Macroeconomic risk and excess returns of property stocks some international evidence

Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence HUANG QIONG (B Eng., Tongji University) A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SCIENCE DEPARTMENT OF REAL ESTATE NATIONAL UNIVERSITY OF SINGAPORE 2004 -i- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Acknowledgements: I want to extend special thanks to Professor Liow Kim Hiang, my respected supervisor, for his guidance and encouragement in the process of this research Throughout the writing of this thesis, I have had deadly helpful advice from Prof Liow I also want to forward a special word to Huang Miaoxing and Yao Wanying, my dear parents, and Yin Lu, my wonderful boyfriend, for their encouragement Huang Qiong NUS 2004 Acknowledgements - ii - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Table of Contents Acknowledgements ii Table of Contents iii List of Tables vi List of Figures vii Executive Summary Chapter One Introduction 1.1 Background 1.2 Research Objective and Scope 1.3 Research Data 1.4 Research Methodology 1.5 Significance of Research 1.6 Organization of Study Chapter Two Literature Review 2.1 Introduction 2.2 Relationship between Stock Market, Real Estate Market and Securitized Property Market 12 2.2.1 Relationship between Stock Market and Physical 12 Real Estate Market 2.2.2 Relationship between Securitized Property and 14 Direct Property Markets 2.2.3 Relationship between Securitized Property Market 17 and Stock Market 2.3 Macroeconomic Conditions and Stock Market 18 2.4 Macroeconomic Factors and Real Estate Market 21 2.5 Time-varying Risk Premium 23 2.6 Summary 25 Table of Contents - iii - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Chapter Three Macroeconomy and Market Review 3.1 Introduction 26 3.2 Hong Kong 26 3.3 Japan 32 3.4 Singapore 38 3.5 United Kingdom 44 Chapter Four Data and Methodology 4.1 Introduction 49 4.2 Research Data: Sources, Definition, and Descriptive Statistics 49 4.2.1 Property Stock Indexes and Risk-free Rates 49 4.2.2 Property Stock Excess Returns 51 4.2.3 Macroeconomic Variables: Variable Choices, Definition and Sources 52 4.2.4 Construction of Macroeconomic Variables 59 4.2.5 Statistics Description of Macroeconomic Variables 61 4.3 Methodology 64 4.3.1 Theoretical Foundation: Arbitrage Pricing Theory 64 4.3.2 Empirical Model and Estimation Procedure 66 4.3.3 Principal Components Analysis 70 4.3.4 Generalized Autoregressive Conditional Heteroskedasticity (GARCH) Models 74 4.3.5 Generalized Method of Moments (GMM) Estimator 78 4.4 Summary 81 Chapter Five Empirical Results and Discussion 5.1 Introduction 82 5.2 PCA Results 82 5.3 GARCH (1,1) Model Estimates 86 Table of Contents - iv - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence 5.4 GMM Estimation 94 5.4.1 Macroeconomic Factor Influences 95 5.4.2 Macroeconomic Risk Impacts 100 5.5 Implication of Findings 105 5.6 Summary 106 Chapter Six Summary and Conclusions 6.1 Summary of Main Findings 107 6.2 Limitations of the Research 108 6.3 Recommendation for Further Research 109 References 110 Appendices 119 Table of Contents -v- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence List of Tables Table 1.1 Property Stock Index Description Table 2.1 A Summary of Key Studies Reviewed Table 3.1 A Sample of Large Listed Japanese Real Estate Companies 37 Table 4.1 Property Stock Price Index and Risk-free Rate 50 Table 4.2 Descriptive Statistics of Monthly Excess Returns on Property Stocks 52 Table 4.3 Summary of the Relationship between the Macroeconomic Variables and Excess Returns on Property Stocks 59 Table 4.4 Glossary and Definitions of Macroeconomic Variables 61 Table 4.5 Descriptive Statistics, Jarque-Bera and Lejung-Box Q Statistics of Macroeconomic Variables Table 4.6 Spearman Correlation Matrix of Macroeconomic Variables 63 Table 5.1 Eigenvalues and Proportions of Variance Explained by Derived Principal Components 83 Table 5.2 Factor Loadings for the Retained Principal Components 86 Table 5.3 Lags in the Mean Equations of GARCH (1,1) for Principal Components and Excess Returns Table 5.4 GARCH (1,1) Estimates for the Principal Components and Excess Returns on Property Stocks 87 Table 5.5 GMM Estimates from the System of Two Equations 96 Table 5.6 Macroeconomic Factor Relations with Property Stock Excess Returns 99 Table 5.7 Links between Macroeconomic risk and the Expected Property Stock Excess Returns and the Conditional Variance of Excess Returns 100 Table 5.8 Estimated Coefficients on Significant Conditional Variance and Covariance Terms of the Principal Components 103 Table 5.9 Relationship of Macroeconomic Risk and Expected Property Stock Excess Returns and Conditional Variances of Excess Returns 104 List of Tables 64 91 - vi - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence List of Figures Figure 1.1 Property Stock Indices Figure 1.2 Research Methodology Framework Figure 3.1 Gross Domestic Production (GDP) and Growth of GDP 27 Figure 3.2 Money Market and Annual Returns of Property Stocks (Hong Kong) 28 Figure 3.3 Money Market and Annual Returns of Property Stocks (Japan) 34 Figure 3.4 Industrial Production Movements and Annual Property Stock Returns Figure 3.5 Money Market and Annual Returns of Property Stocks (Singapore) 38 Figure 3.6 Money Market and Annual Returns of Property Stocks (UK) 45 Figure 5.1 Conditional Variances of the Principal Components and Excess Returns on Property Stocks—Hong Kong 92 Figure 5.2 Conditional Variances of the