory suggests that prices reflect publicly, but not privately, available information. The strong form, maintaining that prices reflect all information – both public and private – does not, by legal mandate, hold. It is generally against securities laws for individuals to trade based on their private information, and thus that information is not typically “imbedded” in securities prices. The rapid and dramatic response of stock prices to new and significant news is strong evidence both that the strong form does not hold and that investors, despite the jaded remarks of the popular press, generally do not trade on inside information.

In the real estate market, conditions are less “perfect,” than in the capital markets. A perfect market is one where there are no costly “frictions.” Costly frictions include taxes, transaction costs (commissions), government regulations, abbreviated information flows, heterogeneous products and a limited number of buyers and sellers. Real estate itself is broadly considered an inefficient and imperfect market, with prices being required to overcome copious and costly frictions. The introduction of REIT’s – a securitized ownership form for real estate – was designed in part to overcome these inefficiencies and imperfections. Given the greater costliness to a buyer or seller delivering good or bad information to the market with his real estate trade, trades often do not take place, and prices do not reflect “available and relevant” information. For example, it may be attractive to an investor to trade on a 10% pricing disparity in the stock market, but such a “spread” often does not even cover the cost of the trade in real estate.

1.2 The Efficient Market Hypothesis

The foundation of the EMH is that all available information is quickly incorporated into a company’s stock price. Fox (2002) explains that this efficient markets (EMH) theory, first offered by Samuelson in 1965 and then expanded by many others, states that security price movements are random because information impacting the value of a given security is already reflected in its price. Prices change only in response to news, which by definition is unpredictable. The theory holds that the random nature of the market is what makes the market “unbeatable” by even the most practiced investors.

The idea of an efficient market operates on several assumptions. Rattiner (2002) explains that in order for a market to be efficient it must first satisfy four conditions: 1) A large number of contending participants who are actively analyzing securities; 2) information arrives to the market fresh and in a random manner; 3) investors adjust to new information quickly in an unbiased manner; and 4) expected returns implicitly include risk In the capital market of stocks and bonds, theses conditions for an efficient market are generally met, allowing the semi-strong form of the EMH to hold true in most cases.

As implied above, the EMH was eventually broken down into three different levels of efficiency, weak form, semi-strong form, and strong form. The weak form of the EMH states that stock prices reflect all available past share price data, and any information about future price movements contained in past movements is already incorporated into the current share price; the chartist or technician looking for predictive power in past pricing and volume data – attaching importance to levels of pricing “resistance” – is wasting his time. Rattiner (2002) explains that the weak form assumes the independence of security returns, and that the correlation between stock prices over time is “virtually nothing”. Under the weak form, technical analysis of past stock price movement provides no competitive advantage.

The semi-strong form of the EMH holds that stock prices fully reflect all public information; therefore fundamental analysis of a stock provides no benefit to the investor. Under this theory, past share price information and any beneficial fundamental information about a company is already discounted in the share price. Findlay and Williams (2000) note that any hunt for a second or “true” value to compare with the current market price in order to find a stock that is “cheap” or “dear” is pointless. However, the semi-strong form does not contend that no one can achieve superior returns; it holds only that higher returns should not be expected (Rattiner 2002).

The final version of the efficient market hypothesis is the strong form. This form states that all possible information about a stock price is considered in the price, including inside information. With this form, even insiders with information unknown to the rest of the investment world cannot beat the market. Rattiner (2002) elaborates on the weak form saying that even if investors beat the market with inside information, they will more than likely fail in other attempts, preventing them from achieving consistent superior returns. The strong form advocates a lack of necessity for investment managers since analysis of all possible information offers no advantage to an investor.

The level of market efficiency increases from the weak form of the EMH to the strong form. Each form also holds the previous form to be true so the strong form is the highest level of efficiency a market can operate under according to the EMH. A key factor in market efficiency is the flow of information. In order for a share price to currently reflect all available information, this information must be able to flow quickly and accurately, through a large and active market free of costly frictions. There are many participants in the market, each having access to a wealth of this “information.” Investors gather information through investment firms, brokers, newspapers, magazines, and of course, the Internet. The Internet has allowed investors to gain access to an even larger measure of information with speed and ease unrivaled by most any other source. The ability of participants quickly to take advantage of this information allows markets to behave efficiently. New information is discounted into share price appropriately, precluding the market’s “missing” the correct price. Therefore, it is generally too late to profit on news by the time one hears of it (Findlay 2000).

The US equity market is one of the most highly analyzed markets in the world and many investors employ techniques every year to “beat the market.” The efficient market hypothesis has led many investors to believe in the efficiency of the market and the futileness of market timing and other techniques. Fox (2002) points out how the logic of the EMH has led to the creation of many index funds that aim to “mimic” the market, rather than to try and outperform it. There are many ideas about the effectiveness of the Efficient Market Hypothesis, particularly about the US equity market and its efficiency under the theory’s provisions. An entirely different set of trading beliefs populate the real estate community, and these beliefs manifest themselves in the trading behavior of the real estate market; seeking to emulate the efficiency of the securities markets, the REIT was introduced to allow the more efficient trading of real estate.

The introduction of REITs to the market has improved efficiency with a more homogeneous, liquid product; however, research still shows that the real estate market is much less efficient than the capital markets. It is towards a better understanding of this research that the following pages are dedicated. We consider the extant literature on REITs and examine an exhaustive REIT data set towards that “better understanding.”

Chapter 2

A Review of Capital and Real Estate Market Efficiency:

A Look at the REIT Market

2.1 Objectives of Chapter Two

In this chapter, the efficiency of the equity markets is re-introduced, and selected research on the EMH is considered. The efficiency of the real estate market is then examined; it is contrasted with the securities markets and patterns of increasing efficiency in the real estate markets are reviewed. Much of this “pattern of increased efficiency” can be attributed to the trading of shares of REIT’s; these shares, their introduction and elements of the research on REIT’s are considered as the chapter comes to a close with a review of the performance of REIT’s and their contribution to the investment environment in the United States.

2.2 US Equity Market and the EMH

The U.S. equity market operates at a certain level of efficiency. The three forms of efficiency provided by the EMH are considered below in order to underscore this efficiency. Studies by Brock et al. (1992), extended by Bessembinder and Chan (1998), look at the implications of technical analysis and the strength of weak form efficiency. In addition, Malkiel and Radisisch (2001) examine the performance of index funds in comparison with actively managed funds to investigate the semi – strong form of efficiency. The strong form of efficiency is a more problematical concept to research due to the illegality of “insider trading”. Adequate data for such research is difficult to find, though actions to “uncover” strong form efficiency, with adjacent prosecutions, are being made. New York’s attorney general, Eliot Spitzer, is unearthing more and more trading scandals. In terms of the general consensus on the Efficient Market Hypothesis and the US equity market, investors tend to feel that the weak form holds true, semi – strong form holds fairly true, and that strong form efficiency does not hold.