Oil Prices and Real Estate Investment Trusts (REITs): Gradual-Shift Causality
and Volatility Transmission Analysis

Saban Nazlioglu, Alper Gormus, Uğur Soytaş

PII: S0140-9883(16)30247-X
DOI: doi:10.1016/j.eneco.2016.09.009
Reference: ENEECO 3440

To appear in: Energy Economics

Received date: 13 January 2016

Revised date: 25 August 2016
Accepted date: 9 September 2016

Please cite this article as: Nazlioglu, Saban, Gormus, Alper, Soytaş, Uğur, Oil Prices
and Real Estate Investment Trusts (REITs): Gradual-Shift Causality and Volatility
Transmission Analysis, Energy Economics (2016), doi:10.1016/j.eneco.2016.09.009

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 ACCEPTED MANUSCRIPT

Oil Prices and Real Estate Investment Trusts (REITs): Gradual-Shift Causality and

Volatility Transmission Analysis

Saban NAZLIOGLU, Pamukkale University, Department of Econometrics, Denizli, Turkey. E-mail:

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snazlioglu@pau.edu.tr, tel: +90 258 296 2694

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Alper GORMUS, Texas A&M University, Commerce. Department of Economics and Finance, Commerce, Texas,
USA. E-mail: al.gormus@tamuc.edu, tel: +1 817 881 8568

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Uğur SOYTAŞ, Middle East Technical University, Department of Business Administration, and Earth System
Science, 06531 Ankara, Turkey. E-mail: soytas@metu.edu.tr, tel: +90 312 2102048

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Abstract:

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According to literature, oil price shocks and volatility can have sector-specific impacts in the

market. While these studies include most asset groups, the dynamic relationship between the
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oil market and Real Estate Investment Trusts (REITs) has not been tested. This study

examines the role of oil price shocks and volatility on six REIT categories: Residential, Hotel,
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Healthcare, Retail, Mortgage and Warehouse/Industrial REITs for the January 2005 -
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December 2013 period. In addition, a new causality approach is proposed by augmenting the
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Toda-Yamamoto method with a Fourier approximation. This approach is capable of capturing

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gradual or smooth shifts and does not require a prior knowledge regarding the number, dates,

and form of structural breaks. The so-called Fourier Toda-Yamamoto causality (mean
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spillover) test finds uni-directional causality running from oil prices to all REITs, except for

the mortgage REITs. In the latter case, the causality is reversed. In addition, the relatively

new and simple causality in variance test shows that there is bi-directional volatility

transmission between the oil market and all REITs. Our results have important implications

for REIT managers and investors.

Keywords: oil prices; real estate investment trusts; smooth shift Granger causality, volatility
spillover
JEL classification: C32; C58; G1

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Oil Prices and Real Estate Investment Trusts (REITs): Gradual-Shift Causality and

Volatility Transmission Analysis

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1. Introduction

Studies involving price and volatility transmission (also referred to as volatility

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spillover or volatility contagion) between markets are essential for long-run portfolio

diversification and hedging strategies, respectively. Although traditionally they were meant

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for financial asset markets, these approaches are increasingly being used on commodity

markets as well. This, in return, continue to intensify the financialization of commodity

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markets (Baffes and Haniotis, 2010) and increase the interest in the dynamics of information

transfer between financial asset and commodity markets (Ordu and Soytas, 2015). Energy
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commodity prices, oil prices in particular, have been shown to significantly impact other
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commodity markets, currency markets, and equity markets around the world (Gormus et al.
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2014; Nazlioglu et al. 2013; Sari et al. 2010 and others). These studies emphasize the
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importance of oil prices in providing significant explanatory power for a wide variety of

market phenomena. Just like all asset classes being not created equal, research has shown oil
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price shocks to impact different asset groups differently. Furthermore, there is evidence of

structural shifts that govern the price and volatility spillovers between markets (Turhan et al.

2013; Sensoy et al. 2014; Soytas and Oran 2011; Nazlioglu et al. 2015).

