SSRN Id1787030 PDF

Are real estate investment trusts (REITs) an inflation hedge?
Gwangheon Hong
College of Business, Sogang University
1 Shinsoo-Dong, Mapo-Ku
Seoul, Korea 121-742
tel: (82)-2-705-8530; e-mail: ghong@sogang.ac.kr
Bong-Soo Lee
Department of Finance, College of Business
Florida State University
311 Rovetta Building
Tallahassee, FL 32306-1110
tel: 850-644-4713; fax: 850-644-4225
e-mail: blee2@cob.fsu.edu
Abstract
Given the recent debate on the empirical validity of the inflation illusion hypothesis,
recent implosion of REIT prices combined with potential inflationary pressure, and a
significant role of the real estate market in the recent financial market meltdown, we
examine whether the observed negative relations between REIT returns and inflation can
be explained by the inflation illusion. We identify the mispricing component in the REIT
prices based on present value models, both linear and loglinear, and then we investigate
whether inflation can explain the mispricing component.
We find some evidence of the inflation illusion hypothesis for the REIT return-
inflation relation for the linear models with a constant interest rate in that the inflation rates
explain some fraction of mispricing components and their effect on mispricing is negative.
However, when we allow for time-varying interest rates, inflation does not explain the
REIT mispricing component anymore. Further, when we take into account a potential
asymmetric effect of positive and negative inflation on the mispricing components in REIT
prices, which is an important implication of the inflation illusion hypothesis, we find that
REIT prices are not easily compatible with the inflation illusion hypothesis. Therefore, we
find only very limited evidence for the inflation illusion hypothesis.
To see whether behavioral factors such as consumer sentiment can better explain the
mispricing components in REIT prices, we use the consumer sentiment index in lieu of
inflation in the regression of the mispricing components. We find that when we include
both the inflation rate and the consumer sentiment index in the regression of the mispricing
components, the consumer sentiments tend to explain the mispricing component while
inflation loses its explanatory power. Therefore, we find some evidence that behavioral
factors such as consumer sentiment could have contributed to the mispricing in the REIT
prices.
Keywords: REIT returns; Inflation hedge; Mispricing

JEL classifications: G12; R31; E44; C32
Electronic copy available at: http://ssrn.com/abstract=1787030

Are real estate investment trusts (REITs) an inflation hedge?
Abstract
significant role of the real estate market in the recent financial market meltdown, we
examine whether the observed negative relations between REIT returns and inflation can
whether inflation can explain the mispricing component.
REIT prices are not easily compatible with the inflation illusion hypothesis. Therefore, we
find only very limited evidence for the inflation illusion hypothesis.
inflation in the regression of the mispricing components. We find that when we include
both the inflation rate and the consumer sentiment index in the regression of the mispricing
components, the consumer sentiments tend to explain the mispricing component while
inflation loses its explanatory power. Therefore, we find some evidence that behavioral
factors such as consumer sentiment could have contributed to the mispricing in the REIT
prices.
Keywords: REIT returns; Inflation hedge; Mispricing
JEL classifications: G12; R31; E44; C32

1. Introduction
The relation between asset returns and inflation has been investigated extensively.
Contrary to the conventional view and the Fisher hypothesis, many empirical studies find a
negative relation between inflation and real stock returns in post-war data for the U.S. and
other countries (e.g., Bodie, 1976; Jaffe and Mandelker, 1976; Nelson and Schwert, 1976;
Fama and Schwert, 1977; Gultekin, 1983; Geske and Roll, 1983; Lee, 1989; Marshall,
1992; Hess and Lee, 1999).
Various theoretical frameworks (hypotheses) and empirical approaches have been
proposed to explain the observed relation between stock returns and inflation. Modigliani
and Cohn (1979) propose the inflation illusion hypothesis, which states that stock market
investors are subject to inflation illusions. According to the inflation illusion hypothesis,
stock market investors fail to understand the effect of inflation on nominal dividend growth
rates, and they extrapolate historical nominal growth rates even in periods of changing
inflation. This implies that stock prices are undervalued when inflation is high and
overvalued when it is low. The inflation illusion hypothesis has been extended by Ritter
and Warr (2002), Campbell and Vuolteenaho (2004), Cohen, Polk, and Vuolteenaho
(2005). Feldstein (1980) proposes the tax hypothesis to explain the inverse relation
between higher inflation and lower share prices.
Fama (1981, 1983) proposes the proxy hypothesis. According to the proxy
hypothesis, high expected inflation proxies for slower expected economic growth. That is,
a positive association between stock returns and real activity, combined with a negative
association between inflation and real activity based on a money demand model, leads to
spurious negative relations between stock returns and inflation. The proxy hypothesis has
been extended by Geske and Roll (1983), who emphasize the monetization of government
deficits and a fiscal and monetary policy linkage. Given that inflation affects value by way
of its effect on the risk premium, Brandt and Wang (2003) propose the time-varying risk
aversion hypothesis.
On the other hand, housing prices have increased substantially in recent years
followed by a collapse. The housing price fluctuations and potential inefficiencies are
documented in Case and Shiller (1989, 1990), Shiller (2005), and Brunnermeier and
Julliard (2008). Economists thought that real estate should provide a good inflation hedge.

However, empirical results have been mixed. For example, evidence from the private
commercial real estate market shows that property acts only as a partial inflation hedge.
For U.S. markets, Hartzell et al. (1987) analyze appraisal-based real estate returns and find
coefficients in excess of one for both expected and unexpected inflation. However, using
owner-occupied homes, income-producing real estate, and real estate investment trusts
(REITs), Gyourko and Linneman (1988) obtain mixed results.1 Overall, prior studies tend
to find that real estate returns are only a partial hedge against inflation. The findings vary
across time periods and countries and depending on the components of returns and
conditioning variables that are included in the models. To some extent, this could be due to
the lack of a reliable, high quality, comprehensive, real estate performance measure and to
potential structural breaks in sample periods. The findings suggest that private real estate
acts as a partial hedge against some components of inflation, while public, securitized real
estate seems to exhibit the negative relationships found in common stock markets (see also
Hoesli, Lizieri, and MacGregor, 2008). 2
Several studies focus on the relation between the securitized real estate market returns
(e.g., REITs) and inflation because it is difficult to obtain high quality, high frequency real
estate return data and appraisal-based returns may not be very reliable. REITs (Real Estate
Investment Trusts) are pooled real estate funds that provide investors with an opportunity
to invest in securitized real properties and mortgages. Regarding U.S. REITs, studies tend
to find the lack of a positive relation between inflation and REIT returns with coefficients
that are negative or non-significant. Examples include Brueggeman et al. (1984), Gyourko
1
Other studies include Wurtzebach et al. (1991), Miles and McCue (1982), and Sirmans and Sirmans (1987).
For other countries, Newell (1996) finds that Australian private real estate only partially hedges both
expected and unexpected inflation. Limmack and Ward (1988) report that U.K. property sectors hedge
expected, but not unexpected, inflation. Hoesli et al. (1997) examine U.K. real estate, and they obtain the
coefficients significantly less than one, with those relating to unexpected inflation being negatively signed.
Barber et al. (1997) use a structural time series approach and find that U.K. real estate provides, at best, a
weak hedge against changes in underlying inflation but no hedge against shocks that change price levels or
against irregular price fluctuations. Stevenson and Murray (1999) examine the inflation hedging ability of
the commercial real estate sector in the Republic of Ireland and do not find evidence to support the
hypothesis that real estate acts as an effective inflation hedge over the period 1985 to 1996. Using Hong
Kong data for 1998-2006, Glascock, Feng, Fan, and Bao (2008) find that real estate assets in Hong Kong are
not a good hedge against inflation, in the short term or long term. Rosental (1999), using the data on single-
family housing in Vancouver, British Columbia, shows that the implicit market for residential buildings is
efficient and that any inefficiencies in the housing market must lie in the market for land itself.
2
Hoesli, Lizieri, and MacGregor (2008) also point out that in researching the inflation hedging qualities of
commercial (investment) real estate, a distinction needs to be made between private and public assets. In both
cases, there are conceptual and data-related issues.
4
and Linneman (1988), Goebel and Kim (1989), Murphy and Kleiman (1989), Titman and
Warga (1986), Park et al. (1990), and Larsen and McQueen (1995).3 As in most prior
research, Chatrath and Liang (1999) also find no evidence that REIT returns are positively
related to temporary or permanent components of inflation measures.4
As for testing the hypotheses on the relation between housing market returns and
inflation, Darrat and Glascock (1989) address the proxy hypothesis, modeling monetary
policy and financial variables -- in particular, movements in federal budget deficits. They
argue that budget deficits are linked to increases in uncertainty, equity premia, and bond
returns, and therefore to real estate returns. Their property data set contains a mixture of
REITs, building firms, and taxable real estate investors.5 Glascock, Lu, and So (2002)
also document a negative relation between REIT returns and inflation. Consistent with
Darrat and Glascock (1989), they find that the perverse negative relation between REIT
returns and inflation is due to the effects of changes in monetary policies.
In addition to the application of the proxy hypothesis, the inflation illusion hypothesis
has been applied recently. Brunnermeier and Julliard (2008) examine potential mispricing
in the housing market, focusing on the price-rent ratio. Specifically, Brunnermeier and
Julliard (2008) make the following statement regarding the role of money illusion, “For
example, people who simply base the decision of whether to rent or buy a house on a
comparison between monthly rent and monthly payment of a fixed nominal interest rate
mortgage suffer from money illusion. They mistakenly assume that real and nominal
interest rates move in lockstep. Hence, they wrongly attribute a decrease in inflation to a
decline in the real interest rate and consequently underestimate the real cost of future
mortgage payments. Therefore, they cause an upward pressure on housing prices when
inflation declines.” In particular, Brunnermeier and Julliard (2008) suggest that among
potential reasons for the housing market inefficiency, money illusion is a strong factor
3
For example, Murphy and Kleiman (1989) run regressions both with and without the market index on the
right-hand side and find observed significant negative coefficients for inflation sensitivity in the former but
coefficients that are indistinguishable from zero in the latter.
4
For other countries, Hoesli et al. (1997) do not find evidence that U.K. property companies hedge
components of inflation. Liu, Hartzell, and Hoesli (1997) investigate whether real estate securities continue
to act as a perverse inflation hedge in foreign countries given security design differences. They find that real
estate securities provide a worse hedge against inflation relative to common stocks in some countries and are
comparable to stocks in other countries.
5
Glascock et al. (2002) revisit this model using a VECM approach and find significant negative coefficients
for general and expected inflation and a negative but non-significant coefficient for unexpected inflation.
5
because frictions make it difficult in the housing market for investors to arbitrage away
possible mispricing. They identify an empirical proxy for mispricing in the housing
market and show that it is largely explained by movements in inflation. Thus, they find
empirical support for the inflation illusion hypothesis for the housing market. They show
that a reduction in inflation can generate substantial increases in housing prices when
agents are subject to money illusion.
Piazzesi and Schneider (2007) consider asset pricing in a general equilibrium model in
which some, but not all, agents suffer from inflation illusion. Illusionary investors mistake
changes in nominal interest rates for changes in real rates, while smart investors understand
the Fisher equation. The presence of smart investors ensures that the equilibrium nominal
interest rate moves with expected inflation. The model also predicts a non-monotonic
relation between the price-to-rent ratio on housing and nominal interest rates (see also
Suleyman and Yan, 2010).
Given the recent renewed interest in the inflation illusion hypothesis both in the stock
market (e.g., Ritter and Warr, 2002; Campbell and Vuolteenaho, 2004; Cohen, Polk, and
Vuolteenaho, 2005) and the housing market (e.g., Brunnermeier and Julliard, 2008) and the
dual nature of REITs reflecting both the stock market and the housing market, we examine
whether the observed negative REIT return-inflation relation is indeed mainly due to
inflation illusion. Traditionally in the United States and other countries, real estate has
been the principal asset held in most private portfolios. Therefore, whether REITs provide
a good inflation hedge is an important and interesting issue to examine.
To address this question and provide new insights into the relation, we propose an
identification of the mispricing component in REIT returns and examine whether the
mispricing component is mainly due to inflation. Further, we use an alternative, more
general identification method of two types of forces that drive the REIT return-inflation
relation, and we reevaluate the proxy hypothesis and the inflation illusion hypothesis.
Overall, we find only very limited evidence for the inflation illusion hypothesis, which is
consistent with recent studies that cast doubt on the empirical validity of the hypothesis for
the general stock market for various reasons.
Mei and Saunders (1997) show that real estate investments by commercial banks and
thrifts have largely been driven by past real estate and market returns rather than by future
6
expected returns. This trend-chasing investment strategy offers an explanation for the poor
performance of their real estate investments. Using REIT data since 1990, Gentry, Jones,
and Mayer (2004) find that REIT stock prices deviate substantially from fundamental
value using net asset values (NAV). Compared to closed-end fund REITs, the deviations in
REIT stock prices are much larger and have much higher insider and institutional
ownership. Thus, they suggest that REIT premiums and discounts reflect more than just
small investor sentiment.6 We also examine whether behavioral factors such as consumer
sentiment, instead of inflation, can better explain the mispricing components in REIT
prices. We find some evidence that behavioral factors such as consumer sentiment could
have contributed to the mispricing in REIT prices.
The paper is organized as follows. In Section 2, we provide empirical identification of
the mispricing component in REIT prices using present value models, first in a linear
model, then in a loglinear model allowing for time-varying discount rates. We also discuss
asymmetric effects in the mispricing components and the identification of positive and
negative relations between REIT returns and inflation. In Section 3, we present the
empirical results of the extent of mispricing due to inflation illusion together with potential
asymmetric effects and the identification of positive and negative relations between REIT
returns and inflation. In Section 4, to test the robustness of our results, we examine the
relation between (aggregate) REITs and inflation for the pre-2000 sample period of 1972-
1999, and the relation between mortgage REITs and inflation. We conclude in Section 5.
2. Empirical identification of the mispricing component in REIT prices
One way to examine the importance of the inflation illusion in the relation between
REIT returns and inflation is to see how much of the mispricing (or non-fundamental)
component of REIT prices is explained by inflation (e.g., Campbell and Vuolteenaho,
2004, for stock market prices; Brunnermeier and Julliard, 2008, for housing prices). In this
6
Vincent (1999) examines the information content of alternative summary performance measures, using
stock returns as the benchmark, for various REITs. Goetzmann and Peng (2006) analyze a bias in
transaction-based price indexes due to the presence of seller reservation prices. Levitt and Syverson (2008)
show that information asymmetry between real estate agents and sellers can contribute to distortions in
housing prices.
7
section, we propose a model that helps identify the mispricing component, which is
defined as the part of the REIT prices that is not related to fundamentals. Then we
examine how much of the mispricing component is related to inflation as a measure of the
inflation illusion.
2.1 Identification of the mispricing component in a linear model when the fundamental
variable is nonstationary.
Suppose that Xt represents a fundamental variable (e.g., dividends in REIT prices).

