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Liquidity and the Future Stock Returns of the REIT Industry

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Abstract

This paper examines how deviations from expected optimal cash holdings affect future stock returns in the real estate investment trust (REIT) industry. Our findings indicate that REIT managers elect to hold less cash to reduce the agency problems of cash flow, supporting the pecking order theory that growth opportunities lead managers to retain more cash on hand. The results show that any deviation from the estimated optimal cash holdings is significantly detrimental to future market performance, suggesting that excess or insufficient cash is harmful to stock returns. The adverse influence of deviations above the optimal value is insignificantly stronger than that of deviations below the optimal value. We also find that the return performances of deviations that do not differ from the expected optimal value surpass those of deviations that differ significantly from the expected level. This implies that REIT managers determine their cash policies based on future growth opportunities and the external costs of capital. Finally, for REIT firms, holding excess or insufficient cash increases the possibility of agency conflict or underinvestment, which will consequently worsen the firm’s future performance.

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Notes

  1. The Internal Revenue Code lists the conditions a company must meet to qualify as a REIT. For example, the company must pay 90% of its taxable income to shareholders every year. It must also invest at least 75% of its total assets in real estate and generate 75% or more of its gross income from investments in or mortgages on real property (http://www.sec.gov/answers/reits.htm).

  2. Hardin and Hill (2008) examine the factors associated with REIT dividends in excess of the mandatory distribution. Ghosh and Sirmans (2006) find an average dividend payout ratio of 150% for their REIT study. The findings suggest that REIT managers have a good deal of control over the allocation of the cash funds. Myers and Rajan (1998) hypothesize that more liquid assets can lead to increased agency problems.

  3. The website http://www.reit.com links to the websites of REIT firms.

  4. Basu (1977, 1983) finds that a portfolio of low price-to-earnings (P/E) ratio stocks has higher average returns than a portfolio of stocks with high ratios. DeBondt and Thaler (1990) argue that the P/E effect can be explained by optimistic earnings expectations. Thus, high P/E firms tend to be poor investments in general.

  5. The Wald test can be used to test the true value of the parameter based on the sample estimate. The Wald statistic is \( \frac{{{{\left( {\hat{\theta } - {\theta_0}} \right)}^2}}}{{{\rm var} \left( {\hat{\theta }} \right)}} \) and is comparable to a chi-square distribution at 5% level.

  6. Sufi (2009) suggests that access to private bank debt is an indicator of the degree of financial constraint, so firms without access to credit lines have greater difficulty raising funds via capital markets. Almeida et al. (2004) show that less financially constrained firms hold less cash than their counterparts in non REIT samples.

  7. Damodaran (2005) points out that REITs carry cash and equivalents equal to only 1.57% of total assets, which is considerably less than the 18.48% average reported for the full sample of public firms.

  8. The annual abnormal returns are calculated by the annual stock returns minus the annual market return of the All-REITs index.

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Authors and Affiliations

  1. Department of Finance, National Sun Yat-sen University, 70 Lien-hai Rd., Kaohsiung, 804, Taiwan, Republic of China

    Ming-Chi Chen, Chin-Yu Wang & So-De Shyu

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  1. Ming-Chi Chen
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  2. Chin-Yu Wang
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  3. So-De Shyu
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Correspondence to Ming-Chi Chen.

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Chen, MC., Wang, CY. & Shyu, SD. Liquidity and the Future Stock Returns of the REIT Industry. J Real Estate Finan Econ 45, 588–603 (2012). https://doi.org/10.1007/s11146-010-9287-7

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