While oil price and volatility shocks have been tested on numerous asset groups, to

our knowledge, there is not a study which evaluates the dynamic relationship between oil

price and Real Estate Investment Trusts (REITs) – at sub-sector level in particular. Huang and

Lee (2009) is the only study that considers the REITs (tested as a single index) and shocks in

oil prices. They show that oil has more impact on REITs than common stocks and the bond

market. Their results consider jump processes but not smooth transitions. We believe the lack

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of literature is due to two reasons: most REITs are fairly new and, traditionally, REITs have

not been included in generalized market studies due to their unique structure. As we show

below, this has progressively changed in the recent years. Although our study still has a

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somewhat short date-span (9 years), it is adequate for our approach. In addition, REITs have

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been shown to be growing larger and becoming a very significant asset group in the market -

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demanding to be analyzed in a similar construct as other well-known asset groups. Since oil

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prices are found to be a significant factor in many aspects of the asset markets, its impact on

REITs need to be evaluated as well.

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REITs; companies which typically operate income-producing real estate, are shown to
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be significant players in the financial assets market (Hoesli et al. 2004; MacKinnon and Al

Zaman 2009). While high unit-value and illiquid holdings have made these assets somewhat

problematic, the impact of REIT securities on the market has increased exponentially;
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reaching a worldwide capitalization of over $1,200 billion (Hoesli and Reka, 2013). In

addition to the intensified link between oil and financial markets due to financialization, this
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relationship carries over to the real estate business.

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Our study is important for at least four reasons. First, knowledge on the nature of
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spillovers will aid policy makers in appraising systematic risks in real estate markets. Second,

risk management and hedging strategies depend on risk transmissions reflected by volatility

spillovers. Third, we examine the spillover dynamics in the subsector level at which different

information transmission patterns can be observed. Fourth, the novel approach we propose

allows gradual shifts to be modeled appropriately, which has implications for both correct

portfolio diversification and hedging decisions.

This study examines the price and volatility spillover dynamics between oil price and

Residential, Hotel, Healthcare, Retail, Mortgage and Warehouse/Industrial REITs for the

January 2005 - December 2013 period. For our tests, a new methodological approach is

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considered in order to account for smooth structural shifts. Traditional procedures that seek

abrupt shifts are inadequate in capturing gradually developing structural changes. To that

effect, we modify the Toda-Yamamoto (1995) Granger causality procedure by embedding a

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Fourier approximation. The Fourier approximation is capable in capturing gradual or

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smoothing shifts and does not require a prior knowledge regarding the number, dates, and

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form of breaks (see, Enders and Lee, 2012a; Enders and Lee, 2012b). As for the risk transfer

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tests, a relatively new and simple volatility spillover test developed by Hafner and Herwartz

(2006) is employed. We find that oil price impacts all REITs with the exception of mortgage

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REITs. In addition, the causality is reversed in the case of mortgage REITs. One possible
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explanation would be that mortgage REITs manage mortgage-backed securities whereas most

other REITs manage physical properties. We also discover bi-directional volatility spillover

between oil and REITs. This shows that REIT managers and investors must closely follow the
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dynamics of the oil market.

The rest of the paper is organized as follows. The next section briefly discusses the
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literature review on the link between oil and financial asset markets with an emphasis on the
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relatively few studies on REITs. Section 3 introduces data descriptions and properties. Section
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4 explains the methodologies employed.

2. Oil and REITs

The impact of oil prices on market dynamics have been well demonstrated in literature

(Ewing and Thompson 2007; Hammoudeh et al. 2010; Arouri et al. 2012; Mensi et al. 2014;

Gormus and Atinc 2016 and others). Linking volatility transmissions between the S&P 500

and energy, food, gold and beverages commodities over the turbulent period from 2000 to

2011, Mensi et. al (2013) suggested a significant volatility transmission between S&P 500

index and oil prices (among other commodities). Their VAR-GARCH model showed some of

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the highest conditional correlations between S&P 500 Index and the oil index. Similarly,

Mollick and Assefa (2013) showed that oil prices significantly impact the U.S. stock markets.

However; they found the impact to vary over time.

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More recently, previous findings have been further confirmed. Du and He (2015)

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demonstrated that while volatility spillovers between the stock markets and oil prices are

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strong, the bidirectional positive spillovers’ strength changed (increased) significantly after

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the financial crisis. On a similar note, when criteria such as market type, location and time

periods were evaluated, oil prices have been further shown to impact different markets

differently (Le and Chang, 2015).