Since fundamental variable in asset prices (e.g., dividends) are usually non-stationary
series, we consider its first-differenced series. The fundamental variable is assumed to
have a MAR (moving average representation) by the Wold representation theorem:
ΔX = c ( L) u = ∑ k =0 c11k u
∞
, (1)
t 11 1t 1t − k
where L is the lag operator (i.e., Lnxt = xt-n) and cij(L) is a polynomial in the lag operator L
(i.e., cij ( L) = ∑ k cijk Lk with ∑ k ≡ ∑ k =0 ).
∞
Assume that REIT price Pt has two components, fundamental and mispricing (i.e.,
non-fundamental) components:
P = P* + b , (2)
t t t
where P * is a fundamental component and b is a mispricing component. We further

t t
assume that the fundamental component of REIT price P* is determined by the expected
t
present discounted value of the fundamental variable Xt:
β 1
P* = E ∑ E ∑ j =1 β Δ X
∞ ∞
β jX = X +
j
, (3)
t t j =1 t+ j 1− β t 1− β t t+ j
where β is a constant discount factor (e.g., Campbell and Shiller, 1987).7
7
A model with a time-varying discount rate will be discussed in Section 2.3 with a loglinear model.
8
Now we consider a case where Xt and Pt are cointegrated of order (1, 1), CI(1, 1), and
the other case where Xt and Pt are not cointegrated.
2.1.1 Cointegrated case
Suppose [Xt, Pt]’ are cointegrated of order (1, 1), CI(1,1). We define a spread between
(i.e., a linear combination of) Xt and Pt as St:
S = P − θ X = ( P* − θ X ) + b
t t t t t t
(4)
1
= S* + b = E ∑ j =1 β Δ X
∞ j
+b ,
t t 1− β t t+ j t
S* = ( P* − θ X ) =
1 and θ = β .
t 1 − β t ∑ j =1
∞
by setting E
j
β ΔX Here, b represents the
t t t+ j 1− β t
mispricing component in price P .

t
To calculate the present value of expected future fundamental variables ΔX , we
t+ j
use the following lemma, whose proof is provided in Hansen and Sargent (1980):
Lemma: Given Δ X = a ( L )ε ,
t t
β (5)
E ∑ j =1 β Δ X
∞ j
= [ a ( L ) − a ( β )] ε .
t t+ j L−β t
Using the lemma, it follows that
β 1
S = S* + b = [c ( L) − c ( β )]u + b . (6)
t t t 1 − β L − β 11 11 1t t
Let b = c (L) u , where u represents a non-fundamental shock that drives b . Then, it

t 22 2t 2t t
follows that
⎡ Δ X t ⎤ ⎡ c11 ( L ), c ( L) ⎤ ⎡ u ⎤
Z = ⎢ ⎥=⎢ 12 ⎥ ⎢ 1t ⎥ . (7)
t ⎢⎣ S t ⎥⎦ ⎢⎣ c 21 ( L ), c ( L ) ⎥ ⎢u ⎥
22 ⎦ ⎣ 2t ⎦
9
Then, the cointegrated model is characterized by
c ( L) = 0,
12
β 1 (8)
c ( L) = [c ( L) − c ( β )].
21 1 − β L − β 11 11
Then, it follows that
St = P − θ X = ( P* − θ X ) + b = c21 ( L) u1t + c22 ( L) u2 t = c21 ( L) u1t + bt

t t t t t
= c21 ( L) c11 ( L)−1 ΔX t + bt = γ ( L) ΔX t + bt = ∑ j =0 γ j ΔX t − j + bt ,
∞
(9)
where γ (L) = c21(L) c11(L)−1. This implies that u1t is a fundamental shock, and c ( L)u is a
22 2t
mispricing component bt of REIT price Pt. That is, when [Xt, Pt]’ are cointegrated of order
(1, 1), CI(1,1), the mispricing component bt of REIT price Pt is extracted from the spread
St as residuals after taking into account current and lagged ΔX t − j :
b = c ( L ) u = S − c ( L ) u = S − c ( L ) c ( L ) −1 Δ X
t 22 2t t 21 1t t 21 11 t
(10)
= S − γ ( L ) ΔX t = S − ∑ j = 0 γ j ΔX t − j .
∞
t t
Then we regress the mispricing component of REIT prices, bt, on inflation rates to see
how much of bt is explained by inflation:
bt = α + β π t + et . (11)
If inflation π t explains a substantial fraction of bt, it can provide support for the inflation
illusion hypothesis.
2.1.2 Non-cointegrated case
10
Suppose [Xt, Pt]’ are not cointegrated although both series are integrated of order one,
I(1), series. Then, we have the following bivariate MAR (moving average representation):
⎡ ΔX t ⎤ ⎡ c ( L), c ( L) ⎤ ⎡ u1t ⎤
Z = ⎢ ⎥ = ⎢ 11 12 ⎥ ⎢ ⎥ . (12)
t Δ
⎢⎣ t ⎥⎦ ⎢⎣ 21 ( ), ( L) u
22 ⎥⎦ ⎢⎣ 2t ⎥⎦
P c L c
Given that Xt is a fundamental variable, we impose c12 ( L) = 0, which identifies u1t as a

fundamental shock and u2t as a non-fundamental shock. Then, it follows
1
S = P − θ X = ( P* − θ X ) + b = S * + b =
t 1 − β t ∑ j =1
∞ j
E β ΔX +b , (13)
t t t t t t t t+ j t
β .
by setting θ =
1− β
Since [Xt, Pt]’ are not cointegrated, it follows that the spread St is integrated of order
one, I(1), process. Thus, it follows from (13) that the mispricing component bt is also an
integrated of order one, I(1), process:
ΔP = c ( L)u + c ( L)u = c ( L)u + (1 − L)b . (14)

t 21 1t 22 2t 21 1t t
That is, c ( L)u (= Δ bt ) is a mispricing component of ΔP . Since ΔX t = c11 ( L)u1t , it

22 2t t
follows that
ΔPt = c21 ( L) u1t + c22 ( L) u2 t = c21 ( L) u1t + (1 − L)bt = c21 ( L) c11 ( L)−1 ΔX t + (1 − L)bt
= γ ( L) ΔX t + (1 − L)bt = ∑ j =0 γ j ΔX t − j + (1 − L)bt ,
∞
(15)
where γ ( L) = c21 ( L) c11 ( L)−1.

Therefore, when stock price Pt and a fundamental variable Xt are non-stationary and
non-cointegrated, the mispricing component in the price will be non-stationary and it is
derived from ΔPt as residuals after taking into account current and lagged ΔX t − j .8
8
Therefore, it is shown that the presence of a cointegration CI(1,1) relation between cash flows (e.g.,
dividends or rents) and REIT prices is a sufficient condition for the absence of a non-stationary mispricing
component in the REIT prices for the sample period. If we define the non-stationary mispricing component
11
Δb = c ( L)u = ΔP − c ( L)u = ΔP − c ( L) c ( L)−1 ΔX
t 22 2t t 21 1t t 21 11 t
(16)
= ΔP − ∑ j =0 γ j ΔX t − j .
∞
Then, as in (11), we regress the mispricing component of REIT prices, Δb , on inflation

t
rates to see how much of the mispricing component Δb is explained by inflation.
t
2.2 Identification of the mispricing component in a linear model when the fundamental
variable is stationary.
Suppose that Xt, a fundamental variable (e.g., dividends in REIT prices), happens to
be a stationary process rather than a nonstationary process. Then, the level of the
fundamental variable is assumed to have a MAR (moving average representation) by the
Wold representation theorem:
X = c ( L) u = ∑ k =0 c11k u
∞
, (1)’
t 11 1t 1t − k
where L is the lag operator (i.e., Lnxt = xt-n) and cij(L) is a polynomial in the lag operator L
(i.e., cij ( L) = ∑ k cijk Lk with ∑ k ≡ ∑ k = 0 ). In this case, the REIT price Pt is supposed to be
∞
a stationary process since it is a present discounted value of a stationary variable.

