Debt level analysis could help investors make sharper choices about real estate

Retail and institutional investors alike often buy stocks in Real Estate Investment Trusts, because they are known as defensive stocks, able to withstand periods of economic downturn, but a new study explains why some of these companies could prove a much safer bet than others.

Investors sometimes think that because stock is generally classified as defensive, not much is going to happen to it in a downturn, but that may not be the case
Eva Steiner

Investors who buy stocks of Real Estate Investment Trusts in search of a "defensive security" should be careful to check those firms’ levels of debt before they commit, a new study suggests.

Real Estate Investment Trusts, or REITs, are publically listed companies that generate income by owning and operating large property portfolios. By purchasing stocks in these companies, investors can share in that income and any capital appreciation, without having to buy the capital-intensive properties themselves.

These stocks are often considered to be low-risk, because they typically generate high dividends for investors and used to be only moderately affected during periods of economic turmoil. As a result, they are often also attractive to the managers of pension and endowment funds looking for high, reliable long-term returns, and are often referred to as "defensive" stocks.

In the new study, however, two researchers from the Universities of Cambridge and Sydney point out that the performance of individual REIT stocks is not always as consistent as this suggests. Instead, they argue that investors should look carefully at certain characteristics within the specific firms.

In particular, they warn that investors should examine these firms’ overall leverage, or the amount of debt that they use to finance their assets. The more indebted the firm is, they suggest, the less robust these so-called defensive stocks are likely to prove, in particular during periods of economic downturn.

The study was co-authored by Dr Eva Steiner, a Fellow and Director of Studies in Land Economy at St John’s College at the University of Cambridge, UK, and Dr Jamie Alcock, from the University of Sydney Business School.

"Investors sometimes think that because stock is generally classified as defensive, not much is going to happen to it in a downturn, but that may not be the case," Dr Steiner said. "The sensitivity of any stock to variation in the broader market environment will fluctuate over time and investors need to know more about the drivers of this sensitivity so that they can make sensible choices. We found that this depends, among other factors, on the overall financial position of the firm."

The idea that firm characteristics can be used to predict the overall sensitivity of its stock to market downturns has not been extensively investigated empirically until now. Most research has looked at the impact of broader, macro-economic trends, such as real and monetary conditions, on returns from real estate stocks, and this data suggests that they are, on average, quite resilient.

The new study, however, shows that the state of a specific REIT can offer investors a more nuanced and accurate picture. Steiner and Alcock looked at a large sample of historical data about the returns and overall characteristics of numerous REIT firms in the United States, covering a 20-year period from 1993 to 2013. On average, they examined data for 55 firms during each quarter over the course of the two decades.

Unlike any previous study, they found that leverage was one of the sharpest means of predicting the likely stability of stocks in these companies - especially during downturns. The more debt a firm had, the more its stock proved sensitive to periods of recession - without any additional gains on the upside. The impact of this relationship seemed to be particularly pronounced during periods of extreme difficulty, such as the 2007/8 sub-prime mortgage crisis.

Other company characteristics also proved important predictors of stock sensitivity. For example, more defensive, lower-risk stocks were consistently associated with small, high-growth firms that were less intensively traded.

Similarly, the researchers found that companies which demonstrated strong growth opportunities were less sensitive to such change. This pattern, they suggest, may recur because such opportunities were often circumstantial, one-off prospects specific to those companies alone, meaning that they would not be affected by broader market fluctuations - making an investment in them more secure.

Although the findings could help investors to construct more robust portfolios capable of weathering an economic storm, the researchers point out that they could also offer guidelines for managers within REITs themselves.

"There are implications for investors at two levels - the ones who buy the stock, who need to know that they are making sensible choices, but also the REIT managers, for whom this has implications regarding the risk management of their firms," Steiner said. "These results could help guide decisions about the investment risk of their firm, for example by choosing the appropriate level of leverage."
The paper, Fundamental Drivers of Dependence in REIT Returns, is published in The Journal of Real Estate Finance and Economics.

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