The Asymmetric Response of Equity REIT Returns to Inflation Journal of Real Estate Finance and Economics Ramchander, S.; Simpson, M.; and Webb, J.
2007
Authors from the College of Business:
Sanjay Ramchander, Associate Professor of Finance and Real Estate, Charles and Gwen Lillis Faculty Fellow
Are real estate investments a good hedge against inflation? This question is of immense interest to portfolio managers and real estate investors. The hedging behavior of real estate returns can be explained as follows. An increase in the inflation rate reduces the effective cost of homeownership because of a decline in the relative cost of mortgage which, in turn, would spur housing demand and result in higher house prices. Alternatively, the hedging properties of real estate can be justified if one assumes that the rental income derived from properties will keep pace with inflation. However, what is surprising is that the vast majority of research documents that returns from real estate, specifically Real Estate Investment Trusts (REITs), are either unrelated or negatively related with inflation.
We contend that the failure of previous research to document a positive relationship between inflation and REIT returns is an artifact of the statistical methodologies that have predominated in these studies. These studies implicitly assume that increases and decreases in inflation have symmetrical effects on REITs and, consequently, the two types of changes are assumed to evoke similar responses from the real estate market.
We apply a pooled estimation methodology to an expansive data set containing 195 publicly traded equity REITs for the period 1981-2002. Equity REIT is a type of REIT which takes ownership or equity interest in rental real estate rather than making loans secured by real estate collateral. Our analyses indicate that employing traditional methodologies, which assume a symmetric response to positive and negative inflation shocks, yield results similar to those documented extensively in the literature. However, when changes in the inflationary variables are separated into positive and negative changes, we find a strong asymmetry in the response of equity REIT returns to inflation. Our results, which are partly contingent on the monetary policy condition of the economy, suggest that not only do equity REITs respond positively to expected and unexpected inflation, by rising when there is an increase in inflation, but they also tend to do so in a way that limits downside risk. That is, equity REIT returns rise when inflation rises, but they do not decline when inflation subsides.