Assume again that REIT price Pt has two components, fundamental and mispricing
(i.e., non-fundamental) components:
P = P* + b , (2)’
t t t
where P * is a fundamental component and b is a mispricing component. We further

t t
assume that the fundamental component of REIT price P* is determined by the expected
t
present discounted value of the fundamental variable Xt. We cans still proceed with
in the REIT prices as a bubble in REIT prices, this can be used as a condition for the presence of the bubble
(see e.g., Lee, 1998).
12
equation (3) using a linear combination of P* and Xt since it is still a present discounted
t
value of future first-differenced fundamental variable, which is stationary. However, as an
alternative, we consider the original present value relation:
P* = E ∑
∞ j
β X , (3)’
t t j =1 t+ j
where β is a constant discount factor.

To calculate the present value of expected future fundamental variables X , we use
t+ j
the Hansen and Sargent (1980) formula given in equation (5) assuming that:
X = a( L) ε ,
t t
β (5)’
E ∑ j =1 β X
∞ j
= [ a ( L ) − a ( β )] ε .
t t+ j L−β t
β
P = P* + b = [c ( L) − c ( β )]u + b . (6)’
t t t L − β 11 11 1t t
Let b = c (L) u , where u represents a non-fundamental shock that drives b . Then, it

t 22 2t 2t t
follows that
⎡ X t ⎤ ⎡ c1 1 ( L ), c (L)⎤ ⎡ u ⎤
Z = ⎢ ⎥= ⎢ 12 ⎥ ⎢ 1t ⎥ . (7 ) '
t ⎢⎣ Pt ⎥⎦ ⎢⎣ c 2 1 ( L ), c ( L )⎥ ⎢u ⎥
22 ⎦ ⎣ 2t ⎦
Then, the model of a stationary fundamental variable is characterized by
c ( L) = 0,
12
β (8)’
c ( L) = [c ( L) − c ( β )].
21 L − β 11 11
Pt = P * + b = c21 ( L) u1t + c22 ( L) u2 t = c21 ( L) u1t + bt

t t
13
= c21 ( L) c11 ( L)−1 X t + bt = γ ( L) X t + bt = ∑ j =0 γ j X t − j + bt ,
∞
(9)’
where γ (L) = c21(L) c11(L)−1. This implies that u1t is a fundamental shock, and c ( L)u is
22 2t
a mispricing component bt of REIT price Pt. That is, in the model of a stationary
fundamental variable, the mispricing component bt of REIT price Pt is extracted from the
Pt as residuals after taking into account current and lagged X t − j :
b = c ( L )u = P − c ( L )u = P − c ( L ) c ( L ) −1 X
t 22 2t t 21 1t t 21 11 t (10)’
= P − γ ( L) X t = P − ∑ j =0 γ j X t − j .
∞
t t
Then we regress the mispricing component of REIT prices, bt, on inflation rates to see
how much of bt is explained by inflation. If inflation π t explains a substantial fraction of
bt, it can provide support for the inflation illusion hypothesis. It is noted that when the
fundamental variable Xt is stationary, the cointegration is no longer an issue.
2.3 Identification of the mispricing component in a loglinear model
Models in Sections 2.1 and 2.2 are based on non-logged (real) REIT prices and
fundamentals with a constant discount rate. Previous studies such as Campbell and Shiller
(1988a, 1988b), Campbell (1991), and Campbell and Ammer (1993) develop log-linear
models allowing for time-varying discount rates.9 They show that the log price-dividend
ratio s2t is given by:
s 2 t = pt − d t = E t ∑ j = 0 ρ j [ Δ d t + j - h t + j ] + η t ,
∞
(17)
where pt and dt are logged REIT price and fundamental variable (e.g., dividend), ht is time-
varying returns, and η t is an approximation error.10 Equation (17) states that the spread
9
Sharpe (2002) shows that the negative relation between equity valuations and expected inflation is the result
of two effects: a rise in expected inflation coincides with both lower expected real earnings growth and
higher required real returns.
10
Golec (1994) shows that dividend yields in REITs’ total returns differ substantially depending on REITs’
compensation incentives.
14
s2t , the log price-dividend ratio, is an expected discounted value of all future dividend
growth rates less returns discounted at the discount rate ρ. That is, the log price-dividend
ratio is an expected discounted value of all future one-period ‘discounted rate-adjusted
dividend growth rates’, ∆dt+j - ht+j. As such, the log price-dividend ratio provides the
optimal forecast of the discounted value of all future dividend growth rates, future returns,
or both.
As in Campbell and Shiller (1988b), we also assume Et ht = Et rt + c. That is, we
assume that there is some variable rt whose beginning-of-period rational expectation, plus a
constant term c, equals the ex ante return on stock ht over the period. While Campbell and
Shiller (1988b) consider the hypothesis that the expected real return on stock equals the
expected real return on commercial paper plus a constant, we consider that the expected
real return on stock equals the expected real return on the long-term government (10-year
Treasury) bond plus a constant since we are also investigating the housing market in
addition to the stock market.11
This model is characterized as the restrictions c12(L) =0, c13(L) =0, and c23 ( L) = 0, on the
following trivariate MAR model:
⎡ Δd t ⎤ ⎡ c11 ( L), c12 ( L), c13 ( L) ⎤ ⎡ edt ⎤

Z t = ⎢ Δdrt ⎥ = ⎢c21 ( L), c22 ( L), c23 ( L) ⎥ ⎢ ert ⎥ , (18)
⎢ ⎥ ⎢ ⎥⎢ ⎥
⎢⎣ s2 t ⎥⎦ ⎢⎣ c31 ( L), c32 ( L), c33 ( L) ⎥⎦ ⎢⎣ ent ⎥⎦
where Δdrt = Δd t − rt , edt = dividend innovation, e rt = interest rate (or stock return)
innovation, and e nt = non-fundamental innovation (e.g., Lee, 1998). That is, with the
above identifying restrictions, we have the following:
Δd t = c11 ( L)edt , Δdrt = c21 ( L)edt + c22 ( L)ert , and
s2 t = c31 ( L)edt + c32 ( L)ert + c33 ( L)ent .
11
For details, see Section 3.1.
15
In the above representation, the mispricing component in the logged price, bt, is given
by c ( L)e , which is part of the log price-dividend ratio s2t that is not related to such
33 nt
fundamental variables as dividends and interest rates(or stock returns). 12 Then, the
mispricing component in the logged price, bt, is derived from s2t as residuals after taking
into account current and lagged Δd t − j and Δdrt − j for j=0, 1, 2, …:
b = c ( L )e = s − c ( L )e − c ( L ) e = s − ∑ j = 0 γ Δd
1 j t − j ∑ j =0 2 j t − j
∞ ∞
− γ r .
t 33 nt 2t 31 dt 32 rt 2t
Then, as in (11), we regress the mispricing component of logged REIT prices, bt, on
inflation rates to see how much of bt is explained by inflation.
2.4 Test for the inflation illusion
The inflation illusion hypothesis can be tested, as in the previous studies, by examining
whether a substantial fraction of the mispricing component of REIT prices is explained by
inflation. However, the hypothesis anticipates not only that inflation is playing an
important role in explaining the mispricing component but also that inflation and REIT
prices are negatively related. That is, when inflation is high, real as well as nominal
interest rates will be high, future cash flows are heavily discounted, and REIT prices will
be lower. Therefore, inflation should affect the mispricing component negatively.
In regression (11), we examine the explanatory power of inflation by using only the
current inflation rates. In a strict sense, we can consider only the current inflation rate to
examine the contemporaneous negative relation between REIT returns and inflation.
However, to be more flexible, we allow for lagged inflation rates to affect the mispricing
components. Therefore, we consider the following three cases with inflation rates: only
the current inflation rate, only the lagged inflation rates, and the current and lagged
inflation rates.
12
Falk and Lee (1998) decompose farmland price movements into movements attributable to fundamental
factors (i.e., factors that influence the time paths of rents and interest rates) and movements attributable to
nonfundamental factors. They formulate a trivariate vector moving average representation of the growth rate
of real rent, the growth rate of real rent minus the real interest rate, and the log of the real price-rent ratio.
16
bt = α + β π t + et , (11.1)
bt = α + ∑ j =1 β j π t − j + et ,
∞
(11.2)
bt = α + ∑ j =0 β j π t − j + et .
∞
(11.3)
We test for the null hypothesis that inflation rates as a group do not affect the
mispricing component and for the null hypothesis that the net cumulative effect of inflation
is zero, as follows:
H10: β j = 0 for each j, and
H20: ∑ j
β j = 0.
2.5 Asymmetric relation in the mispricing
We consider another implication of the inflation illusion hypothesis. According to the

hypothesis, REIT prices are undervalued when inflation is high and become overvalued
when inflation falls.13 Therefore, the hypothesis anticipates that both positive and negative
inflation shocks drive only a negative REIT return-inflation relation. This implies that both
positive and negative inflation rates are negatively related to the mispricing component in
REIT prices. While Simpson, Ramchander, and Webb (2007) examine asymmetric
responses of equity REIT to positive and negative inflation rates, we examine the effect of
positive and negative inflation rates on the mispricing component of REIT prices. 14
To examine this implication of the inflation illusion hypothesis, we employ a simple
dummy variable regression:
bt = a + b1 π 1t + b2 π 2t + et, (11.4)
13
The latter case is emphasized by Brunnermeier and Julliard (2008) in examining potential mispricing in the
housing market. They argue that people suffer from money illusion and mistakenly assume that real and
nominal interest rates move in lockstep. Hence, they wrongly attribute a decrease in inflation to a decline in
the real interest rate and consequently underestimate the real cost of future mortgage payments. Therefore,
they cause an upward pressure on housing prices when inflation declines.
14
Applying a pooled estimation methodology to an expansive data set containing 195 publicly traded equity
REITs for the period 1981-2002, Simpson et al. (2007) document a strong asymmetry in the response of
equity REIT returns to inflation. Specifically, they find that equity REIT returns rise in response to both
increases and decreases in inflation.
17
where π 1t = Dt x π t = positive inflation; π 2t = (1- Dt ) x π t = negative inflation; and Dt = 1
when π t > 0, otherwise 0. That is, the inflation illusion hypothesis anticipates that both
b1 < 0 and b2 < 0.
2.6 Identification of positive and negative relations between REIT returns and inflation
based on structural VAR identification of two shocks and components
Both the inflation illusion hypothesis and the proxy hypothesis purport to explain the
observed negative relation between stock returns and inflation. To examine whether there
is indeed only a negative relation between asset returns and inflation, in this section, we
propose a method of identifying two distinct disturbances (i.e., positive and negative
shocks) to inflation as a means of testing for the presence of two types of relations between
REIT returns and inflation.15 We discuss this based on the structural VAR identification.
Consider a 2-by-1 vector, Wt, consisting of the rate of inflation, πt, and (real) REIT returns,
REIT: Wt = [πt, REITt]'. By the Wold theorem, Wt has the following bivariate moving
average representation (BMAR):
Wt = [πt, REITt]'= B(L) et, or
⎡ π t ⎤ ⎡ B11 ( L), B12 ( L) ⎤ ⎡ e1t ⎤

⎢ REIT ⎥ = ⎢ B ( L), B ( L) ⎥ ⎢ ⎥ , (19)
⎣ t⎦ ⎣ 21 22 ⎦ ⎣ e2 t ⎦
where πt = inflation rate; REITt = (real) REIT returns; et is a 2-by-1 vector of disturbances
consisting of e1t and e2t; L is the lag operator (i.e., Lnxt = xt-n); Bij(L) for i, j = 1, 2 is a
15
Hess and Lee (1999) provide a theoretical model showing that there are aggregate supply and aggregate
demand shocks that affect the relation between stock returns and inflation. To empirically identify the two
shocks, following Blanchard and Quah (1989) they use a structural VAR (vector autoregression)
identification method by imposing permanent and temporary disturbances for aggregate supply and demand
shocks, respectively.
Falk and Lee (2004) develop and estimate a structural vector autoregressive model to examine the dynamic
responses of the inventory and sales of new single family homes to transitory and permanent shocks.
18
polynomial in the lag operator L (i.e., Bij ( L) = ∑ k bijk Lk with ∑ ∑
∞
k
≡ k =0
); and the
disturbances are orthonormalized such that var(et) = I.

