1. RETURN OF REIT AND EXPECTED INCOME GROWTH OF REAL ESTATE ASSET Sherry Y.S. Xu Department of Real Estate and Construction Faculty of Architecture The University of Hong Kong

2. RESEARCH QUESTIONS Is there relationship between REITs and real estate market? Which elements of the two markets can be linked? How would these elements relate to each other?

3. PROPOSITIONS As the underlying portfolio of REIT, the real estate asset would has certain relations to its return. Though actual rent growth cannot reflect the return of REIT, it would have dependence on the expected rent growth of underlying real estate assets.

4. RESEARCH OBJECTIVES Dependent variable: total return of REITs Independent variables: 1) stock market factor ---- stock market price index 2) economic factor ---- real interest rate 3) real estate market factor ---- expected income (rent) growth of real estate asset

5. what is expected income growth? The expected income growth can be defined as the rate at which the cash-flow of certain asset will grow over a period of time For real estate asset, the expected income growth can be regarded as the rent growth of the property in the investors’ expectation.

6. where does expected income growth come from? DCF Model first formally expressed in Fisher (1930) and Williams (1938)’s work Gordon Growth Model a variant of DCF model was derived by Gordon (1959) Here, P, D, g, k represent the asset’s value, income, expected income growth and required return rate respectively.

7. what is expected income growth usually used for? Evaluation of the asset’s price Prediction of the asset’s return *in most of the previous research, the assets are almost stocks, REITs and real estate assets. Several very important relationships: expected income growth expected return Income yield price

8. Previous literatures on the application of expected income growth ArticleAssets examinedApplicationsDataTesting MethodsTime period Chen et al. (2004)Real estateto evaluate the real estate asset as one of several factors in the model NOI index by NCREIFOLS Model1982 – 2003 Hung and Glascock (2008) REITsto find out the momentum return of REITs when dividend yield is shock REITs’ returns from the CRSP database VAR Model1997 – 2000 Johnson (2002)Equitiesto test the momentum effects in stock returns under condition that the expected dividend growth varying over time Equity (especially real estate stocks) returns from the CRSP database VAR Model1993 – 2000 Plazzi et al. (2008)Commercial real estate to measure the risk of commercial real estate investment Returns and growth in rents of commercial real estate on metropolitan areas VAR Model1986 – 2002 Shilling and Sing (2007)Real estateto predict the return of real estate asset Return from NEREIF data base and ex-ante return from Korparz Survey VAR Model1988 – 2006 Sing et al. (2007)Property and property stock to predict the returns of both property and property stock Real estate return (URA of Singapore) and property stock return (SGX-PTYS) VAR Model1988 – 2006 Some of the recent research adopting expected income growth

9. What are the common methods to get the expected income growth the conventional estimating method : VAR model (Vector Auto Regressive) (first applied in Campbell and Shiller (1988a,b)’s research) based on different datasets 1)historical income growths 2) historical income yields

10. Previous literatures making estimation of expected income (dividend) growth ArticleAssets examined Estimating method(s)DataTime period Ang and Bekaert (2007)Equitiesauto-regressive modelS&P 500 stock price return and total return 1935 – 2001 Ang and Liu (2007)Equitiesauto-regressive modelS&P 500 return data1935 – 2001 Bansal and Yaron (2004)Equitiesauto-regressive modelEquity prices and realized consumption growth data 1929 – 1999 Chiang (2008)REITsauto-regressive modelCenter for Research in Security Prices (CRSP) / Ziman Real Estate Database for REITs’ returns 1980 – 2006 Fama (1990)Equitiesauto-regressive modelAnnual NYSE value- weighted returns 1953 – 1987 Fama and French (2001)Equitiesauto-regressive modelCRSP and Compustat1926 – 1999 Lettau and Ludvigson (2005)Equitiesauto-regressive modelStock dividend and return from CRSP 1947 – 2001 Menzly et al. (2004)Equitiesauto-regressive modelCRSP value-weighted stock market index 1948 – 2001 Schwert (1990)Equitiesauto-regressive modelNYSE value-weighted returns 1889 – 1988 Some of the recent research estimating expected income growth

11. Why to construct a new model 1) VAR model can be a good forecasting model, but in a sense it is an atheoretical model. 2)The problem of the predictability of the expected income growth.

12. Deviation of the new model Based on Gordon Growth Model, we further assume that the required rate of return (i) would change with constant growth (G) as well, then we get the variant of GGM: Here, P = price of asset, D = income of asset, g=expected income growth, i=required rate of return, G = the growth of required rate of return (1)

13. How to find out growth of required rate of return Required rate of return (i) = cost of capital = risk-free return rate =yield of government bond growth of igrowth of bond yield is equal to spread of bond yield (S) = longest-period bond yield (iL) – shortest-period bond yield (i0) (2)

14. the expected income growth model Combining equation (1) and (2), we can get the model for capturing the expected income growth of certain asset as followed: Solving the function above with Newton-Raphson Method, the expected income growth of asset (g) can be calculated

15. Study in Hong Kong market Source: Rating and Valuation Department, Hong Kong SAR & Hong Kong Monetary Authority

16. Study in Hong Kong market (continued) Source: Rating and Valuation Department, Hong Kong SAR & Hong Kong Monetary Authority

17. EMPIRICAL TEST Empirical model: Here, Rit and ERGit refer to the total return and weighted expected income growth of certain portfolio of the ith REIT at time t respectively; HSIt, INTt, INFt represent the Hang Seng Index, Interest rate and Inflation rate in Hong Kong at time t respectively.

18. Empirical results: ① Return of all REITs in Hong Kong show strong positive dependence on the stock market factor; ② Three of them show significant negative relationship with real interest rate; ③ One of them shows significant positive dependence on the expected rent growth of its underlying real estate asset. EMPIRICAL TEST (continued)

19. Conclusions The contributions of this study: combining the government bond market with asset market to find out the change of time value of the money; capturing the expected income growth based on a mathematical model other than forecasting investigation or econometrics model; finding out the relationship between REITs market and direct real estate market.

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