Investor Recognition and Expected Returns of EREITs

Executive Summary. The Merton (1987) model suggests that investors demand a higher return when required to trade on the basis of incomplete information. This research tests if the prediction of the Merton model can be validated for EREITs. The results are broadly consistent with the predictions of the Merton model. Returns increase monotonically with shadow cost. However, an analysis of portfolios sorted by shadow cost and size evidences some nonlinearity in the return-shadow cost relationship. The Fama-Macbeth regression analysis illustrates that shadow cost of incomplete information is a priced factor in the REIT return-generating process even in the presence of other control variables. The shadow cost is shown to be time varying, becoming increasingly significant as a return-generating factor in the post 1991 period of REIT industry ownership and control restructuring. Finally, the simulation of zero-cost trading strategies shows that a long position in high shadow cost REITs and a short position in low shadow cost REITs results in positive net benefits on the average.