This representation implies that we interpret inflation and REIT returns are driven by
two types of disturbances (or shocks), e1t and e2t. The time paths of the dynamic effects of
the two types of disturbances on inflation and REIT returns are implied by the coefficients
of the polynomials Bij(L) for i, j = 1, 2.
The BMAR model (i.e., estimates of B(L)) in (19) is derived by inverting a bivariate
vector autoregression (BVAR). By estimating the following BVAR of Wt = [πt, REITt]':
Wt = A(L) Wt-1 + ut, (20)
where A(L) = [Aij(L)] = [ Σk aijk Lk-1] for i, j = 1, 2, ut = [u1t, u2t]' = Wt - E (Wt | Wt-s, s ≥ 1)
with var(ut) = Ω, we obtain estimates of A(L) and Ω. By inverting this BVAR of Wt, we
derive a BMAR of Wt:
Wt = [I - A(L)L] -1 ut, (21)
where I is the identity matrix of rank 2.

Estimates of B(L) can be obtained by noticing that
B0 et = ut, (22)
and that
Wt = B(L) et = [I - A(L)L]-1 ut. (23)
Using (22), (23) implies that
B(L) = [I - A(L)L]-1 B0. (24)
Since estimates of A(L) are obtained by estimates of the BVAR in (20), to calculate
B(L), we only need an estimate of B0. This can be obtained by taking the variance of each
side of (22):
19
B0 B0' = Ω. (25)
Here, we obtain three restrictions for the four elements of B0: b110, b120, b210, b220. This
implies that we need an additional restriction for this bivariate model to achieve just-
identification.
In this paper, as a means of identifying the two distinct types of shocks, positive
inflation shock et+ and negative inflation shock et- , we propose the identifying restriction
that the two shocks have a same magnitude with an opposite sign:
b110 + b120 = 0. (26)
3. Empirical results
3.1 Data and preliminary findings
For our empirical analysis, we use REIT data for the sample period of 1972-2010,
which are obtained from the National Association of Real Estate Investment Trusts web
site: http://www.reit.com/IndustryDataPerformance/FTSENAREITUSRealEstateIndex
HistoricalValu/MonthlyIndexValuesReturns19722010/tabid/208/Default.aspx.
The web site contains FTSE NAREIT U.S. Real Estate Index series performance
indexes for all publicly traded REITs. For interest rates, we use the long-term government
(10-year Treasury) bond yield. 16 The CPI series and interest rates are obtained from
Shiller’s web site: http://www.econ.yale.edu/~shiller/data.htm.
Table 1 reports simple statistics for various REIT returns, cross correlations between
REIT returns and inflation, and the estimation results of the regression of various REIT
returns on inflation rates. For the cross correlations, we report not only contemporaneous
correlations but also the cross correlations with one lag and one lead to allow for a
potential mismatch in timing in the compilation of data. We report preliminary statistics
using both monthly (Panel A) and quarterly (Panel B) REIT series.
16
See Section 2.3 for the discussion of using interest rates for stock returns (see also Campbell and Shiller,
1988b).
20
In Panel A of Table 1, various monthly REIT returns are presented: aggregate
(composite) returns (REIT), equity returns (REITE), mortgage returns (REITM), and
hybrid returns (REITH). 17 They all show negative contemporaneous correlations with
inflation rate. The Ljung-Box statistics show that nominal REIT returns are not significant
as a group including one lagged and one lead cross correlations except for the mortgage
REIT returns. However, all of the real returns are significantly negative as a group. These
findings are confirmed in the regression of various REIT returns on inflation: the
coefficients of inflation for nominal returns are insignificantly negative except for the
mortgage REIT returns (REITM), but all the coefficients of inflation for real returns are
significantly negative. This confirms that REITs are not a good inflation hedge, in general,
for the sample period of 1972 -2010.
In Panel B of Table 1, with the quarterly REIT returns, we observe a similar result: all
the REIT returns are negatively correlated with inflation and the real REIT returns are
significantly negatively correlated, confirming that REITs are not an inflation hedge, in
general. The only exception to this observation is equity REIT: nominal equity REIT
returns (REITE) show an insignificant positive correlation with inflation, while real equity
REIT returns (RREITE) show an insignificant negative correlation with inflation. It is also
observed that mortgage REIT returns have a significant negative correlation with inflation
both for nominal (REITM) and real returns (RREITM). Since there is little difference
between monthly and quarterly REIT return-inflation relations, we focus our analysis of
the mispricing on aggregate (real) quarterly REIT returns in the following sections.
Before we move on to the analysis of the mispricing components in REITs, we
examine potential unit root and cointegration in REIT prices and dividends as another
preliminary step. Table 2 reports the test results using both monthly returns (Panel A) and
quarterly returns (Panel B). For both monthly and quarterly REIT returns, we find that
nominal REIT prices (Pn) are a nonstationary, I(1), process. However, nominal dividends
17
The REIT Composite Index contains all the publicly traded U.S. REITs. The Index, which is further
subdivided into equity, mortgage, and hybrid subcategories, also serves as the selection universe for the
REITs. Equity REIT is a REIT that owns, or has an "equity interest" in, rental real estate (rather than making
loans secured by real estate collateral). Hybrid REIT is a REIT that combines the investment strategies of
both equity REITs and mortgage REITs. Mortgage REIT is a REIT that makes or owns loans and other
obligations that are secured by real estate collateral.
21
(Dn), real prices (P), and real dividends (D) are all stationary, I(0), processes without a unit
root although there is some evidence that nominal dividends (Dn) may be marginally
nonstationary according to the augmented Dickey-Fuller test with four lags. This is rather
unusual in that for the general stock market, both stock prices and dividends tend to be
nonstationary and cointegrated. This implies that, among others, the cointegration between
real REIT prices and real REIT dividends is not a serious issue. As usual, we find that CPI
series is nonstationary, while inflation rate is stationary. In addition, the linear
combination of real REIT prices and dividends, S, is also stationary, as expected. Not
surprisingly, when we implement the cointegration test, we find that the null of one
cointegrating vector is rejected (see Panel B.2 of Table 2).
To further analyze these findings, we plot nominal and real REIT prices and dividend
series in Figure 1. The figure shows that among the variables, only nominal REIT price
shows a stochastic trend while other series look stationary. In particular, given a steady
increase in CPI series over time, both real REIT prices and dividends look very stable over
time, consistent with the finding of a stationary process based on the unit root tests above.
Further, it is noted that nominal REIT prices do not appear to catch up with the CPI for
most of the sample period, except for possibly during the most recent housing boom period
around 2006. This also confirms that REITs, for most of the sample period, are not a good
inflation hedge. The figure also shows a drastic decline in REIT prices since 2007: the
REIT price index peaked at 213.68 in January 2007 and declined to a low of 61.43 in
February 2009. Since then, the REIT price index recovered to 119.50 in March 2010.
3.2 The mispricing component in REITs

3.2.1 Using the first-differenced dividends
As in equation (10), we regress the linear combination of the REIT prices and
dividends, St, on current and lagged first-differenced dividends to derive a mispricing
component of the REIT prices (i.e., bt = NF1t). Then we regress the mispricing component
on inflation as in equation (11). The estimation results are presented in Panel A of Table 3.
The adjusted R2 is 0.031 when the current inflation rate is used as the regressor; 0.151
when four lagged inflation rates are used [i.e., INF(t-1) through INF(t-4)]; and 0.150 when
22
the current and four lagged inflation rates are used. We also look at whether inflation rates
as a group have a net (cumulative) effect on the mispricing component. We find that
inflation rates tend to have a significant negative net effect on mispricing. Therefore,
given that inflation explains some variation (i.e., 3 ~ 15%) in the mispricing component of
the REIT prices, we find some evidence for the inflation illusion hypothesis.
When we regress the mispricing component of the first differenced REIT prices (i.e.,
Δbt = NF2t), the adjusted R2 is 0.041 when the current inflation rate is used as the
regressor; 0.027 when four lagged inflation rates are used [i.e., INF(t-1) through INF(t-4)];
and 0.060 when the current and four lagged inflation rates are used. However, we find
that inflation does not have a significant negative effect on mispricing. Therefore, we find
rather weak evidence for the inflation illusion hypothesis with the model of the first-
differenced REIT prices.
When we implement a similar procedure using a loglinear model as discussed above by
regressing the mispricing component of the spread (=log(p(t))-log(d(t))), (i.e., bt = NF3t),
on inflation, we find that the adjusted R2 is -0.010 when the current inflation rate is used as
the regressor; -0.018 when four lagged inflation rates are used [i.e., INF(t-1) through
INF(t-4)]; and -0.031 when the current and four lagged inflation rates are used.
Accordingly, inflation does not have a significant negative effect on mispricing. This
implies that once time-varying interest rates (or returns) are taken into account, inflation
does not have explanatory power for the mispricing, and this can be substantial evidence
against the inflation illusion hypothesis for the REITs.
Overall, our finding, with the linear models with a constant interest rate, shows that
inflation explains some fraction of various mispricing components of REIT prices.
However, once we allow for time-varying interest rates, inflation loses its explanatory
power for the mispricing component in REITs. This indicates that the inflation illusion
hypothesis is not effective in explaining the observed negative relation between REIT
returns and inflation.
3.2.2 Using the level of dividends
23
In Table 2, we find that both nominal and real REIT dividends are stationary although
there is some evidence otherwise. Therefore, we use the level of dividends, instead of the
first-differenced dividends, to calculate the mispricing component of REIT prices. As in
equation (10)’, we regress the REIT prices on current and lagged dividend levels to derive
a mispricing component of the REIT prices (i.e., bt = NF1t), and then we regress the
mispricing component on inflation. The estimation results are presented in Table 4. The
adjusted R2 is -0.005 when the current inflation rate is used as the regressor; 0.030 when
four lagged inflation rates are used [i.e., INF(t-1) through INF(t-4)]; and 0.039 when the
current and four lagged inflation rates are used. We also find that while the current
inflation does not have a significant effect, past inflation rates, as a group, have a
significant negative net effect on mispricing. Therefore, we find some evidence for the
inflation illusion hypothesis using the level of dividends although the explanatory power of
the inflation for the mispricing component is not as strong as the case with the first-
differenced dividends discussed above for Table 3.
When we regress the mispricing component of the first differenced REIT prices, (i.e.,
Δbt = NF2t), the adjusted R2 is -0.004 when the current inflation rate is used as the
regressor; 0.008 when four lagged inflation rates are used [i.e., INF(t-1) through INF(t-4)];
and 0.025 when the current and four lagged inflation rates are used. Further, we find that
inflation does not have a significant effect on mispricing. Therefore, we find little evidence
for the inflation illusion hypothesis with the model of the first-differenced REIT prices.
When we implement a similar procedure using a loglinear model (i.e., bt = NF3t), we
find that the adjusted R2 is -0.010 when the current inflation rate is used as the regressor;
-0.040 when four lagged inflation rates are used [i.e., INF(t-1) through INF(t-4)]; and
-0.045 when the current and four lagged inflation rates are used. Accordingly, inflation
does not have any significant effect on mispricing. This again implies that once time-
varying interest rates (or returns) are taken into account, inflation does not have any
explanatory power for the mispricing, and this can be substantial evidence against the
inflation illusion hypothesis for REITs.
Overall, we find that inflation explains some fraction of various mispricing
components of REIT prices using the level of dividends although the explanatory power of
inflation for the mispricing component is weaker than the case with the first-differenced
24
dividends. However, once we take time-varying interest rates into account, inflation loses
its explanatory power for the mispricing component in REITs. This indicates that the
inflation illusion hypothesis is not effective in explaining the observed negative REIT
returns and inflation relation.
3.3 Asymmetric relation between mispricing and inflation for U.S. REIT prices
Now we examine a potential asymmetric relation between mispricing and inflation as

