SPECULATIVE TRADING IN REITS

• Author: Benjamin M. Blau,Ryan J. Whitby
• Date: 01 February 2014
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/jfir.12028

SPECULATIVE TRADING IN REITS

Benjamin M. Blau and Ryan J. Whitby

Utah State University

Abstract

The recent extremes in the real estate economic cycle have created an ideal setting to

investigate the role of speculative trading. Specifically, we focus on speculative trading in

real estate investment trusts (REITs) during the recent boom and bust in real estate.

Although we find a strong relation between speculative trading in REITs and the

economic cycle, we do not find evidence that speculative trading is related to future

returns. Our results suggest that although increased speculative trading is apparent in

REITs during the boom years, the level of speculative trading in REITs does not appear to

affect the quality of markets at large.

JEL Classification: G10, G14, G19

I. Introduction

In both the popular press and academic research, much has been said about speculative

trading. With regard to the energy markets, Gary Gensler, chairman of the Commodity

Futures Trading Commission, indicated that “every option must be on the table”to curb

“excessive speculation.”

1

On the other end of the spectrum, Buyuksahin and Harris (2010)

state that “speculators provide immediacy and facilitate the needs of hedgers by mitigating

price risk, while adding to overall trading volume, which contributes to more liquid and well‐

functioning markets”(p. 169). A similar conclusion is reached in Friedman (1953). Other

research describes both the positive and negative externalities associated with speculation in

markets (Stein 1987; Wang 2010). Regardless of which side of the debate has more merit, a

better understanding of speculative trading is critical to the design and improvement of

financial markets. In this article, we focus on the role of speculative trading in real estate

investment trust (REIT) stock during the latest real estate economic cycle.

The recent boom and bust in real estate has created an ideal setting to investigate

the role of speculative trading in the marketplace. The U.S. Commodity Futures Trading

Commission defines a speculator as “a trader who does not hedge, but who trades with the

objective of achieving profits through the successful anticipation of price movements.”

2

We gratefully acknowledge helpful comments by seminar participants at the University of Montana, Utah

State University, and the American Real Estate Society Annual Conference. We also thank the Associate Editor

David Harrison and an anonymous referee for insightful comments and suggestions.

1

Commodity Futures Trading Commission Speeches and Testimony, July 29, 2009. http://www.cftc.gov/

PressRoom/SpeechesTestimony/genslerstatement072809

2

“CFTC Glossary: A Guide to the Language of the Futures Industry,”Commodity Futures Trading

Commission, 2012. Available at cftc.gov.

The Journal of Financial Research Vol. XXXVII, No. 1 Pages 55–74 Spring 2014

55

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

With respect to real estate, we can think of speculation in several ways. One avenue for

speculation in real estate is to buy and sell actual properties to try and profit from changing

prices. In recent years, extreme examples were reported of speculators overbuilding and

property “flipping”in cities across the United States. Speculators were betting that rapidly

rising prices would translate into large profits. Another natural avenue to speculate on real

estate is through the equity markets and the purchase of REIT stock. In this article, our use

of REIT is always a reference to the equity securities that are traded with respect to the

underlying real estate.

REITs are an attractive asset to speculators for several reasons. First, REITs trade in

liquid markets, which allows positions to be opened and closed daily if desired. Second, the

transaction costs associated with purchasing REITs are smaller than those associated with

purchasing real property. Third, although exposure to real estate through REITs is more

diversified, the numerous REITs available for purchase allow speculators to focus on specific

property types or regions without facing the varying levels of information asymmetry that

would be encountered with more direct investments.

3

We focus on speculative trading in

REITs, but we acknowledge that the role of speculators in direct real estate markets could be

quite different. Although speculative trading in the assets held by REITs would eventually

show up in prices and could be related to the speculative trading of REIT securities, the

illiquidity, uniqueness, and high transaction costs associated with the underlying assets allows

for potentially large deviations between REIT prices and the underlying net asset values.

We focus on two primary questions. First, what is the relation between

speculative trading and REIT performance during the recent real estate economic cycle?

Given the anecdotal evidence of speculation in real property in recent years as well as the

ease and convenience of trading equity REITs, we hypothesize that speculative trading in

REITs will increase during the boom periods. Results from our tests show a strong relation

between our proxy for speculative trading and the economic cycle in real estate. Although

speculative trading in REITs is indistinguishable from speculative trading in non‐REITs

over our entire sample (1993–2011), we find that speculative trading in REITs was

markedly higher than speculative trading in non‐REITs during the real estate boom

period. These results are supported in both our univariate and multivariate tests.

The second question we examine is whether speculative trading in REITs is

related to future returns. Stein (1987) develops a model that shows that although increased

speculation can benefit markets through greater risk sharing, it is also possible for

increased speculation to change the information content of prices enough to have a

destabilizing influence that outweighs the benefits. If speculative trading adversely affects

market prices by driving them too high or too low, then speculative trading should have

some predictive power with respect to future returns. In other words, if more speculation

causes prices to deviate from fundamentals, then REITs with more speculative trading

should have larger reversals. Conversely, if speculative trading is unrelated to future

returns, then the relation between speculative trading and prices in REITs is less clear.

Results in this study do not show that REITs with more speculative trading have larger

3

Although REIT managers can mitigate some of the informational asymmetries faced by investors looking to

gain exposure outside their areas of expertise, additional agency costs arise that could negate much of that benefit.

56 The Journal of Financial Research