Principal Components and Excess Returns on Property Stocks—Japan 92 Figure 5.3 Conditional Variances of the Principal Components and Excess Returns on Property Stocks—Singapore 93 Figure 5.4 Conditional Variances of the Principal Components and Excess Returns on Property Stocks—United Kingdom 93 List of Figures 40 - vii - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Executive Summary Following the development of modern portfolio theory and equilibrium valuation theories such as capital asset pricing model (CAPM) and arbitrage pricing theory (APT) in mainstream finance, a number of studies have examined the risk-return performance and pricing of real estate in the macroeconomic context Additionally, recognizing that certain risk factors might change over time, some studies have considered time variations in returns and risk premia This area of research has greatly enhanced investors’ understanding of the possible relationship between real estate performance and various macroeconomic factors and is especially meaningful when real estate is a significant asset of a nation’s economy such as in USA, UK and many developed economies in Asian countries With the increasing importance of listed property company shares in Asia and internationally, considerable attention has been given to examining various aspects of this type of indirect property investment vehicle Given the increasing level of international investment in Asian property companies in recent years, it is timely to investigate the macroeconomic driving forces of excess returns on property stocks in established markets such as Hong Kong, Japan, and Singapore As an extension of previous work, this research seeks to provide an alternative perspective on the dynamic relationship between property stock market and macroeconomy by examining whether the expected risk premium on property stocks in Hong Kong, Singapore and two welldeveloped markets of Japan and UK could be linked to the conditional volatilities of a set of principal components derived from six chosen macroeconomic variables This research uses monthly indices for the four property stock markets from May 1986 to March 2003 Six macroeconomic variables are chosen as joint proxy of macroeconomic condition for each market They are: growth in gross domestic product (GDPG), industrial production growth Executive Summary -1- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence (INDPG), unexpected inflation (UINFL), interest rate (INTR), money supply growth (M2G), and changes in exchange rate (XCHG) Three econometric techniques are involved in this research: Principal Component Analysis (PCA), Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model and Generalized Method of Moments (GMM) estimator The final results suggest that the expected risk premiums on property stocks of the four markets are time varying and dynamically linked to the conditional volatilities of the macroeconomic factors In addition, the conditional variance of property stock excess returns is also time varying and related in a predictable way to the conditional variances and conditional covariances of the macroeconomic factors The findings of this research have useful implications For international investors who need to understand the links between securitized property market and the marcoeconomy, this research uncovers the linkages and provides some dynamics about the structure of the relationships between excess returns and macroeconomic risks of property stocks This can be very useful to institutional investors and portfolio managers interested in global asset market that includes Asian securitized property markets such as Hong Kong, Japan, and Singapore Additionally policy makers may play a role in influencing the expected risk premium on securitized property markets through the use of macroeconomic policy Executive Summary -2- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence CHAPTER ONE INTRODUCTION 1.1 Background Following the development of modern portfolio theory and equilibrium valuation theories such as the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) in mainstream finance, a number of studies have examined the risk-return performance and pricing of real estate in the macroeconomic context Using the APT, Chen, Roll and Ross (1986) show that economic variables indeed have systematic effects on stock market returns Macroeconomic variables become risk factors in stock markets and multifactor model seeks to measure the risk premia attached to these various risk factors and further to assess whether they are significantly “priced” into stock market returns Employing multifactor formulation, many studies have investigated the impacts of macroeconomic factors on property market and securitized property market1 Additionally, recognizing that certain risk factors might change over time, studies such as Ling and Naranjo (1997) and Mei and Hu (2000) have considered time variations in returns and risk premia This area of research has greatly enhanced investors’ understanding of the possible relationship between real estate performance and various macroeconomic factors and is especially meaningful when real estate is a significant asset of a nation’s economy such as in the USA, the UK and many developed economies in Asian countries In addition to direct investment in real estate, there are two common types of indirect or securitized property investment vehicles available to investors The first type is property investment trusts, mainly known as