discussed in Section 2.5 with the regression in (11.4). The estimation results of the
asymmetric regression models are presented in Table 5. The regression of the mispricing
component NF1 has an adjusted R2 of 0.021 with a positive inflation, while it has an
adjusted R2 of -0.007 with a negative inflation. Further, neither inflation is significant in
the regressions.
When we include both positive and negative inflation rates in the regression of the
mispricing component, the positive inflation has a significant negative effect on mispricing,
but the negative inflation is not significant at all. A similar observation is made for the
NF2 and NF3 in that positive inflation tends to have a significant negative effect on the
mispricing component, but negative inflation has even a significant positive effect on the
mispricing component, showing a significantly different effect on the mispricing
component. Therefore, we find little evidence overall in favor of the potential symmetric
effect of positive and negative inflation based on the inflation illusion hypothesis.
3.4 Further analysis with consumer sentiments
Since we find little evidence for the inflation illusion hypothesis for U.S. REITs, we
further examine whether the mispricing in the REITs is related to behavioral factors such
as consumer sentiment. We implement similar analyses using the consumer confidence
index by the University of Michigan (http://www.sca.isr.umich.edu/main.php) instead of
inflation as a regressor in the mispricing components.
3.4.1 Using the first-differenced dividends
25
As in equation (10), we regress the linear combination of the REIT prices and
dividends St on current and lagged first-differenced dividends to derive a mispricing
on consumer sentiments (CS). The estimation results are presented in Panel B of Table 3.
The adjusted R2 is 0.074 when the current consumer sentiment index is used as the
regressor; 0.055 when four lagged consumer sentiment indexes are used [i.e., CS(t-1)
through CS(t-4)]; and 0.058 when the current and four lagged consumer sentiment indexes
are used. We also look at whether consumer sentiments as a group have a net (cumulative)
effect on the mispricing component. We find that consumer sentiment indexes tend to have
a significant positive net effect on mispricing. Therefore, consumer sentiment indexes tend
to explain some variation (i.e., 5 ~ 8%) in the mispricing component of the REIT prices
with a significant positive effect on the components.
An interesting question would be which variable, between inflation and consumer
sentiment, has more explanatory power for the REIT mispricing component. To answer
this question, we include both the current inflation and consumer sentiment index in the
regression of the mispricing components. We find that the current inflation has a negative
sign but is insignificant, while the consumer sentiment index has a significantly positive
sign. Therefore, the comparison of the Panel A of Table 3 shows that in the presence of
the consumer sentiment index in the regression, inflation loses its explanatory power. This
suggests that, among other things, the mispricing in the REITs is more likely due to
consumer sentiment than inflation.
Δbt = NF2t), the adjusted R2 is 0.011 when the current consumer sentiment index is used as
the regressor; 0.039 when four lagged consumer sentiment indexes are used [i.e., CS(t-1)
are used. However, we find that the consumer sentiment index does not have a significant
positive effect on mispricing. Therefore, we find little evidence for the consumer sentiment
index explaining the mispricing component with the model of the first-differenced REIT
prices. When we include the current inflation and consumer sentiment index in the
regression of the mispricing components, NF2, the current inflation has a negative sign but
26
is insignificant and the consumer sentiment index has a positive sign but is insignificant
too. In other words, neither variable dominates in this model.
regressing the mispricing component of the spread (i.e., bt = NF3t) on consumer sentiment
indexes, we find that the adjusted R2 is 0.058 when the current consumer sentiment index
is used as the regressor; 0.102 when four lagged consumer sentiment indexes are used [i.e.,
CS(t-1) through CS(t-4)]; and 0.153 when the current and four lagged consumer sentiment
indexes are used. The current consumer sentiment index has a significant positive effect
on mispricing. However, lagged consumer sentiment indexes as a group do not have a
significant positive effect on mispricing. When we include the current inflation and the
consumer sentiment index in the regression of the mispricing components, the current
inflation has a negative sign but is insignificant, while the consumer sentiment index has a
significantly positive sign. Compared to Panel A of Table 3, this implies that even after
we take into account time-varying interest rates, the consumer sentiment index maintains
its explanatory power for the mispricing component, while inflation does not have
explanatory power for the mispricing.
Overall, our finding shows that between inflation rates and consumer sentiment
indexes, the latter has stronger explanatory power for the mispricing components in REITs.
This suggests that the mispricing in the REITs is more likely due to consumer sentiments
than inflation illusion, although both may be behavioral factors.
3.4.2 Using the level of dividends
As in Section 3.2.2, we again use the level of dividends, instead of the first-differenced
dividends, in calculating the mispricing component of REIT prices to see whether this
results in different estimation results with consumer sentiment. As in equation (10)’, we
regress the REIT prices on the current and lagged level of dividends to derive a mispricing
on the consumer sentiment index. The estimation results are presented in Panel B of Table
4. The adjusted R2 is 0.029 when the current consumer sentiment index is used as the
regressor; 0.020 when four lagged consumer sentiment indexes are used [i.e., CS(t-1)
27
are used. We find that consumer sentiment indexes tend to have a significant positive net
effect on mispricing. Therefore, consumer sentiment indexes tend to explain some
variation (i.e., about 2%) in the mispricing component of the REIT prices with a significant
positive effect on the components, although the adjusted R2 is not as high as the case with
the first-differenced dividend models in Panel B of Table 3.
When we include both the current inflation and consumer sentiment index in the
regression of the mispricing components, the current inflation has a negative sign but is
insignificant, while the consumer sentiment index has a significantly positive sign.
Therefore, the comparison of Panel A of Table 4 shows that in the presence of the
consumer sentiment index in the regression, inflation loses its explanatory power. This
suggests that, among other things, the mispricing of REITs is more likely due to consumer
sentiments than inflation.
Δbt = NF2t), the adjusted R2 is -0.006 when the current consumer sentiment index is used
as the regressor; 0.044 when four lagged consumer sentiment indexes are used [i.e., CS(t-
1) through CS(t-4)]; and 0.058 when the current and four lagged consumer sentiment
indexes are used. However, we find that the consumer sentiment index does not have a
significant effect on mispricing. Therefore, we find little evidence that the consumer
sentiment index explains the mispricing component using the model of the first-differenced
REIT prices. When we include the current inflation and the consumer sentiment index in
the regression of the mispricing components, NF2, the current inflation has a negative sign
but is insignificant and the consumer sentiment index has a positive sign but is
insignificant, too. Neither variable dominates in this model.
regressing the mispricing component of the spread (i.e., bt = NF3t) on consumer sentiment
indexes, we find that the adjusted R2 is 0.039 when the current consumer sentiment index
is used as the regressor; 0.035 when four lagged consumer sentiment indexes are used [i.e.,
CS(t-1) through CS(t-4)]; and 0.064 when the current and four lagged consumer sentiment
indexes are used. The current consumer sentiment index has a significant positive effect
on mispricing. However, lagged consumer sentiment indexes as a group do not have a
28
significant positive effect on mispricing. When we include both the current inflation rate
and the consumer sentiment index in the regression of the mispricing components, the
current inflation has a negative sign but is insignificant, while consumer sentiment index
has a significantly positive sign. Compared to Panel A of Table 4, this implies that even
after we take into account time-varying interest rates (or returns), the consumer sentiment
index maintains its explanatory power for the mispricing component, while inflation does
not have explanatory power for the mispricing.
Overall, our finding shows that between inflation rates and consumer sentiment
indexes, the latter has stronger explanatory power for the mispricing components in REITs.
This suggests that the mispricing in the REITs is more likely due to consumer sentiment
than inflation illusion, although both may be behavioral factors.
3.5 Positive and negative shocks to inflation and REIT returns
In Table 1, we find that the REIT return-inflation relation is negative in the sample
period of 1972-2010 as in the stock return-inflation relation. Therefore, both the proxy
hypothesis and the inflation illusion hypothesis purport to explain a negative relation
between asset returns and inflation. However, in the pre-war period, the stock return-
inflation relation is positive. Therefore, the two hypotheses are very limited in explaining
both positive and negative relations between asset returns and inflation relation. Lee
(2010) further shows that even in the post-war period, there are two forces in the economy
that drive either a positive or negative relation between stock returns and inflation. Since
we identify positive and negative inflation shocks in Section 2.6, we further examine
whether there are indeed two forces that drive positive and negative relations between
REIT returns and inflation.
To examine possible asymmetric relations between REIT returns and positive and
negative inflation rates, Figure 2 presents the plots of dynamic impulse responses of
inflation and REIT returns to positive and negative shocks to inflation for the sample
period of 1972-2010 after we identify them as discussed in Section 2.6. We observe in
Figure 2 that the positive inflation shock, which affects inflation positively over time,
initially affects REIT returns negatively, driving a negative (contemporaneous) correlation
between REIT returns and inflation. However, the negative inflation shock initially affects
29
both inflation and REIT returns negatively, driving a positive correlation between REIT
returns and inflation. Therefore, we confirm that there are indeed two types of shocks
driving the relation between REIT returns and inflation in different manners in the sample
period. It is also observed that positive and negative inflation shocks initially affect
inflation in opposite directions but in the same magnitude by construction (i.e., b110 + b120
= 0). However, the size of the effect of the positive inflation shock on REIT returns is
greater than that of the negative inflation shock. This implies that between the two types
of inflation shocks, the positive shocks, which drive a negative relation between REIT
returns and inflation, play a more important role in the relation. As a result, we observe
only their net effect, a negative relation between REIT returns and inflation.
In Table 7, we report the relative importance of positive and negative shocks to
inflation based on the forecast error variance decomposition of inflation and REIT returns
for various forecasting horizons after we identify positive and negative inflation shocks.
By construction, positive and negative shocks initially explain 50% of the forecast error
variance of inflation. However, in explaining REIT returns, the positive inflation shock is
more important than the negative inflation shock throughout the horizons: initially positive
shocks explain 59% while negative shocks explain 41% of the forecast error variance of
REIT returns. Since the positive shock drives a negative relation between REIT returns
and inflation, we observe a negative correlation in the sample period.
Overall, our identification of positive and negative inflation shocks implies the
presence of two distinct forces that drive the REIT return-inflation relation and can explain
the observed negative correlation between REIT returns and inflation for the sample
periods.
According to the inflation illusion hypothesis, when inflation rises, investors tend to
discount expected future earnings and dividends more heavily using higher discount rates.
As a result, REIT prices are undervalued when inflation rises, resulting in a negative REIT
return-inflation relation. When inflation falls, REIT prices are overvalued, which also
results in a negative REIT return-inflation relation. However, the bivariate VAR
identification finds that there are two --positive and negative-- distinct relations between
REIT returns and inflation in the sample period. Our finding, based on the identification of
positive and negative inflation shocks, is not easily compatible with the inflation illusion
30
hypothesis that predicts only a negative REIT return-inflation relation regardless of
whether inflationary shocks are positive or negative. The finding is not easily compatible
with the proxy hypothesis for a similar reason.
4. Robustness
4.1 Subsample relations
The literature does not always find that REIT returns are negatively related to inflation.
To see the robustness of the negative relation between various REIT returns and inflation,
we report cross correlations and regression relations for the pre-2000 period of 1972-1999
in Table 8 using both monthly (Panel A) and quarterly (Panel B) REIT series.
In Panel A of Table 8, aggregate monthly REIT index returns (REIT) are significantly
negatively related to inflation not only for nominal returns but also for real returns. A
similar relation is found for equity REIT returns (REITE), mortgage REIT returns
(REITM), and hybrid REIT returns (REITH). Therefore, for monthly REIT returns, we
find a more strongly negative relation for the sample period of 1972-1999.
For the quarterly data in Panel B of Table 8, we find a similar finding. Both nominal
and real aggregate quarterly REIT index returns are significantly negatively related to
inflation. Although nominal component REIT returns are not necessarily significantly
negatively related to inflation, they are all negatively related, and real REIT returns are all
significantly negatively related to inflation. Compared to the cross correlations for the
whole sample period reported in Table 1, this subperiod’s cross correlations tend to be
larger and more significant except for the mortgage REIT returns. Therefore, the negative
relation we observe for the whole sample period of 1972-2010 seems robust and even
stronger for the pre-2000 period, confirming that REITs were not a good inflation hedge
for both the sub period and the whole sample period we consider.
4.2 Further analysis with the mortgage REIT returns
So far, we have analyzed the mispricing components using the aggregate REIT returns.
In Table 1, it is shown that among component REIT returns, mortgage REIT returns
(REITM) show the strongest negative relation with inflation for the sample period of 1972-
31
2010. In this section, we examine the mispricing component in the mortgage REIT returns
to see whether the findings for the aggregate REIT returns are robust for the mortgage
REIT returns.18
In Panel A of Table 3 (REITM column), when the mispricing component in REIT
prices are computed using current and four lagged first differenced dividends, we find that
inflation explains some fraction (i.e., 2~14%) of the mispricing component of mortgage
REIT prices with a negative sign when we use linear models (i.e., NF1 or NF2) with a
constant interest rate. When we introduce time-varying interest rates in the loglinear
model (i.e., NF3), inflation explains a small fraction of the mispricing components (e.g.,
less than 0.6% of the adjusted R2). Therefore, we find a similar relation as in the aggregate
REIT return case: the inflation explains some fraction of the mispricing components of the
mortgage REIT prices in the linear model. However, once we take into account time-
varying interest rates, inflation loses its explanatory power for the mispricing component in
mortgage REITs. This indicates that the inflation illusion hypothesis is not effective in
explaining the observed negative mortgage REIT returns and inflation relation.
In Panel A of Table 4 (REITM column), when the mispricing component in the
mortgage REIT prices are computed using current and four lagged levels of dividends, we
find that the explanatory power of inflation is weaker than the case with the first-
differenced dividends and the inflation rate is not significant in any mispricing components
in either the linear or loglinear model. This again indicates that the inflation illusion
hypothesis is not effective in explaining the observed negative REIT returns and inflation
relation.
In Table 5 (REITM column), we reexamine the potential asymmetric effects of
inflation on the mortgage REIT mispricing when the mispricing component in the
mortgage REIT prices are computed using current and four lagged first differenced
dividends. When we include both positive and negative inflation rates in the regression of
the mispricing component, the positive inflation has a significant negative effect on
18
Lee and Chiang (2004) extend Seck’s (1996) approach to investigate the substitutability between equity
REITs and mortgage REITs. They find that the two types of real estate investment trusts are highly
substitutable. An important implication of this study is that investors who believe they have superior
forecasting abilities for a set of economic factors will be indifferent to invest in either equity REITs or
mortgage REITs. Another implication is that REITs can be treated as a single asset class in constructing a
diversified multi-asset portfolio.
32
mispricing but negative inflation has a positive effect on the mispricing component,
showing a significantly different effect on the mispricing component. We observe similar
findings in the REITM column of Table 6, when the mispricing component in the
mortgage REIT prices are computed using current and four lagged levels of dividends.
Therefore, we find little evidence in favor of the potential asymmetric effect of positive
and negative inflation based on the inflation illusion hypothesis.
Since we find little evidence for the inflation illusion hypothesis for the U.S. mortgage
REITs, we further examine whether the mispricing in the mortgage REITs is related to
consumer sentiments. In Panel B of Table 3 (REITM column), when the mispricing
component in the mortgage REIT prices are computed using current and four lagged first
differenced dividends, we find that the consumer sentiment has a significant positive effect
on the mispricing components using NF1 and NF3. When both the inflation rate and the
consumer sentiment index are included in the regression of the mispricing components, the
inflation rate has a significant negative effect and the consumer sentiment index has a
significant positive effect on the mispricing components of NF1 and NF3. Still, the
consumer sentiment index is relatively more significant than the inflation rate. In NF2, the
consumer sentiment index is not significant. Further, it is noted that in Panel A of Table 3,
inflation rate explains less than 1% of the mortgage REIT mispricing in NF3 with time-
varying interest rates. However, consumer sentiments explain a substantial fraction (31
~42%) of the mispricing component of the mortgage REIT in NF3. A similar observation
is made in Panel B of Table 4 when the mispricing component in the mortgage REIT
prices are computed using current and four lagged dividends. Overall, as in the case of the
aggregate REIT returns, our finding shows that between inflation rates and consumer
sentiment indexes, the latter has stronger explanatory power for the mispricing components
in the mortgage REITs. This suggests that the mispricing in the mortgage REITs is more
likely due to consumer sentiment than inflation illusion, although both may be behavioral
factors.
33
5. Concluding remarks
significant role of the real estate market in the recent financial market meltdown, we have
examined whether the observed negative relations between REIT returns and inflation can
whether inflation can explain the mispricing component. We examine not only the extent
of the explanatory power of inflation rates for the mispricing components but also the
negative effect of inflation rates, as the inflation illusion hypothesis anticipates.
REIT prices are not easily compatible with the inflation illusion hypothesis in that both
positive and negative inflation rates do not have a negative effect on the mispricing
components. In addition, we show, based on a bivariate identification, that there are indeed
two forces that drive either a positive or negative relation between REIT returns and
inflation. The inflation illusion hypothesis and the proxy hypothesis are not easily
compatible with this finding either.
Therefore, we find only very limited evidence for the inflation illusion hypothesis,
which is consistent with recent studies that cast doubt on the empirical validity of the
hypothesis for the general stock market for various reasons (e.g., Thomas and Zhang,
2007; Chen, Lung, and Wang, 2009; Wei and Joutz, 2009). As discussed by Piazzesi and
Schneider (2007) and Suleyman and Yan (2010), one way to understand the finding of
limited evidence for the inflation illusion hypothesis is that a very small fraction of
34
investors, if any, suffer from it and as a result we anticipate a non-monotonic relation
between REIT returns and inflation.
inflation in the regression of the mispricing components. We find that consumer sentiment
generally has a positive effect on the mispricing components. More importantly, when we
include both the inflation rate and the consumer sentiment index in the regression of the
mispricing components, the consumer sentiments tend to explain the mispricing
component while inflation loses its explanatory power. This observation is made even
when we allow for time-varying interest rates. Therefore, we find some evidence that
behavioral factors such as consumer sentiment could have contributed to the mispricing in
the REIT prices.
35
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40
Table 1
Regressions and cross correlations
Panel A: The U.S. monthly data
Sample period: 1972:01 To 2010:03 (monthly), 459 obs.
Sample Mean STD. Error Cross Correlations with INF(t-k)

