Canadian real estate investment trusts: A review of the IPO literature and preliminary analysis of Canadian REIT IPO pricing

Canadian Journal of Administrative Sciences, Dec 2002 by Jane Londerville

Several theories have evolved to explain why this underpricing might be rational. The most commonly offered explanation was developed by Rock (1986) and involves the "winner's curse." His model requires uncertainty about the potential performance of a company after it goes public and groups of investors interested in the offering who have heterogeneous information about the value of the firm. Those who are better informed will bid on what they perceive to be underpriced offerings and leave the others. The less informed investor is just as likely to bid on a "properly" priced offering as an underpriced one. Most new issues are rationed, so that the poorly informed investor ends up with a disproportionately large share of the IPOs that do not appreciate after they go on the market. This produces an adverse selection problem for uninformed investors. Deliberate underpricing of an average IPO by the issuer compensates the poorly informed investor for facing the winner's curse; if this were not done, the non-institutional investor would likely stay completely out of the IPO market and raising new funds would prove difficult.

Beatty and Ritter (1986) extended and tested Rock's model. They argued that one firm alone cannot provide a credible signal that it has underpriced its IPO in expected terms, since it will only go public once. The investment bank is required to vouch for the fact that the stock is priced below its expected value in the market. Since the investment bank relies on its reputation to gain future business, this signal from them should be credible. The empirical results identify a loss of market share for investment bankers who do not adequately underprice IPOs in the first time period of their study. They also find that greater uncertainty about the expected results for the firm requires greater underpricing of its IPO to attract investors. It is therefore in the firm's interest to release as much information as possible about what projects it is funding with the IPO proceeds.

This raises an interesting distinction between REIT IPOs and taking a private operating company public. Companies have two reasons for not wanting to be too specific about their future plans with the proceeds of a public offering. They do not want to be sued by investors if things do not go according to plan. And, they do not want their competitors to gain an advantage through increased knowledge about their operations. REITs, on the other hand, so long as they have appropriate purchase options on the properties they intend to buy, can reveal as much detail as they know about the assets they intend to acquire with the IPO proceeds, including type of property, size, location, major tenants, previous year's rent, and so on. For the Canadian REITs in this study, the significant amount of information revealed about their intended property acquisitions should have decreased the required underpricing for their IPO, if Beatty and Ritter are correct.

Rock's model was substantiated by the results of Chalk and Peavy (1987) who found that returns differed by initial price per share of the offering and that shares which sold for less than $1 initially accounted for much of the excess returns. There is likely to be considerable uncertainty about the outcome for the companies issuing these penny stocks. As well, there is likely to be a broader mix of potential investors the lower the initial offering price of the stock.