Quick Bio: James Shilling is a professor of finance and chair of the real estate department at DePaul University. During his 37-year academic career, he has authored or co-authored approximately 100 papers on a variety of real estate topics, many of them focused on REIT management, REIT investment performance and investment performance of direct real estate holdings.

By Brad Case

Portfolio: Some of your research has focused on institutional investment in direct real estate and in REITs. You found that the importance of REIT stock ownership increases with an increasing ratio of current-to-future liabilities. Since current liabilities are becoming a greater share of total pension liabilities, does that imply that institutional investors should invest more in REITs?

Shilling: It is common to think of institutional investors like insurance companies, pension funds and endowments as being motivated the desire to maintain a stable funding ratio as close to one as possible, which implies minimizing the deviation of actual values of assets and liabilities.

However, institutional investors have liquidity needs, too. Historically, these needs have caused most investors to limit their investments in direct real estate equities to levels where liquidity is not a concern. But limiting one's exposure to real estate, particularly in the current environment, may be a real mistake. Fortunately, the risk of being inadequately hedged against unanticipated changes in inflation can be easily mitigated by investing in real estate through indirect means, like REITs, without taking on illiquidity risk.

My recommendation is that institutions that have not already done so should seriously consider increasing their allocation to REIT shares to hedge against inflation-adjusted liabilities. A limited allocation to real estate is optimal in the absence of serious inflation risk in the United States in the last 10 years. However, in the presence of significant inflation risk, large positions in REITs are a way to hedge against unanticipated changes in inflation and to circumvent the liquidity problems associated with investing directly in real estate equities.

Portfolio: You also found that smaller institutional investors tended to invest in REITs because they couldn't justify the cost of acquiring direct real estate, while medium-size institutions tended to invest directly in real estate. The largest investors tended to hold more of their real estate in REITs—this time as a tactical asset allocation tool. If institutional investors are becoming more active investors, does that suggest that tactical allocation through REIT investment will continue to increase?

Shilling: In theory, it is possible for REIT securities to earn excess returns. The explanation is that REIT managers tend to possess superior information in a market where there tends to be a high degree of local segmentation. This degree of local segmentation is generally unique to real estate markets. Hence, as institutional investors become more tactical in their asset allocations, we should see greater allocations to REITs because tactical investing is all about looking for positive excess returns.

Portfolio: In a separate research project, you concluded equity REITs are one of the two asset classes that deliver portfolio gains when consumption growth is low or volatile. Can you explain the implications of that finding for portfolio investment strategies?

Shilling: Traditional academic portfolio theory assumes a mean-variance frontier, where investors want portfolios with greater mean return and lower volatility. That means they are willing to accept more volatile portfolios only if they receive a higher average return.

However, if investors want to avoid having to make additional financial contributions to a plan in times of economic hardship, then they might want to hold a portfolio that takes larger positions in stocks like REITs than typically identified in mean-variance optimized portfolio. The reason is that REIT securities are defensive assets. When consumption growth is low or volatile, REIT securities tend to have high payoffs.

Thus, in this context, an institutional investor who invests solely in a broad-based market portfolio—including stocks and bonds, and a small amount of real estate—may be forced to draw additional financial contributions from the plan sponsor in bad times. In contrast, an institution that holds a specially constructed portfolio with a large allocation in REIT securities should be able to minimize these financial draws.

Portfolio: In your research, you found that one can earn positive and significant excess returns by going long on a portfolio of highly liquid REITs in good times, and by going long on a portfolio of highly leveraged REITs in bad times. Can you explain that?

Shilling: Our research generally shows that investors who select assets based on conditioning variables are better able to earn positive abnormal returns than investors who randomly select assets. In good times (when REITs sell at a premium to NAV), this conditioning includes selecting a portfolio of highly liquid REIT stocks that are better positioned for acquisitions and growth than highly leveraged REITs.

In bad times (when REITs sell at a discount to NAV), this conditioning includes selecting REITs that have high leverage, because high leverage constrains REIT management to pay out cash flows.

Portfolio: You have studied dividend yield spreads and dividend payout ratios on REITs and found that high yield spreads and low payout ratios forecasted strong excess returns. You attributed this to the observations that yield spreads indicate the extent to which REITs are "cheap or expensive," while payout ratios are correlated inversely with valuable growth opportunities. Any observations on whether the current market situation is ripe for strong returns going forward?

Shilling: The possibility that REIT returns are predictable enhances the appeal of investing in REIT securities. A high REIT dividend yield means that REIT prices should grow more quickly than dividends until the dividend yield ratio is re-established, causing future returns to be high. However, a low REIT dividend yield means that prices should grow more slowly, causing future returns to be low. The current dividend yield for equity REIT securities is approximately 5 percent, up from a recent low of 3.7 percent in the fourth quarter of 2006.

However, this current dividend yield does not give robust evidence that future excess returns should be positive, even though there has been a dramatic decline in REIT share prices and a surge in yields since fourth quarter of 2006. The reason is that there is simply a large near-term degree of uncertainty over the direction of commercial property prices.

For example, the current price-to-NAV ratio for equity REITs is predicting a fall in future property prices of approximately 20 percent. This forecast appears to be predicated in part on a slowdown in economic growth worldwide and partly on the de-leveraging that is likely to take place as the financial sector takes hits to its assets. Currently, however, most commercial property markets appear to be solid.

Portfolio: Are REITs part of your investment portfolio?

Shilling: Yes, REITs are a part of my investment portfolio. Further, I am struck by the argument that REIT securities earn positive excess returns.