k= -1 0 1 Q Stat. Signif.
INF 0.365 0.382
REIT 0.879 5.207 0.053 -0.065 -0.043 4.055 0.256
RREIT 0.516 5.232 0.010 -0.135*** -0.086* 11.896 0.008
REITE 1.063 4.990 0.091* -0.038 -0.043 5.295 0.151
RREITE 0.698 5.011 0.046 -0.112** -0.088* 10.293 0.016
REITM 0.560 6.064 -0.063 -0.122 -0.075 11.275 0.010
RREITM 0.199 6.096 -0.100 ** -0.183*** -0.112 ** 25.823 0.000
REITH 0.661 6.752 0.073 -0.057 -0.044 4.791 0.188
RREITH 0.298 6.765 0.040 -0.112** -0.078* 9.253 0.026
Dependent Constant INF R2 bar

Variable (t-stat) (t-stat)
REIT 1.999 *** -0.877 0.002

(3.57) (-1.38)
RREIT 1.190 *** -1.851 *** 0.016
(3.55) (-2.92)
REITE 1.242 *** -0.491 -0.001

(3.85) (-0.80)
RREITE 1.233 *** -1.467 ** 0.010
(3.83) (-2.41)
REITM 1.264*** -1.929*** 0.013

(3.25) (-2.62)
RREITM 1.262 *** -2.916*** 0.031
(3.26) (-3.98)
REITH 1.025** -0.999 0.001

(2.35) (-1.21)
RREITH 1.019** -1.977** 0.010
(2.35) (-2.40)
41
Panel B: The U.S. quarterly data
Sample period: 1972:I To 2010:I (quarterly), 153 obs.
Sample Mean STD. Error Cross Correlations with INF(t-k)

k= -1 0 1 Q Stat Signif.
INF 1.100 1.010
REIT 2.728 9.817 -0.133* -0.0457 0.100 4.651 0.199
RREIT 1.624 9.825 -0.175** -0.1415* 0.057 8.366 0.039
REITE 3.260 9.121 -0.083 0.0023 0.113 3.050 0.384
RREITE 2.145 9.121 -0.129 -0.1020 0.066 4.900 0.179
REITM 1.796 11.626 -0.092 -0.1613** 0.009 5.374 0.146
RREITM 0.716 11.685 -0.126 -0.2442*** -0.028 11.835 0.008
REITH 2.105 12.487 0.029 -0.0414 -0.054 0.850 0.837
RREITH 1.008 12.433 -0.003 -0.1188 -0.088 3.397 0.334
dependent constant INF R2 bar

variable (t-stat) (t-stat)
REIT 0.032*** -0.444 -0.005

(2.73) (-0.56)
RREIT 0.031*** -1.377* 0.014
(2.69) (-1.76)
REITE 0.032*** 0.021 -0.007

(2.95) (0.03)
RREITE 0.032*** -0.921 0.004
(2.90) (-1.26)
REITM 0.038*** -1.856** 0.020

(2.79) (-2.01)
RREITM 0.038*** -2.824*** 0.054
(2.81) (-3.10)
REITH 0.027* -0.512 -0.005

(1.78) (-0.51)
RREITH 0.026* -1.462 0.008
(1.77) (-1.47)
Notes:
REIT = aggregate (Composite) REITs (nominal) returns;
REITE = equity REITs (nominal) returns; REITM = mortgage REITs (nominal) returns;
hybrid REITs (nominal) returns; RREIT = real REITs returns;
INF= inflation rate.
***, ** and * denote significance at 1% , 5%, and 10%, respectively.
42
Table 2
Unit root and cointegration tests
Panel A. The U.S.: 1972:1 -2010:3 (monthly data)
A.1 Unit Root Tests

(i) Augmented Dickey-Fuller regression (ii) Phillips-Perron regression
m
Δxt = a0 + αxt −1 + ∑ γ i Δxt −i + vt xt = b0 + bxt −1 + vt
i =1
Variables ( x t ) Dickey-Fuller test Phillips-Perron test

τα (2 lags) τα (4 lags) Z(tb) (2 lags) Z(tb) (4 lags)
Pn -1.681 -2.267 -1.740 -1.849