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The literature has also shown that the dynamic relationship with oil prices may be

sector specific. For example, Arouri and Nquyen (2010) tested to see whether oil prices have

any unique influences on sector-specific stocks in the market. Concentrating on the European
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markets, they found evidence for significant differences between sector-responses to oil-price

shocks. Their study suggests the importance of including oil assets in diversified portfolios.
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Following a similar approach, Lee et al. (2012) evaluated G7 countries’ stock markets and
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showed that while certain sectors were impacted more/less than others, the impacts also
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varied among different countries.

Based on the evidence provided in the studies discussed above, it is only natural to ask

whether oil plays a similar role in the case of REITs. Although there are studies focusing on

REITs, there are no studies that we know of on the link between oil market and REITs at sub-

sector level.

Several studies have looked at the different dynamics of REITs including their

operational efficiency, property-type characteristics, ownership structures and their place in

the overall market. For example, REITs have been shown to be technically inefficient and the

inefficiencies are mainly caused by poor input utilization and their failure to operate at

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constant returns to scale. Also, as their leverage structure increase, REITs’ input utilization

has been shown to further decrease (Anderson et al., 2002). This creates a unique problem for

market participants because differences in structures can change nature of the shocks which

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might impact these assets.

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All REITs are not created equal. It is only natural to assume the specific asset groups

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managed under these companies affect the corresponding REIT’s market performance

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differently. For example, while retail REITs trade at a significant premium on average,

warehouse/industrial REITs are shown to trade at a discount (Capozza and Lee, 1995).

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Furthermore, equity REITs are demonstrated to be significantly related to stock-market risk
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factors, whereas mortgage REITs are shown to be influenced by both the stock and bond-

market factors (Peterson and Hsieh, 1997). Following suit, the market dynamics of REITs are

becoming ever more important for the larger market. As evidence, we see that REITs
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ownership structures are drastically changing as they are becoming more diverse and popular.

For example, prior to 1990, institutional investors did not prefer to buy REIT stocks.
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However; after 1990, institutional ownership in REITs has increased dramatically (Chan et
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al., 1998). As the market participation in such a sector increases, it is only natural for
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investors to put more value on the micro structures rather than the overall market when

making investment decisions. Hence, the studies mentioned above and others point to the fact

that evaluating an entire sector as one body can sometimes be misleading.

In addition to changes in ownership, the drivers of REIT performance have also

shifted over time. A large body of literature has already demonstrated stock and bond returns

to have significant power in explaining REIT returns and risks (Chan et al. 1998; Ling and

Naranjo, 1999; Karolyi and Sanders, 1998 and others). In particular, after 1990, REITs’

returns went from being largely affected by similar economic factors which impact large-cap

stocks, to being more sensitive to small-cap and real estate specific drivers (Clayton and

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MacKinnon, 2003). Furthermore, Chang et. al (2013) showed that while there were strong co-

movement and causality between the U.S. stock market and the real estate market, these

relationships were observed to become increasingly long-term in nature.

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Aside from causality studies, volatility-impact approaches have been popular for all

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asset groups and have shown significant value over the last decade. These studies involving

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the international stock markets, commodity markets and foreign exchange markets, have

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aided (and continue to aid) market participants in portfolio positioning and governments in

policy making. When the volatility structures of REITs are evaluated, sector-specific

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characteristics emerge. Using CAPM and APT type models, Titman and Warga (1986) found
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that REIT performance measures can vary substantially but these measures lack statistical

significance due to high return volatility. Devaney (2001) showed that excess return and the

conditional variance relationship is positive for mortgage REITs – whereas interest rates were
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found to have a negative relationship. While, due to their high-levels of leverage REITs

exhibit asymmetric conditional correlations, Yang et. al. (2010) suggested that REITs do not
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provide a strong hedging potential for the stock market. On a similar note, Hoesli and Reka
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(2013) also showed strong volatility spillover effects between REITs and the U.S. stock
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market. Furthermore, their findings presented significant conditional tail distribution

dependencies and correlations.

The only study that we could find on oil and REIT relationship is Huang and Lee

(2009). Using a general Bloomberg REIT index, they investigate how the REIT returns

respond to changes in the oil, stock and bond markets as well as in interest rates and inflation.

They argue that REITs, in general, provide a partial hedging against the oil market volatility.

