REITs have demonstrated increased volatility lately, but is it here to stay?

By Allen Kenney

If you see financial professionals wobbling around a bit more than usual lately, don't be alarmed. They're just riding the new-and-improved roller coaster that is the stock market.

The herky-jerky ups and downs in short-term returns are the most visible sign of volatility, a primary measure of an investment's level of risk. Every form of investment security has it, albeit in different doses. It's the simple reality that people have to accept when they jump in the investing pool.

Vaneesha Boney, an assistant professor of finance at the University of Denver's Daniels College of Business, carefully sums it up: "Explaining volatility can actually get a little complicated, but, in essence, it tells an investor the dispersion in price associated with a security over a given time period. The greater the dispersion, the greater the price movements around an expected return, thus indicating greater risk. Less dispersion, all things constant, means less risk."

According to conventional investment theory, investors are forced to make discrete tradeoffs between an investment's stability and its potential for outsized performance. Less volatile assets, such as bonds, typically produce steady returns capped at low levels. Conversely, highly volatile asset classes and industry sectors, such as emerging market securities and high-tech stocks, offer tempting return potential, so long as investors can stomach more severe peaks and valleys in pricing and the higher risk of losses.

REITs have long been considered one of the less volatile investment vehicles. In the last year, though, the industry has dealt with its own spate of anxiety-inducing volatility. "The fundamental earnings of REITs are less volatile than those of other companies. However, the volatility of their stock prices has risen to being very close to that of the general market," says Glenn Mueller, a professor at the University of Denver and a real estate investment strategist with Dividend Capital Group. "While REITs have not been as volatile as the general stock market historically, the introduction of derivatives and hedging of REIT stocks has increased their price volatility in the past few years, just as they have done to the rest of the stock market."

As contamination from a messy mortgage market has roiled economies around the globe, investors and market analysts have witnessed more pronounced volatility in measures of REITs' performance, as well as in sectors of equity and fixed-income markets. Yet, the impact and staying power of this latest trend in the REIT market has yet to be borne out.

Hedged Bets

Simon Stevenson, a finance professor with the Cass Business School in London, notes that REIT laws' dividend payout rules have contributed to their reputation as a relatively stable investment. In the United States, for example, REITs are required to distribute at least 90 percent of their taxable income each year to shareholders in the form of dividends.

If REITs historically have been so stable, what has brought about the recent volatility? In fact, Mueller contends that REITs open themselves up to more volatility exposure just by going public. "When you go to the publicly traded REIT market, you get the benefit of liquidity. In return, you have to accept the increased price volatility," he says.

Brad Case, NAREIT's vice president for research and industry information, offers a more prosaic diagnosis.

"Since 1973, stock market researchers have documented that volatility increases during downturns. Lately, the economy, real estate, the stock market and—until recently—REIT stocks all have been in a downturn, so it should come as no surprise that REIT volatility is up," Case says. "What investors need to think about, though, is what is going to happen to REITs in the future assuming we're closer to a recovery in prices."

Stevenson also points out that research has shown volatility to be on the rise among real estate stocks. Like many, Stevenson attributes these swings to the growth in the sheer volume of trading in REITs that has occurred during the last decade. A significant number of REIT-based derivatives have hit the market in the last decade, catching the attention of active traders such as hedge funds, he says. When these funds short-sell a stock or bet heavily on a company, it can push the price one way or the other, according to Mueller.

"With all these new derivatives like hedging and short sales, the volatility in the market actually has increased," Mueller says. "Hedge funds say, 'Here's a reason why real estate might go down, so we're going to short REITs.' That actually creates more volatility."

Lately, Stevenson attributes some of the upswing in volatility to external factors beyond the REIT industry's control. He points out that the latest headlines in the financial media around the world have revolved around issues linked to real estate, adding to the volatility.

"You also have to consider that an additional element in the last year or so is the negative sentiment regarding real estate generally and the uncertainty following the fallout of the subprime residential mortgage crisis and the credit crunch," Stevenson says. "This alone has led to large increases in both volume and volatility."

However, as many industry observers have noted, the business of most REITs isn't related to the subprime crisis. Additionally, the relatively low leverage of REITs minimizes the impact of the credit crunch on their performance. As a result, such negative sentiment may be misplaced.

Tom G. Geurts, director of academic affairs for the Schack Institute of Real Estate at New York University, says the real story has been not only the recent volatility in REITs, but its confluence with shaken investor confidence as well.

"Volatility is not the only thing that matters at the moment. What is perhaps even more important is the psyche of investors," he says. "When volatility in the market coincides with a lack of confidence, it prolongs downturns."