Dn -7.428 -6.038 -21.816 -22.055
CPI -0.356 -0.421 -0.339 -0.338
INF -7.734 -5.924 -10.568 -10.640
P -4.827 -4.384 -4.694 -4.578

D -4.299 -3.594 -16.743 -17.942
Critical values: 1%= -3.447 5%= -2.868 10%= -2.570
Panel B. The U.S.: 1972:I -2010:I (quarterly data)
B.1 Unit Root Tests

(i) Augmented Dickey-Fuller regression (ii) Phillips-Perron regression
m
Δxt = a0 + αxt −1 + ∑ γ i Δxt −i + vt xt = b0 + bxt −1 + vt
i =1
Variables ( x t ) Dickey-Fuller test Phillips-Perron test

τα (2 lags) τα (4 lags) Z(tb) (2 lags) Z(tb) (4 lags)
Pn -2.093 -2.198 -1.965 -2.049

Dn -3.023 -2.346 -7.030 -7.526
INF -3.604 -2.206 -7.620 -8.078
P -5.114 -5.545 -4.644 -4.545

D -2.633 -2.957 -3.382 -3.442
S -4.927 -5.177 -5.883 -5.899
CS -2.519 -2.858 -2.610 -2.751
43
B.2 Cointegration tests
Eigenvalue L-max Trace H0:r p-r L-max90 Trace90
The REIT index price and dividend series (quarterly, real non-logged)
0.181 29.86 55.29 0 2 10.60 13.31
0.156 25.44 25.44 1 1 2.71 2.71
Notes:
Pn = REIT nominal prices; Dn = nominal dividends;
P = REIT real prices; D = real dividends;
INF = inflation rate; CS = consumer sentiment index;
S is a linear combination of P and D using quarterly data from 1972:01 to 2010:01 (non-logged real
series):
Pt = 11.765 + 30.915 Dt + St
(3.65) (5.82) adj. R2 = 0.597
Critical values: 1%= -3.475 5%= -2.881 10%= -2.577

(Fuller (1976, Tables 8.5.1 and 8.5.2, pp. 371-373)). The details of the adjusted t-statistics Z(tb)
can be found in the work of Phillips and Perron (1988).
44
Table 3
Explanatory power of inflation for the mispricing component in REIT prices calculated using
current and four lagged first differenced dividends
Panel A. Using inflation
This table reports estimates of the regression of mispricing component in (composite) REIT (REIT
column) and mortgage REIT (REITM column) on current inflation rate, lagged inflation rates, and
current and lagged inflation rates:
NFi t = αi + βi INFt + ei ,t , (11.1)

m
NFit = αi + ∑ βi INFt −i + ei ,t , (11.2)
i =1
m
NFit = αi + ∑ βi INFt −i + ei ,t , for i = 1, 2, 3, (11.3)
i =0
where NF1 = mispricing component in REIT prices calculated using current and four lagged first
differenced dividends, NF2 = mispricing component in the first differenced REIT prices, and NF3
= mispricing component in the difference in log prices and log dividends.
***, **, and * represent significance at 1%, 5%, and 10% level, respectively.
For model (11.1) with the current inflation, we report a constant and coefficient of the current
inflation. For model (11.2) with lagged inflation rates, we report chi-square test of the null that
each coefficient is zero, and the sum of coefficients with the chi-square test that the sum is zero.
For model (11.3) with the current and lagged inflation rates, we report chi-square test of the null
that each coefficient is zero, and the sum of coefficients of the current and lagged inflation rates
with the chi-square test that the sum is zero.
REIT REITM
NF1 NF2 NF3 NF1 NF2 NF3
Current INF
Constant 1.514 * 0.812 0.007 1.583 *** 0.966 *** 0.024
Coefficient -1.374 * -0.737 -0.910 -1.436 ** -0.876 *** -0.033
Adj. R2 0.031 0.041 -0.010 0.075 0.084 0.000
Lagged INF
Each coeff. = 0 25.589 *** 7.041 2.865 14.615 *** 5.950 3.356
Sum of coeff. -4.001 *** -0.681 -9.315 -2.403 *** -0.661 -16.612 *
Adj. R2 0.151 0.027 -0.018 0.124 0.026 0.003
Current &
Lagged INF
Each coeff. = 0 31.105 *** 8.249 2.892 15.320 *** 20.810 *** 4.287
Sum of coeff. -3.873 *** -0.847 * -9.518 -2.579 *** -0.882 * -20.310 *
Adj. R2 0.150 0.060 -0.031 0.138 0.113 0.005
45
Panel B. Using consumer sentiments
column) and mortgage REIT (REITM column) on current consumer sentiment index, lagged
consumer sentiment indexes, and current and lagged consumer sentiment indexes.
REIT REITM
Current CS
Constant 13.693 *** -3.057 -0.392 ** -10.778 *** -1.888 -1.142 ***
Coefficient 0.161 *** 0.036 0.004 ** 0.126 *** 0.022 0.013 ***
Adj. R2 0.074 0.011 0.058 0.093 0.002 0.416
Current INF and CS

Constant -1.057 *** -0.765 -0.390 ** -7.297 *** 1.197 -0.131 ***
INF -0.759 -0.659 -1.537 -1.002 ** -0.888 *** -4.975 ***
t-stat (-1.25) (-1.13) (-0.55) (-2.11) (-3.07) (-2.62)
CS 0.140 *** 0.018 0.005 ** 0.097 *** -0.003 0.013 ***
t-stat (2.98) (0.50) (2.45) (3.50) (-0.13) (8.55)
Adj. R2 0.078 0.038 0.052 0.122 0.078 0.438
Lagged CS
Each coeff 11.603 ** 7.392 22.909 *** 12.280 ** 4.315 54.123 ***
Sum of coeff. 0.137 *** -0.010 0.001 0.096 *** 0.008 0.012 ***
Adj. R2 0.055 0.039 0.102 0.088 0.032 0.312
Current & Lagged CS

Each coeff. = 0 11.857 ** 20.222 *** 33.417 *** 13.434 ** 5.384 69.609 ***
Sum of coeff. 0.151 *** 0.002 0.001 0.107 *** 0.006 0.012 ***
Adj. R2 0.058 0.066 0.153 0.094 0.027 0.389
46
Table 4
Explanatory power of inflation for the mispricing component in REIT prices calculated using
current and four lagged levels of dividends
Panel A. Using inflation
column) and mortgage REIT (REITM column) on current inflation rate, lagged inflation rates, and
current and lagged inflation rates:
NFi t = αi + βi INFt + ei ,t , (11.1)
m
NFit = αi + ∑ βi INFt −i + ei ,t , (11.2)
i =1
m
NFit = αi + ∑ βi INFt −i + ei ,t , for i = 1, 2, 3, (11.3)
i =0
where NF1 = mispricing component in REIT prices calculated using current and four lagged levels
of dividends, NF2 = mispricing component in the first differenced REIT prices, and NF3 =
mispricing component in the difference in log prices and log dividends.
For model (11.1) with the current inflation, we report a constant and coefficient of the current
inflation. For model (11.2) with lagged inflation rates, we report chi-square test of the null that
each coefficient is zero, and the sum of coefficients with the chi-square test that the sum is zero.
For model (11.3) with the current and lagged inflation rates, we report chi-square test of the null
that each coefficient is zero, and the sum of coefficients of the current and lagged inflation rates
with the chi-square test that the sum is zero.
REIT REITM
Current INF
Constant 0.285 0.182 -0.007 0.290 0.105 0.019
Coefficient -0.259 -0.165 -1.011 -0.263 -0.095 -0.027
Adj. R2 -0.005 -0.004 -0.010 -0.003 -0.005 -0.004
Lagged INF
Each coeff. = 0 9.646 ** 5.487 0.373 4.890 6.420 2.352
Sum of coeff. -1.962 ** 0.358 1.382 -0.630 0.533 -14.119 *
Adj. R2 0.030 0.008 -0.040 -0.005 0.011 -0.010
Current & Lagged INF

Each coeff. = 0 13.562 ** 5.977 0.936 4.918 10.326 * 2.945
Sum of coeff. -1.751 ** 0.236 3.345 -0.656 0.409 -17.003 *
Adj. R2 0.039 0.025 -0.045 -0.011 0.045 -0.013
47
Panel B. Using consumer sentiments
column) and mortgage REIT (REITM column) on current consumer sentiment index, lagged
consumer sentiment indexes, and current and lagged consumer sentiment indexes.
REIT REITMP
Current CS
Constant 8.650 ** -0.463 -0.310 ** -5.210 * 1.739 -1.137 ***
Coefficient 0.102 ** 0.005 0.004 ** 0.061 ** -0.020 0.013 ***
Adj. R2 0.029 -0.006 0.039 0.024 0.004 0.419
Current INF and CS

Constant -9.397 ** 0.097 -0.311 ** -5.237 ** 2.472 -1.128 ***
INF -0.215 -0.161 0.531 0.764 * -0.211 -4.341 **
t-stat (-0.38) (-0.30) (0.21) (0.02) (-0.87) (-2.23)
CS 0.108 ** 0.001 0.004 * 0.061 -0.026 0.013 ***
t-stat (2.47) (0.03) (1.94) (2.59) ** (-1.50) (8.27)
Adj. R2 0.023 -0.011 0.029 0.017 * 0.004 0.434
Lagged CS
Each coeff. = 0 7.480 10.304 ** 10.317 ** 8.722 * 10.154 ** 51.246 ***
Sum of coeff. 0.087 ** -0.036 0.001 0.036 -0.036 ** 0.012 ***
Adj. R2 0.020 0.044 0.035 0.036 0.059 0.313
Current & Lagged CS

Each coeff. = 0 7.592 17.485 *** 15.930 *** 9.013 10.192 * 67.058 ***
Sum of coeff. 0.094 ** -0.027 0.001 0.041 -0.040 ** 0.012 ***
Adj. R2 0.016 0.058 0.064 0.033 0.062 0.392
48
Table 5
Asymmetric relation between mispricing and inflation when mispricing component in REIT
prices is calculated using current and four lagged first differenced dividends
column) and mortgage REIT (REITM column) on current inflation rate, positive inflation,
negative inflation, and both positive and negative inflation rates:
NFi t = a + b1 π 1t + b2 π 2t , for i = 1, 2, 3, (11.4)
where π 1t = positive inflation; π 2t = negative inflation,

NF1 = mispricing component in REIT prices calculated using current and four lagged first
differenced dividends, NF2 = mispricing component in the first differenced REIT prices, and NF3
= mispricing component in the difference in log prices and log dividends (or rents).
REIT RREITM
Asymmetric
relation
constant 1.147 1.062 *** 0.048 * 2.096 ** 0.980 *** 0.1030 **
Coeff. Of π 1t -1.281 -1.022 *** -5.740 * -1.832 *** -0.933 *** -0.117 ***
t-stat -1.594 (-2.98) (-1.66) (-2.74) (-2.71) (-3.03)

Adj. R2 0.021 0.071 0.023 0.098 0.074 0.077
Constant 0.333 ** 0.206 *** 0.003 0.019 ** 0.076 ** -0.004