High oil price expectations result in positive response of REIT returns and this impact is

higher than stock and bond market’s impacts. Their study does not distinguish between REIT

categories and only allow for jump processes.

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Although oil is shown to be an important factor for all financial assets, the relationship

between oil and REITs have been minimally evaluated. The increasing size and investor

utilization of the REIT asset group and the oil’s impacts on the entire market/economy

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structure provides a necessity for the interaction to be tested. This paper attempts to fill this

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gap. Utilizing a sector-specific data set, our study tests for volatility spillovers and

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incorporates a new methodology to test for mean spillovers between the oil market and

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different REIT categories. We show that oil price and volatility play an important role in all

REIT categories even when we control for smooth structural changes.

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3. Data

Our dataset consists of six asset-type REIT indexes and the WTI daily spot oil prices.

While the use of indexes in similar studies is common, subsector-level indexes do not exist
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for REITs. In order to create these indexes, we identify the publically traded U.S. REITs per

their reported asset mix. Due to the overlapping nature of some asset groups, we exclude
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REITs which identify their assets as “mix” or as a unique group which is not one of the
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common types as we test in this study. Our indexes consist of a minimum of ten REITs under
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each asset category which include Residential, Hotel, Healthcare, Retail, Mortgage and

Warehouse/Industrial. Each index is constructed as a value-weighted and daily rebalanced

group with a base value of 100. For value-weighting, we use the simple capitalization value

(price x shares outstanding) and calculate weighted-averages for the assets within each index

daily. Due to many REITs’ inception dates being fairly recent, it was difficult to get a very

large span of data while maintaining a minimum of ten assets in each index. For this reason,

our data spans nine years of daily data from January 2005 to December 2013. The number of

REITs is 13 in residential, 15 in warehouse/industrial, 20 in retail, 10 in healthcare, 12 in

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hotels, and 14 in mortgage. We obtained all REIT data from the Bloomberg database and

WTI Spot Oil prices from the U.S. Energy Information Administration (www.eia.gov).

Before we discuss the inferences from the causality analysis, it would be valuable to

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mention some of the general observations related to the data properties. Figure 1 plots the

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dynamics of oil prices and several REITs we test in this study. A casual observation would

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indicate that oil prices and REITs fluctuate with close connection after the financial crisis. A

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similar observation, however, seems difficult to establish for the series prior to the crisis

period. Another interesting observation is that while healthcare and mortgage REITs seem to

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be moving together, other REITs (hotel, warehouse/industrial, residential, and retail) behave
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as a separate group on their own.
Oil Price Healthcare Hotel
160 700 250

140 600
200
120 500
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100 400 150

80 300 100
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60 200
50
40 100

20 0 0
05 06 07 08 09 10 11 12 13 05 06 07 08 09 10 11 12 13 05 06 07 08 09 10 11 12 13

Industrial Mortgage Residental

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300 300 280

240
250 250
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200
200 200
160
150 150
120

100 100
80
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50 50 40
05 06 07 08 09 10 11 12 13 05 06 07 08 09 10 11 12 13 05 06 07 08 09 10 11 12 13

Retail
300

250

200

150

100

50

0
05 06 07 08 09 10 11 12 13

Figure 1: Dynamics of oil prices and REITs indexes (level series).

A closer investigation of the data characteristics can be accomplished by studying

Table 1. At first glance it seems that all the variables have a wide range of fluctuations due to

higher differences between minimum and maximum values of the series. Nevertheless, the oil

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prices present smaller mean and standard deviations with respect to the REITs. An interesting

observation is that among the REITs series, healthcare REITs have the largest mean and

standard deviation and hotel REITs have the smallest mean and standard deviation. This data

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characteristic can be attributed to the fact that healthcare REITs move at a wide range

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between 87.61 and 671.70 while hotel REITs fluctuate within a shorter band from 28.23 and

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231.22. These numbers could simply imply that healthcare REITs are likely to be more risky

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compared to hotel REITs. If we look at the skewness and kurtosis results, we can make some

simple inferences related to asymmetry and distribution of the dataset. These results indicate

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that all the series, but hotel REITs, have positive and right-tailed skewness. This stylized fact
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is also supported by the Jarque-Bera statistic which rejects the null hypothesis of normality.

