From "Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions," an unpublished working paper by Jarjisu Sa-Aadu, James D. Shilling and Ashish Tiwari, 2006

Professors from the University of Wisconsin and University of Iowa business schools found that REITs provide an important hedging function, noting that REITs "deliver portfolio gains when consumption growth is low and/or volatile, i.e., when investors really care for such benefits."

"We find dramatic differences in the timing of the improvements in portfolio performance yielded by different asset classes, suggesting different relative abilities of asset classes to provide a kind of insurance against adverse shocks to consumption growth opportunities. Of the various assets tested, commodities/precious metals and equity REITs are the two asset classes that possess desirable properties in terms of the timing of their respective economic benefits. The results suggest that these two assets provide insurance against deterioration in consumption opportunities.

THE STRENGTH OF REIT PERFORMANCE

Source: J. Sa-Aadu, J.D. Shilling and A. Tiwari

To the extent possible, equilibrium reasoning suggests that investors who dislike poor performance in their investment portfolios should overweight assets such as real estate, commodities and precious metals, and government bonds.

A major finding of the paper is that commodities/precious metals and real estate appear to be powerful vehicles for hedging against adverse shocks to consumption growth opportunities. Not only do these asset classes offer significant gains in portfolio performance, the gains vary directly with the standard deviation of consumption growth rate.

This analysis suggests that the optimal mean-variance tangency portfolio is heavily weighted in equity REITs and precious metals in the bad state of the economy, while also including government bonds."

REIT Dividend Payouts Demonstrate Transparency

From "Spatial Diversification, Dividend Policy, and Credit Scoring in Real Estate," an unpublished Ph.D. dissertation by Darren K. Hayunga, 2006

A finance Ph.D. student challenges earlier research that suggested REITs may take advantage of inefficient monitoring and/or information advantages in setting their dividend payouts. Instead, Darren K. Hayunga, now assistant professor, University of Texas at Arlington, finds that REIT dividend payouts reflect current earnings, with adjustments to keep dividend streams smooth and protect against volatility.

"REITs possess a straightforward organizational structure to examine dividend policy especially when compared to industrial firms. For non-REIT firms, project confidentiality, adverse selection and moral hazard can hinder the direct transfer of information between market participants.

Conversely, REIT investors and analysts are aware of the real estate assets and mortgages held by publicly traded REITs. In addition, agency costs and asymmetric information are reduced since REITs must continuously be active in the capital markets, and these markets act as an additional monitor of firm activities.

I find that the dividend payment(s) made by equity REIT managers are not materially affected by traditional measures of agency costs or asymmetric information. Instead, the results confirm the importance of contemporaneous net income and the level of dividends paid last period."

Optimal Allocations to Real Estate Are Consistent Across Holding Periods

From "Real Estate in the Mixed-Asset Porfolio: the question of consistency” from the Journal of Property Investment and Finance, by Stephen Lee and Simon Stevenson, 2006

Two finance professors from University College Dublin and the University of Reading in England found that the importance of real estate in an investment portfolio is consistent, regardless of the investor's time horizon (research based on a Jones Lang LaSalle index of direct real estate returns).

RETURN-ENHANCING REAL ESTATE ALLOCATIONS

Source: Lee & Stevenson (2006), Table 6

"First, the results suggest strongly that real estate has possessed the attribute of consistency in optimized portfolios. Real estate constantly had positive allocations over time periods ranging from 5- to 25-years, and for most levels of portfolio return, irrespective of whether real estate is used to enhance returns or reduce risk.

Secondly, the benefits from including real estate in the mixed-asset portfolio tend to increase as the investment horizon is extended. This implies that real estate should be considered as a strategic asset in the mixed- asset portfolio especially for those investors with longer holding periods."

Search for Market-Beating Returns Leads to Value REITs

From "Extrapolation Theory and the Pricing of REIT Stocks," by Joseph T.L. Ooi, James R. Webb and Dingding Zhou, forthcoming in Journal of Real Estate Research, 2007

A team of researchers from Cleveland State and the National University of Singapore has found that undervalued REITs—those that carry low prices relative to their earnings, dividends, book assets, or other measures of fundamental value—outperformed growth REITs consistently between 1991 and 2000 without exposing investors to higher risks.

"We identified a pocket of inefficiency in the REIT market which astute investors can take advantage of to earn superior returns. Between 1991 and 2000, the one-, two-, and three-year buy-and-hold size-adjusted returns for value REITs are 4.1 percent, 9.7 percent, and 12.2 percent higher than for growth REITs.

The return differentials are still significant [3.6 percent, 5.4 percent, and 8.3 percent] when mortgage REITs are excluded from the study sample. The result supports the hypothesis that REIT stocks are systematically mispriced due to naïve extrapolation of their future growth prospects. The actual growth rates of value REITs are higher than that expected by the market, as implied by their price multiples.

Growth REITs are less susceptible to mispricing. One possible explanation is that growth REITs are subjected to fewer mispricing errors because they attract more institutional and sophisticated investors. Value REITs, on the other hand, are held predominantly by small investors who tend to underestimate the future growth prospects of value stocks, due to excessive extrapolation associated with the firm's fundamentals and or market-wide sentiment."

NAREIT’s Work on FFO Increased Value to REIT Investors

From "The Effect of Increased Transparency on Manipulation and Value Relevance of Non-GAAP Disclosures by Real Estate Investment Trusts (REITs)," an unpublished working paper by Bok Baik, Bruce K. Billings and Richard M. Morton, 2006

Three Florida State business school professors have found evidence that increased transparency in the computation of funds from operations (FFO) increased its "value relevance" to potential REIT investors.

"NAREIT solicited feedback from industry executives, the analyst community, institutional investors and other industry participants and convened a best financial practices council to better clarify the definition of FFO and encourage greater uniformity and transparency in practice with the intent of increasing credibility in the financial markets. The result of this effort was a National Policy Bulletin, effective Jan. 1, 2000, which formally approved the recommendations of the best practices council to improve FFO reporting.

These results suggest that reporting initiatives aimed at reducing the extent of discretion in FFO also reduced the extent of opportunistic reporting. We further find that the usefulness of FFO to investors increased over this period, suggesting that the reporting oversight to increase uniformity in calculating FFO enhanced the perceived reliability of FFO for valuation purposes. Furthermore, we can trace some of FFO's increased value relevance to the practice of reconciling FFO to generally accepted accounting principles/earnings per share (GAAP EPS), which makes departures from GAAP more transparent."