Risk-Adjusted Performance of Real Estate Stocks: Evidence from Developing Markets

Journal of Real Estate Research, The, Oct-Dec 2004 by Ooi, Joseph T L, Liow, Kim-Hiang

Abstract This paper examines the performance of real estate stocks listed in seven developing markets in East Asia between 1992 and 2002. Using panel regressions, the goal is to identify determinants of the risk-adjusted returns of real estate securities traded in these markets. The empirical evidence suggests that size, book-to-market value, capital structure and market diversification have significant influence on the performance of real estate securities. Asset structure and development exposure, however, do not appear to have any significant effect on the returns behavior, while dividend yield has limited influence. As expected, interest rates and market condition have significant impact on the returns of real estate stocks. The Asian Financial Crisis also has an adverse impact on stocks' performance.

Introduction

In their attempt to enhance returns and diversify risks, corporations and pension funds in the United States have increased their investment overseas since the 1990s (Carman, 1997). Following this trend, traded stocks of real estate-related organizations provide an indirect route for investors to gain international real estate exposure without being burdened with the chores of acquiring, managing and disposing the physical real estate in distant countries. The advantages of including global real estate stocks to achieve more efficient portfolios have been highlighted in numerous studies, the more recent ones being Eichholtz and Koedijk (1996), Eichholtz (1997), Ling and Naranjo (2002) and Hamelink and Hoesli (2002). International diversification through real estate stocks is, however, more complicated than previously thought. Despite the presence of a worldwide systematic risk factor, a successful diversification strategy would require the investors to critically consider how country-specific and company-specific factors affect securitized real estate returns across different markets. Generally, diversification opportunities are greater across continents as compared to within continents. Country-specific factors are important determinants of international real estate security returns (Ling and Naranjo, 2002; Hamelink and Hoesli, 2002; and Bond, Karolyi and Sanders, 2003). Indeed, comparing the relative strength of country-specific and worldwide risk factors, Griffin (2002) concludes that the domestic factor is better able to explain time-series variation in stock returns than the global factor. Furthermore, potential diversification within countries should not be ignored given the existence of company-specific risk factors in international real estate returns.

This paper examines the historical performance of property-related stocks publicly traded in seven stock markets in East Asia: Hong Kong, Indonesia, Malaysia, Singapore, South Korea, Taiwan and Thailand. Until the mid 1990s, the dominant story in the region was one of strong economic growth with high asset inflation. Corresponding to massive inflows of foreign capital into the region, real estate values escalated rapidly. Investors were attracted to the region by potential capital gains rather than rental income, as reflected by the low initial yields associated with prime real estate located in major cities in Asia. Given the focus on capital growth, it was not surprising that real estate returns in Asia were more volatile than real estate investment trust (REIT) stocks in the U.S. The robust growth story, however, came to a dramatic halt when the Financial Crisis hit the region in 1997. Characterized by significant devaluation of regional currencies, the flight of foreign capital, the closing of many banks, and rapid deterioration in employment rates and domestic economies, the Asian Financial Crisis escalated the volatility of real estate returns in the region. The impact of the Financial Crisis was, nevertheless, felt in varying degree across the region, with the worst hit economies being Indonesia, Thailand and South Korea. At the peak of the crisis, the Indonesian rupiah was reported to have lost 84% of its value against the USD, while the loss suffered by the Korean and Thailand's currencies exceeded 50%.' Entering into the new millennium, many of the markets in East Asia are still undergoing restructuring and consolidation. Real estate securitixation via commercial mortgage-backed securities and REITs is starting to gain popularity. As of the end 2003, REITs have been introduced in Japan, Singapore and South Korea; while active discussions on the legislative frameworks are on-going in Malaysia, Hong Kong and Taiwan. Furthermore, real estate stocks in East Asia are now regarded less as growth stocks as compared to what was the case prior to 1997.

There are a few reasons why we think the performance of real estate securities in the East Asia region provides an interesting arena for examination. First, from a global investor's perspective, there is more scope for risk diversification in segmented markets as compared to developed markets, which are already fully integrated into the global capital markets. second, few studies have examined the return behaviors of real estate securities outside the U.S. or other western markets, particularly those in developing markets that have different institutional and market structures. Research on the performance of common stocks in emerging markets (such as Bekaert, Erb, Harvey and Viskanta, 1997) reveals three different market characteristics-high average returns, high volatility and low correlations both across the emerging markets and with developed markets. Bond, Karolyi and Sanders (2003) also observe that there is a regional pattern with respect to the sensitivity of real estate returns to country-specific market risk, which is much more significant for real estate markets in the Asia-Pacific region than those in Europe or North America. Third, because of the volatile nature of real estate stocks in the region, this study will provide a better understanding on the returns behavior of securitized real estate in different business cycles, especially during a financial meltdown.