With respect to linear association between the oil prices and REITs, the correlation

coefficients indicate that the correlations between the oil prices and REITs appear to slightly
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differ. The oil prices have relatively higher correlations with mortgage and

warehouse/industrial REITs while we observe a smaller linear association with hotel REITs.
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While this would not indicate causality as will be discussed later in the paper, one of the
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reasons for a comparatively unique response in mortgage REITs could be due to the holdings
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of these REITs to be very different. The investments of mortgage REITs, consisting of

mortgage-backed securities rather than actual/physical properties, could be making them more

susceptible to specific shocks related to their holdings as we saw during the 2007/2008 crisis.

As for the association between REITs, the correlation among each REIT class is relatively

high where hotel REITs have relatively smaller correlations with healthcare and mortgage

REITs. It is important, however, to note that correlation does not imply causality. While a

correlation coefficient measures linear dependence, causality concept implies a predictive

power from one variable to other variable. It is, therefore, required to employ advanced tools

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in determining causal linkages between the oil prices and REITs indexes. Our causality tests

speak to that effect later in the discussion.

Further evaluating the data characteristics, we finally investigate whether shocks to a

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series are temporary or permanent in nature. We first employ a battery of conventional unit

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root tests to investigate this phenomenon, namely ADF test of Dickey and Fuller (1979), DF-

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GLS test of Elliot et al. (1996), and KPSS test by Kwiatkowski et al. (1992). Note that ADF

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and DF-GLS tests are designed to test for the null of unit root, but KPSS test is developed for

testing stationarity under the null hypothesis. These conventional unit root tests do not take

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structural shifts into consideration. Time series are likely to include breaks and in order to
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account for them, we employ the unit root test with structural shifts by Zivot and Adrews

(1992) which extends the conventional ADF test by adding dummy variables into the

regression model. The results are reported in panel C of Table 1.

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Looking at Table 1, the ADF and DF-GLS tests indicate that the null hypothesis

cannot be rejected for all data series. This provides supporting evidence on the random walk
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behavior of the series which implies the existence of permanent shocks. The results from
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KPSS test also support the same conclusion since the null hypothesis of stationarity is rejected
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at 1 percent level of significance. The results from the unit root test with structural shift in

table 1 are similar to those from without structural breaks. The Zivot and Andrews’s test

shows that the null hypothesis of unit root cannot be rejected for all the variables at 1 percent

level of significance. Accordingly, the structural shifts do not seem to effect the unit root

behavior of the variables.

Table 1: Data properties

Panel A: Oil Healthcare Hotel W/I Mortgage Residential Retail
Summary stats. Prices REIT's REIT's REIT's REIT's REIT’s REIT's
Mean 80.358 258.786 142.960 169.412 151.311 144.895 148.782
Median 80.050 200.852 148.860 160.805 140.829 133.876 136.957
Maximum 145.310 671.705 231.227 295.648 266.351 258.361 283.354

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Minimum 30.280 87.613 28.233 54.413 69.886 46.858 32.374

Std. Dev. 20.202 149.065 45.502 56.766 56.386 50.336 55.774
Skewness 0.211 0.872 -0.372 0.319 0.371 0.353 0.383
Kurtosis 2.767 2.504 2.509 2.198 1.729 2.187 2.430
Jarque-Bera 21.878 310.168 74.987 99.124 204.282 109.523 86.064
Probability 0.000 0.000 0.000 0.000 0.000 0.000 0.000

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Observations 2265 2265 2265 2265 2265 2265 2265

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Panel B: Oil Healthcare Hotel W/I Mortgage Residential Retail
Correlations Prices REIT's REIT's REIT's REIT's REIT’s REIT's

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Oil Prices 1
Healthcare REIT's 0.596 1

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Hotel REIT's 0.444 0.615 1
W/I REIT's 0.608 0.896 0.875 1
Mortgage REIT's 0.621 0.948 0.519 0.823 1
Residential REIT’s 0.540 0.887 0.859 0.978 0.804 1

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Retail REIT's 0.576 0.883 0.876 0.981 0.795 0.983 1