Real Estate Investment Trusts (REITs) in the USA and List Property Trusts (LPTs) in Australia The second type of securitized real estate investment, popularly known in markets such as UK, Hong Kong and Singapore, consists of shares of Please refer to Chapter 2-“Literature Review” Chapter One Introduction -1- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence risk premium of property stocks is time varying when it is related to the time varying macroeconomic risk There is no consensus on the influence of macroeconomic risk on the property stock expected excess returns across the four markets and this would provide very useful implications for the international portfolio investors On the other hand, a similar pattern is found in the relationship between conditional variance of property stock excess returns and macroeconomic conditional volatilities across the four markets The finding is that a higher conditional variance of property stock excess returns is generally associated with a more volatile macroeconomic environment This result is also meaningful for the property stock investors to predict the their investment risks by the way of expecting the macroeconomic conditions This study enhances the investors’ knowledge on the properties of return and risk profile on property stocks in various macroeconomic conditions This would help international investors to price this investment instrument accurately, and to design diversified mixed asset portfolios or portfolios across markets Consideration of those money and financial market indicators in this study, for example, the unexpected inflation and the interest rate as well as exchange rate, is important for the investors to make better expectations, design optimal strategies, and seek for appropriate financial tools to hedge the risk in different markets 6.2 Limitations of the Research This empirical research is not without its limitations Specific attributes of the three Asian markets examined here may contribute to the significant empirical results Compared to other emerging markets in Asian, Hong Kong, Japan and Singapore are well-developed economies Since the features of various markets are different, we are not able to detect the macroeconomic influences on property stock market of the economic environment that is widely different from the Hong Kong, Japan and Singapore In addition, this study has not Chapter Six Summary and Conclusions - 108 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence exhausted the effects of all documented macroeconomic variables (for examples, the term structure of interest rate, consumption, unemployment, oil prices etc) on property stock markets due to lack of sufficiently long historical data series in the four markets especially in the developing markets of Hong Kong and Singapore 6.3 Recommendation for Further Research This study is expected to provide some indications for further research More markets should be examined in further studies Different methodology, study period, and market conditions would generate different results and provide more evidence for comparison Evidence in various countries and different economic condition periods would be useful for better understanding mechanism of property stock markets, either in academics or practices Additionally, different data frequency especially quarterly data can be tried Similarly, this will provide some comparative evidence Finally, further study can embark on exploring the relationship between macroeconomic risk and property stock excess returns by using other country specific macroeconomic variables or extending the research by using global factors Since many Asian developing markets are influenced by particular institutional factors, further research can include these factors into the variable set Chapter Six Summary and Conclusions - 109 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence REFERENCES: Acton, M J and D M Poutasse (1997) “ The correlation of publicly and privately traded real estate”, Journal of Real Estate Finance 14 (2), 13-19 Akgiray, V and G.G Booth (1988) “The stable law model of stock returns”, Journal of Business and Economic Statistics 6, 51-57 Ambrose, B., E Ancel, and M Griffiths (1992) “ The fractural structure of real estate investment trust returns: a search for evidence of market segmentation and nonlinear dependency”, Journal of the American Real Estate and Urban 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119 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Much like a usual F test, the null hypothesis of no ARCH effects will not be rejected if the LM test statistics provides evidence that a1 through a q are jointly equal to zero It is clearly evident that estimation would be inaccurate if the conventional econometric model is used but the assumption of homoskedasticity is deviated In such a situation, the standard error estimates could be wrong ARCH and GARCH models help to model the tendency of the movements in the disturbances This is one of the reasons why ARCH and GARCH models are preferable to conventional econometric models Appendices - 120 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Appendix II GMM Assumption for Identification The assumption of orthogonality conditions is the basic idea to construct the coefficient identification functions The identification function can be derived from rewriting the orthogonality conditions As we know,  z i1 ⋅ ε i1   z i1 ⋅ ( yi1 − xi'1 β1 )   z ⋅ε    z ⋅ ( yi − xi' β )  , g (wi ; β ) ≡  i i  That is, g (wi ; β ) ≡  i  M    M     '  z im ⋅ ε im   z im ⋅ ( yim − xim β m ) where m β ∑ L j ×1 j =1 β1  β  if L is the element of ≡  2 M    β m  β j vector So the orthogonality conditions are E [g (wi ; β )] = Then coefficients will be identified if βˆ = β is the only solution to E [g (w i ; βˆ )] = Appendices - 121 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence Appendix III GMM Assumption for Asymptotic Normality To ensure asymptotic normality, g i is assumed to be a martingale difference sequence, and ( ) ( ) E g i g i' is nonsingular Here, E g i g i' can be extended as the following matrix structure ( ) ( )  E ε i1ε i1 z i1 z i'1  E g i g i' =  M  E ε im ε i1 z im z i'1  ( ) ( ) ( ) '  E ε i1ε im z i1 z im  M  '  L E ε im ε im z im z im  L Given the population orthogonality conditions above, the sample analogue can be defined as  z i1 ⋅ ( yi1 − xi'1 βˆ1 )     z i ⋅ ( yi − xi' βˆ )  ˆ gn β ≡  n M   ' ˆ  z im ⋅ ( yim − xim β m ) () () Coefficient vectors will be obtained by minimizing the difference of g n βˆ from zero Appendices - 122 - [...]... compared and evaluated; (b) To measure time-varying conditional variances and conditional covariances of macroeconomic factors (representing macroeconomic risk) and excess return of property stocks; and Chapter One Introduction -3- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence (c) To derive a relationship between macroeconomic risk and expected excess return of property. .. Introduction -7- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence (b) It provides additional insights into the risk- return profile of international property stocks in the context of macroeconomy and hence complements international real estate literature in asset pricing and performance measurement; and (c) It employs a combination of PCA, GARCH and GMM techniques... Literature Review - 13 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence significant Using a nonlinear technique, Wilson and Okunev (1999) do not find evidence for the so called “long co-memory effects” between stock and property markets in UK and US, but they find some evidence of this in Australia In an international context, they present evidence of long co-memory... variables on the variation of the filtered property returns series There is, however, some evidence that the interest rate term structure and unexpected inflation have contemporaneous effects on property returns Chapter Two Literature Review - 22 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence The issue of the relationship between macroeconomy and property market is... Mei and Hu (2000) develop a multi-factor latent variable model to examine the time variation of expected returns on Asian property stocks Using data from 1990 Chapter Two Literature Review - 24 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence to 1997, they find strong evidence of the time-varying risk premium on property company shares and this suggests that property. .. studies of Perry (1982), Pindyck (1984), Poterba and Summers (1986), Akgiray and Booth (1988) Other literature follows the timevarying risk premium framework when seeking for the macroeconomic determinants of returns Fama and French (1989) find that the macroeconomic factors and the sensitivities of stock and Chapter Two Literature Review - 23 - Macroeconomic Risk and Excess Returns on Property Stocks: Some. .. - 17 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence 2.3 Macroeconomic Conditions and Stock Market There is substantial evidence that expected variations in stock and bond returns are related to the state of the economy as reflected in the key macroeconomic variables Fama (1981) and Chen, Roll and Ross (1986) are the first researchers who document that some real... Asia and internationally Second, this study derives a relationship between excess returns of securitized property and macroeconomic risk which is measured by the conditional volatility of macroeconomic variables Third, we use a combination of principal component analysis, GARCH (1,1) modeling and GMM to investigate the time varying nature of the excess property stock returns and the macroeconomic risk. .. behaviours of excess returns on Asian property stocks is relatively lacked This study fills the gap and contributes to strengthening the understanding of time-varying excess return on property stocks Furthermore, given the increasing level of international investment in Asian property companies in recent years, it is timely to investigate the macroeconomic drivers of excess returns on property stocks in... extension of previous work, this research seeks to provide an alternative perspective on the dynamic relations between property stock market and the macroeconomy by examining Chapter One Introduction -2- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence whether the expected risk premium on property stocks in Hong Kong, Singapore and two welldeveloped markets of Japan and ... Expected Property Stock Excess Returns and Conditional Variances of Excess Returns 104 List of Tables 64 91 - vi - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence. .. -3- Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence (c) To derive a relationship between macroeconomic risk and expected excess return of property stocks and. .. the macroeconomic factors and the sensitivities of stock and Chapter Two Literature Review - 23 - Macroeconomic Risk and Excess Returns on Property Stocks: Some International Evidence bond returns