On the Return Dynamics and Diversification Benefits of Property Sector REITs in the Japanese Market

Abstract

This thesis consists of three empirical chapters. First, we examine the long-run linkages and short-term dynamics between Japan REITs, direct real estate and stocks. Our estimation using a vector error correction model shows the long-run cointegration relation between REITs and direct real estate, where stocks can be excluded from the long-run relation. We present the short-run bidirectional causality between REITs and direct real estate and the causal relation between REITs and stocks. The cointegration relation implies that Japanese REITs have a comparative advantage in terms of liquidity providing the same diversification benefit as a real estate asset.

Second, we develop a new methodology for deriving the variance-covariance matrix between the cumulative returns of assets over different time horizons from a vector error correction model, a framework that accounts for their long-run relationship and short-run dynamics. Our estimation results show the term structure of volatility for each asset increase with the increase in time horizon. Further, we find that J-REITs and direct real estate assets are positively correlated. Their correlation increases with the time horizon and converges to unity in the limit. We use the estimated variance-covariance matrix into a buy-and-hold portfolio. We find that the portfolio weight of Japanese REITs is reduced with the increase in time horizon. Our result suggests the substitutability of REITs as real estate is horizon-dependent, consistent with the high level of correlation between REITs and direct real estate.
 
Third, we examine the dynamic role of Japanese REITs in a mixed-asset portfolio. Using a DCC-GJRGARCH model, we derive forecast estimates of time-varying volatility of REITs and correlations with other assets returns. Using the estimates, we construct dynamics out-of-sample portfolios between these three assets on a daily basis. Our results show the diversification benefits of incorporating REITs over a benchmark portfolio consisting of stocks and bonds. We analyse the economic benefit of including REITs in improving the investor’s utility over the average transaction cost. Our results affirm that Japanese REITs are portfolio diversifiers for active portfolio management.