Boney maintains that the growing presence of REITs among major market indexes, including the S&P 500, also has had some effect on the companies' overall stock price movement. "There is evidence that the REITs included in the index have indeed become more volatile. Although the overall number of REITs that have been added to this index is relatively small in nature, these REITs tend to be those with the largest capitalization. Thus, they are widely held by institutional and retail investors alike," she says.

Who Cares?

To some extent, the beauty of volatility really lies in the eye of the beholder.

In general, financial theory holds that investors less interested in current valuations have less reason to fear volatility. Investors who need liquidity from their portfolios, on the other hand, expose themselves to potential losses if they liquidate their holdings in periods of dramatic market fluctuations.

Consequently, young members of the workforce who are starting to save for retirement should be less concerned about volatility, in theory, considering they shouldn't need access to that money for decades. Despite periodic dips in prices, Boney maintains these investors have more than enough time during their investment horizon to offset short-term volatility losses.

"History has shown that our domestic markets are strong and rebound," says Boney, noting that the U.S. market's return has averaged between 8 percent and 12 percent annually. In particular, REIT returns have averaged almost 12 percent for the last 30 years.

A couple looking to buy their first home with proceeds from their stock portfolio, however, probably should be more worried about dramatic drops in the value of their holdings, Boney says. Such investors are in a similar position to that of employees approaching retirement. Both are facing short time horizons in which price risk exposure takes on greater importance, according to Stevenson.

But Case notes that REITs' volatility hasn't increased nearly as much over long periods as it has on a daily basis.

"The standard deviation of daily returns in the past year has been more than twice its long-term average. But most investors aren't day-traders," Case says. "The standard deviation of quarterly returns is only about one-tenth higher than its long-term average. That quarterly time horizon is probably more relevant for most investors."

As in the case of hedge funds, some types of investors actually profit from highly volatile securities. "Particularly for an asset like REITs, increased volatility will affect short-term investors to a greater extent. However, this can be positive. The greater the volatility, the more potential short-run trading opportunities may arise," Stevenson says.

Volatility can be "ideal" for these market speculators, according to Boney. Such investors try to profit from near-term price movements by stocks, rather than seeking capital appreciation over a longer time horizon.

"Therefore, a volatile market where prices are shifting rapidly offers the incentive for these traders to enter the market," she says. Geurts says this type of behavior actually has the effect of raising volatility, as frenzied trading creates more movements in price.

"Day traders like volatility, since that enables them to buy in a trough and sell after a rally," he says. "In effect, they create the volatility they enjoy by buying and selling rapidly."

A Lasting Impact?

Mueller says the investment community's perception of the potential risks REITs pose has evolved as hedge funds have increased their trading of the companies' stocks.

"For their first 42 years, REITs had exhibited low volatility in their stock prices, because they were income-producing, utility-like stocks," Mueller says. "Since hedge funds and derivatives came along, the volume of REIT stock trading has increased, making individual investors nervous because they were used to less volatility. This has created a new challenge for the REIT industry."

Part of that challenge is retaining REITs' place in retirement portfolios. The income-producing and diversification attributes of REITs have added to their popularity in retirement plans, in part serving as a dampener for the total portfolio's level of volatility. If the industry's overall volatility grows to match that of the market at large, it could lessen their appeal in this regard.

"In the long run, portfolio simulations show that the inclusion of REITs in a comprehensive portfolio decreases its volatility in the long term, making it an attractive asset class for many," Boney says.

Geurts says this latest round of volatility could have a lasting impression on some investors' take on REITs, which could create a windfall for prudent buyers.

"Those investors might perceive that REITs are more volatile due to recent experience and shy away from them. This will create buying opportunities for savvy investors, especially seeing that investors tend to have short memories," he says.

Stevenson admits the recent bout of volatility could impact the market's overall perception of REITs. He adds, however, that REITs still remain more stable than equities in general.

"In the long run the lower volatility of REITs relative to stocks should be a beneficial factor, together with the impact of the high dividend payout," Stevenson says.

Boney emphasizes that investors should focus on "permanent shocks" to the market that could have a lasting impact on an asset class, as opposed to more "transitory shocks." In that sense, they should consider what is underlying a spike in volatility, rather than just taking note of the erratic movements alone.

"Investors should understand that markets are dynamic in nature," she says. "Prices move up, and prices can—and do—move down."

So, is the market experiencing one of those permanent shocks?

"My feeling is that REITs will continue to be an attractive asset class going forward, and that the volatility associated with REITs in general will not be as significant in the future," Boney says.