Coeff. Of π 2 t -0.029 1.621 ** 6.431 *** -0.057 -0.416 * 0.060 ***
t-stat (-0.03) (2.11) (4.01) -0.130 (-1.71) (4.99)
2
Adj. R -0.007 0.251 0.134 -0.006 0.086 0.184
Constant 2.151 ** 1.708 *** 0.063 * 2.290 *** 1.257 *** 0.099 **
Coeff. of π 1t -1.825 ** -1.372 *** -6.958 * -1.937 *** -1.083 *** -0.114 *
Coeff. of π 2 t 0.774 2.285 *** 8.842 *** 0.950 0.106 0.098 ***
2
Adj. R 0.035 0.133 0.039 0.096 0.092 0.065
χ 2 (1) test 3.302 * 26.679 *** 10.291 *** 6.250 ** 6.721 *** 13.013 ***
Signi. Level(%) 6.919 0.000 0.134 1.244 0.953 0.031
49
Table 6
Asymmetric relation between mispricing and inflation when mispricing component in REIT
prices is calculated using current and four lagged levels of dividends
column) and mortgage REIT (REITM column) on current inflation rate, positive inflation,
negative inflation, and both positive and negative inflation rates:
NFi t = a + b1 π 1t + b2 π 2t , for i = 1, 2, 3, (11.4)
where π 1t = positive inflation; π 2t = negative inflation,

NF1 = mispricing component in REIT prices calculated using current and four lagged levels of
dividends, NF2 = mispricing component in the first differenced REIT prices, and NF3 =
mispricing component in the difference in log prices and log dividends (or rents).
REIT REITM
Asymmetric
relation
Constant -0.142 0.405 0.005 0.661 0.045 0.093 **
Coeff. of π 1t -0.076 -0.406 -0.840 -0.517 -0.071 -0.106 ***
t-stat (-0.10) (-1.25) (-0.25) (-0.87) (-0.2473) (-2.66))
Adj. R2 -0.007 0.007 -0.011 0.004 -0.006 0.063
Constant 0.261 * 0.169 *** 0.006 -0.037 0.038 -0.003

Coeff. of π 2t 0.577 1.936 *** 5.769 *** 0.514 0.015 0.065 ***
t-stat (0.52) (2.59) (1.25) (3.85)
Adj. R2 0.004 0.336 0.105 0.046 -0.007 0.185
Constant 0.574 0.902 ** 0.024 0.604 0.153 0.092 *

Coeff. of π 1t -0.464 -0.675 * -2.399 -0.486 -0.129 -0.105 **
Coeff. of π 2t 0.715 2.260 *** 6.509 *** 0.797 0.066 0.100 ***
2
Adj. R -0.010 0.061 0.001 -0.003 -0.012 0.057
χ 2 (1) test 0.652 14.971 *** 3.242 * 1.867 0.205 11.618 *
Signi. Level(%) 41.943 0.011 7.176 17.187 65.113 0.065 ***
50
Figure 1. Quarterly REIT prices and dividends with CPI
250
Series1
Series2
200
Series3
Series4
Series5
150
100
50
0
19 : 02
1 9 : 04
1 9 : 02
1 9 : 04
1 9 : 02
1 9 : 04
19 : 02
19 : 04
19 : 02
1 9 : 04
1 9 : 02
1 9 : 04
1 9 : 02
1 9 : 04
19 : 02
19 : 04
19 : 02
1 9 : 04
2 0 : 02
20 : 04
2 0 : 02
2 0 : 04
20 : 02
20 : 04
20 : 0 2
4
:0
75
72
73
76
78
87
79
81
82
84
85
88
90
99
91
93
94
96
97
00
02
03
05
06
08
09
19
Notes:
series 1 = nominal prices (Pn);
series 2 = nominal dividends*30 (Dn*30);
series 3 = cpi;
series 4 = real prices;
series 5 = real dividends*30 (D*30).
51
Figure 2.1 Response of inflation to positive (series 1) and
negative (series 2) own shocks
0.008
0.006 Series1
Series2
0.004
0.002
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.002
-0.004
-0.006
-0.008
Figure 2.2 Response of REIT returns to positive (series 1) and

negative (series 2) inflation shocks
0.03
0.02
0.01
0
-0.01 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.02
-0.03
-0.04
-0.05 Series1
-0.06 Series2
-0.07
-0.08
Table 7
Relative importance of positive and negative shocks to inflation
Bivariate model of [ π , REIT]

π (positive/negative) REIT (positive/negative)
______________________________________________________________________________________
Horizon h: 1 quarter 50.000 50.000 58.595 41.405

2 quarters 51.219 48.781 56.681 43.319
4 quarters 51.219 48.781 55.630 44.370
8 quarters 50.050 49.950 55.064 44.936
12 quarters 49.858 50.142 54.998 45.002
24 quarters 49.773 50.227 54.985 45.015
52
Table 8
Regressions and cross correlations for sub sample periods
Panel A: The U.S. monthly data
Sample period: 1972:01 To 1999:12 (monthly), 336obs.
Sample mean std. error cross correlations with INF(t-k)

k= -1 0 1 Q stat signif.
INF 0.421 0.344
REIT 0.796 4.506 -0.041 -0.151*** -0.059 9.500 0.023
RREIT 0.377 4.545 -0.088* -0.225*** -0.105* 23.411 0.000
REITE 1.025 3.953 -0.002 -0.137** -0.077 8.304 0.040
RREITE 0.605 3.994 -0.056* -0.220*** -0.130** 23.153 0.000
REITM 0.427 5.829 -0.057 -0.101* -0.042 5.156 0.161
RREITM 0.010 5.844 -0.093* -0.159*** -0.078 13.501 0.004
REITH 0.600 5.712 -0.012 -0.091* 0.001 2.869 0.412
RREITH 0.182 5.723 -0.050 -0.150*** -0.037 8.932 0.030
2
dependent constant INF R bar
REIT 1.631*** -1.984*** 0.020

(4.24) (-2.80)
RREIT 1.625*** -2.965*** 0.048
(4.25) (-4.21)
REITE 1.685*** -1.569** 0.016

(4.98) (-2.52)
RREITE 1.680*** -2.555** 0.046
(4.99) (-4.12)
REITM 1.150** -1.717* 0.008

(2.30) (-1.86)
RREITM 1.144** -2.694*** 0.022
(2.29) (-2.94)
REITH 1.239** -1.516* 0.005

(2.52) (-1.68)
RREITH 1.234** -2.499** 0.020
(2.52) (-2.78)
53
Panel B: The U.S. quarterly data
Sample period: 1972:I To 1999:4 (quarterly), 112 observations
Sample mean std. error cross correlations with INF(t-k)

k= -1 0 1 Q stat signif.
INF 1.271 0.917
REIT 2.480 8.845 -0.171* -0.170* -0.005 6.625 0.085
RREIT 1.215 8.900 -0.232* -0.268*** -0.072 14.955 0.002
REITE 3.137 7.456 -0.092 -0.137 -0.029 3.226 0.358
RREITE 1.860 7.531 -0.169* -0.255*** -0.107 12.010 0.007
REITM 1.400 11.240 -0.176* -0.132 0.015 5.553 0.136
RREITM 0.149 11.231 -0.224** -0.209** -0.038 10.929 0.012
REITH 1.915 11.029 -0.111 -0.092 0.063 2.843 0.417
RREITH 0.653 10.975 -0.163* -0.173* 0.009 6.470 0.091
2
dependent constant INF R bar
REIT 0.046*** -1.636* 0.020

(3.22) (-1.81)
RREIT 0.045*** -2.596*** 0.063
(3.24) (-2.91)
REITE 0.045*** -1.115 0.010

(3.79) (-1.45)
RREITE 0.045*** -2.092*** 0.056
(3.81) (-2.76)
REITM 0.035* -1.613 0.008

(1.91) (-1.39)
RREITM 0.034* -2.561** 0.035
(1.91) (-2.24)
REITH 0.033* -1.106 -0.001

(1.86) (-0.97)
RREITH 0.033* -2.067* 0.021
(1.87) (-1.84)
Notes: REIT = aggregate (Composite) REITs (nominal) returns;

REITE = equity REITs (nominal) returns; REITM = mortgage REITs (nominal) returns;
REITH = hybrid REITs (nominal) returns; RREIT = real REITs returns; INF= inflation rate.
***, ** and * denote significance at 1% , 5%, and 10%, respectively.
54

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Are real estate investment trusts (REITs) an inflation hedge?

Keywords: REIT returns; Inflation hedge; Mispricing

Electronic copy available at: http://ssrn.com/abstract=1787030

Keywords: REIT returns; Inflation hedge; Mispricing

JEL classifications: G12; R31; E44; C32

Electronic copy available at: http://ssrn.com/abstract=1787030

Electronic copy available at: http://ssrn.com/abstract=1787030

2. Empirical identification of the mispricing component in REIT prices

Suppose that Xt represents a fundamental variable (e.g., dividends in REIT prices).

where P * is a fundamental component and b is a mispricing component. We further

where β is a constant discount factor (e.g., Campbell and Shiller, 1987).7

2.1.1 Cointegrated case

mispricing component in price P .

Using the lemma, it follows that

Let b = c (L) u , where u represents a non-fundamental shock that drives b . Then, it

Then, it follows that

St = P − θ X = ( P* − θ X ) + b = c21 ( L) u1t + c22 ( L) u2 t = c21 ( L) u1t + bt

2.1.2 Non-cointegrated case

Given that Xt is a fundamental variable, we impose c12 ( L) = 0, which identifies u1t as a

ΔP = c ( L)u + c ( L)u = c ( L)u + (1 − L)b . (14)

That is, c ( L)u (= Δ bt ) is a mispricing component of ΔP . Since ΔX t = c11 ( L)u1t , it

where γ ( L) = c21 ( L) c11 ( L)−1.

Then, as in (11), we regress the mispricing component of REIT prices, Δb , on inflation

a stationary process since it is a present discounted value of a stationary variable.

where P * is a fundamental component and b is a mispricing component. We further

where β is a constant discount factor.

Then, it follows that

Let b = c (L) u , where u represents a non-fundamental shock that drives b . Then, it

Then, the model of a stationary fundamental variable is characterized by

Then, it follows that

Pt = P * + b = c21 ( L) u1t + c22 ( L) u2 t = c21 ( L) u1t + bt

2.3 Identification of the mispricing component in a loglinear model

⎡ Δd t ⎤ ⎡ c11 ( L), c12 ( L), c13 ( L) ⎤ ⎡ edt ⎤

Δd t = c11 ( L)edt , Δdrt = c21 ( L)edt + c22 ( L)ert , and

s2 t = c31 ( L)edt + c32 ( L)ert + c33 ( L)ent .

into account current and lagged Δd t − j and Δdrt − j for j=0, 1, 2, …:

2.4 Test for the inflation illusion

H10: β j = 0 for each j, and

2.5 Asymmetric relation in the mispricing

We consider another implication of the inflation illusion hypothesis. According to the

Wt = [πt, REITt]'= B(L) et, or

⎡ π t ⎤ ⎡ B11 ( L), B12 ( L) ⎤ ⎡ e1t ⎤

disturbances are orthonormalized such that var(et) = I.

Wt = A(L) Wt-1 + ut, (20)

Wt = [I - A(L)L] -1 ut, (21)

where I is the identity matrix of rank 2.

Wt = B(L) et = [I - A(L)L]-1 ut. (23)

Using (22), (23) implies that

B(L) = [I - A(L)L]-1 B0. (24)

b110 + b120 = 0. (26)

3.1 Data and preliminary findings

3.2 The mispricing component in REITs

3.2.2 Using the level of dividends

Now we examine a potential asymmetric relation between mispricing and inflation as

3.4 Further analysis with consumer sentiments

3.4.1 Using the first-differenced dividends

3.4.2 Using the level of dividends

REITM 1.264* -1.929* 0.013

REITM 0.038* -1.856 0.020

Constant 0.333 0.206 * 0.003 0.019 0.076 -0.004

REIT 1.631* -1.984* 0.020

REITE 1.685* -1.569 0.016