Panel C:
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Unit root
No shifts
ADF -2.437 -0.330 -0.839 -1.203 -0.897 -0.727 -0.608
DF-GLS -0.582 1.090 0.104 0.024 0.019 0.190 0.320
KPSS 2.061*** 4.980*** 1.397*** 3.354*** 5.269*** 3.278*** 3.092***
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Structural shift
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ZA-one break -4.912 -3.564 -4.031 -2.064 -1.910 -3.514 -3.484

W/I: Warehouse/industrial. ZA: Zivot and Andrews (1992) ADF unit root test with a break. Unit root test with no
shifts include a constant term. Unit root tests with shift include a structural shift in the constant term. The
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optimal lag(s) were determined by Schwarz information criterion for ADF, DF-GLS, and ZA tests. Bartlett
kernel for spectral estimation method and Newey-West method for bandwith were used for KPSS test.
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ADF critical values are -3.433 (1%), -2.862 (5%), -2.567 (10%), DF-GLS critical values are -12.566 (1%), -
1.941 (5%), -1.616 (10%), KPSS critical values are 0.739 (1%), 0.463 (5%), 0.347 (10%), ZA critical values are
-5.34 (1%), -4.80 (5%), -4.58 (10%).
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4. Empirical methodology

4.1. Granger causality test

To investigate the causal linkages between oil prices and REIT’s, we utilize the Granger

causality approach proposed by Toda and Yamamoto (1995). The approach is based on

estimating a VAR(p+d) model where p is lag lengths and d is the maximum integration

degree of the variables. The VAR(p+d) model is written as

(1)

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where yt consists of K endogenous variables,  is a vector of intercept terms,  are

coefficient matrices and t are white noise residuals. The null hypothesis of Granger non-

causality is based on zero restriction on first p parameters ( H0 : 1  ...   p  0 ) of the Kth

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element of . Wald statistic for this hypothesis has an asymptotic  2 distribution with p

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degrees of freedom.

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yt in equation (1) are assumed not to have any structural shifts by the assumption that

the intercept terms  are constant over time. Monte Carlo simulations by Ventosa-Santaularia

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and Vera-Valdés (2008) show that when data generating process has structural shifts, the null
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of non-causality can be rejected even though two variables do not have any causal linkage.

Enders and Jones (2015) show a similar finding using Monte Carlo simulations. It indicates
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that ignoring structural breaks in a VAR model results in a misspecification error that in turn
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leads Granger causality test to be biased towards a false rejection of the true null hypothesis.

Authors further reveal that unless breaks are properly modelled, Granger causality tests tend
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to have an over-rejection problem of the null of non-causality. Thereby, inferences from a

standard Granger causality analysis may be misleading when structural breaks are ignored or
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taken into account improperly. These findings not only indicate the importance of accounting

for any structural shifts but also necessitate a careful treatment of how breaks are captured.

The traditional approach for modelling breaks is to use dummy variables in which

shifts are assumed to be sharp (for example, Perron, 1989; Zivot and Adrews, 1992; Lee and

Strazicich, 2003). Smooth transition approach is also used in controlling for structural breaks

since structural changes can be gradual in nature (inter alia, Leybourne at al., 1998;

Kapetanios et al., 2003). Both approaches require the knowledge on break dates, as well as

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the number and functional forms1 of the breaks. To deal with these problems, Fourier

approximation, which is based on a variant of Flexible Fourier Form by Gallant (1981), is

proposed for capturing structural shifts (see, Becker et al., 2006; Enders and Lee, 2012a and

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2012b; Rodrigues and Taylor, 2012). The Fourier approximation does not require a prior

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knowledge on the number, dates, and form of breaks and captures structural shifts as a

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gradual/smooth process by using a small number of low-frequency components.

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In a VAR specification, controlling for structural breaks and determining the original

source of breaks is difficult because a break in one variable potentially causes shifts in other

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variables (Ng and Vogelsang, 2002; Enders and Jones, 2015). In a recent paper, Enders and
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Jones (2015) employ a Fourier approximation by using small number of low frequency

components in order to simplify determination of the form of shifts and estimation of the

number and dates of breaks in a VAR framework. They show that the standard Granger
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causality test has reasonable size and power properties when the breaks are sharp and

performs much better when the breaks are gradual. The standard Granger causality analysis is
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sensitive to the unit root and co-integration properties of the VAR model and necessitates
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testing for unit root and co-integration for causal inferences because Wald test not only has a
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non-standard distribution if the variables in VAR model are integrated or co-integrated, but

also depends on nuisance parameters (Toda and Yamamoto, 1995; Dolado and Lütkepohl,

1996). The Toda and Yamamoto approach overcomes these problems and is robust to unit

root and co-integration properties of the VAR system. By extending the Toda-Yamamoto

framework with gradual structural shifts by means of a Fourier approximation, we propose a

novel and simple approach to take into account breaks in Granger causality analysis.

