The Other Side of Value: The Effect of Quality on Price and Return in Real Estate

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Author Information : Sara Kelly Anzinger (GRESB B.V.)

Chinmoy Ghosh (School of Business, University of Connecticut)

Milena Petrova (Whitman School of Management, Syracuse University)

Year of Publication : Journal of Real Estate Finance and Economics (2016)

Summary of Findings : Quality real estate stocks generally trade at higher prices, however, quality in listed real estate is not fully reflected in price with high quality real estate stocks outperforming low quality real estate stocks by 3.6 percent quarterly, on average over 1999-2013.

Research Questions : 1. Is quality a persistent characteristic in the performance of real estate assets?

2. Is quality of real estate stocks reflected in their stock prices?

3. Is quality of real estate stocks fully reflected in their stock prices - i.e. do real estate risk-adjusted returns vary with quality?

4. Does a long high quality, short low quality portfolio of real estate assets yield higher risk-adjusted returns?

5. Does inclusion of a quality factor create a superior asset-pricing model for real estate stocks?

What we know : Profitability, investment and quality have received increased recent attention in the finance literature as potential factors explaining the cross section of average returns. Fama and French (2015) document convincing evidence that profitability and investment are priced factors in explaining returns. In light of the recent focus on quality (or its components) as a factor in asset-pricing models, our paper examines whether quality premium exists in the cross section of real estate equity returns. Given the regulatory requirements that REITs face and the distinct characteristics of real estate assets – tangibility, illiquidity, capital intensiveness and long holding periods, we argue that the quality attributes – profitability, growth, safety and payout – may be even more important in real estate than for conventional firms.

Novel Findings : We find that quality is a persistent and predictable characteristic in U.S. real estate returns. Although quality is a significant determinant of price of real estate assets, its explanatory power is limited to 11.5 percent. Returns to a quality minus junk (QMJ) real estate portfolio are significant across time periods and are highest during 1999-2003 and the financial crisis. In essence, quality is not fully priced in listed real estate stocks for the sample period 1999-2013.

To our knowledge, our study is the first to add a quality factor to the empirical asset-pricing model applied to REITs and REOCs. We closely follow the aggregate stock market studies by Asness et al. (2013) and, to a lesser extent, Fama and French (2015). However, we present unique results that contrast with the findings of these two papers. Specifically, in contrast with Asness et al. (2013), we find quality to be a more predictable characteristic in the valuation of U.S. real estate stocks than for the aggregate U.S. stock market. Similar to the findings for the aggregate stock market in Asness et al. (2013), quality in listed real estate appears to be underpriced as implied by the limited explanatory power of the price of quality and higher risk-adjusted returns to quality. However, a long quality, short junk portfolio (QMJ) of real estate stocks produced average risk-adjusted returns of 3.6 percent per quarter, considerably higher than the risk-adjusted returns reported by Asness et al. (2013) for a long quality, short junk portfolio in the aggregate stock market.

Implications for Practice : Our findings should be of interest to managers pursuing alpha and hedging strategies. A long quality, short junk portfolio of real estate stocks is found to be a positive alpha strategy that has yielded, on average, 3.6 percent per quarter on a risk-adjusted basis. The returns and factor loadings of other long/short portfolios (PMU, GMM, SMV, and HpMLp) can also be exploited in alpha strategies.

Full Citations : Anzinger, S. K., Ghosh C. and M. Petrova, "The Other Side of Value: The Effect of Quality on Price and Return in Real Estate", Journal of Real Estate Finance and Economics, 2016, pp 1-29.

Abstract : We examine the effect of quality on price and return in real estate. Quality real estate stocks generally trade at higher prices. However, similar to findings in the aggregate stock market (Asness et al., 2013), quality in listed real estate is not fully reflected in price. A long quality, short junk portfolio (QMJ) is found to produce average risk-adjusted returns of 3.6 percent per quarter (14.4 percent annually). QMJ has a significantly positive coefficient when added as a dependent variable to a four-factor model explaining U.S. real estate excess returns, including market, size, value and momentum factors, and leads to a small improvement in the overall fit of the model. Further investigation of the components of quality shows that profitability has a consistently positive relationship with real estate excess returns, while higher dividend payout is consistently associated with lower returns, in contrast to findings for conventional firms.

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Milena Petrova

Milena Petrova

Professor Petrova is an associate professor of finance­. Her primary research interests are in the areas of real estate capital markets, REITs, commercial real estate, corporate finance and corporate governance.
Milena Petrova
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