In order to account for structural shifts, we relax the assumption of the intercept terms

 being constant over time and modify the VAR model in equation (1) as
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The form of structural shifts is assumed to be instantaneous in the dummy variable approach. In the smooth
transition approach, the form of shifts is assumed to be an exponential smooth transition or to be a logistic
smooth transition.

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(2)

where the intercept terms (t) are the functions of time and denote any structural shifts in yt .

In order to capture structural shifts as a gradual process with an unknown date, number and

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form of breaks, the Fourier expansion is defined by:

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(3)

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where n is the number of frequencies, 1k and 2k measures the amplitude and displacement of

the frequency, respectively. On a side note, large value of n is most likely to be associated

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with a stochastic parameter variation, decreasing the degrees of freedom and leading to an

over-fitting problem. A single Fourier frequency on the other hand mimics a variety of breaks
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in deterministic components regardless of date, number, and form of breaks (Becker et al.,

2006). We therefore use a single frequency component and hence define (t) as
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(4)

where k denotes the frequency for the approximation. By substituting equation (4) in equation
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(2), we obtain
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. (5)
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In this specification, testing the null hypothesis of Granger non-causality is the same as it is in

equation (1) and the hypothesis can be tested using the Wald statistic. Lütkepohl (2005:

pp.103, 320) suggests using F-statistic instead of Wald test because  2 distribution is often a

poor approximation of the small sample distribution of the causality statistics and the tail of F

distribution is fatter than that of the  2 distribution. The recent works in the Granger causality

literature have relied on bootstrapping critical values in order to increase the power of test

statistic in small samples as well as being robust in the unit root and co-integration properties

of the data (see Mantolos, 2000; Hatemi-J, 2002; Hacker and Hatemi-J, 2006; Balcilar et al.,

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2010). We use the bootstrap distribution of F-statistics by employing the residual sampling

bootstrap approach originally proposed by Efron (1979)2.

In equation (5), the specification problem requires determining the number of Fourier

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frequency and lag lengths. A common approach to determine p is to benefit from an

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information criterion such as Akaike or Schwarz. This approach also can be used for equation

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(5) with a slight modification since it also requires the determination of frequency k.

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Specifically, we set the number of Fourier frequency to k max , the number of number of lags

p max and select the optimal number of k and p with the smallest value of the information

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to

criterion.
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4.2. Volatility spillover test

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This study also employs a Lagrange multiplier (LM) based causality-in-variance (volatility
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spillover) test by Hafner and Herwartz (2006) to assess the existence and direction of dynamic

volatility transmission between the variables of interest. Earlier causality-in-variance tests

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(Cheung and Ng, 1996; Hong, 2001) rely on the cross-correlation functions (CCF) of the

standardized residuals from univariate GARCH3 equations of any two series. The CCF
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statistics exhibit significant oversizing in small samples when the volatility processes are

leptokurtic (Hafner and Herwartz, 2006) and require a selection of lead and lag orders. The

causality-in-variance test by Hafner and Herwartz (2006) does not have the shortcomings of

earlier tests and has increasing power as sample size grows.

To test the null hypothesis of no volatility spillover, the procedure is followed as:

 it  it  it2 (1  zj ), 

z jt   2jt 1 ,  2jt 1  (6)

2
In order to save space, we omit the details of the bootstrap procedure here and refer the interested reader to
Hatemi-J (2002) and Balcilar et al. (2010).
3
Since the focus of this paper is to investigate volatility spillover using the causality-in-variance approach, we do not outline
ARCH and GARCH models in order to save space. We kindly refer an interested reader to Engle (1982), Bollerslev (1986), and
Bollerslev et al. (1992) for a detailed explanation of the volatility models.

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where  it and  it are respectively the standardized residuals and the conditional variance
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(volatility) for the series i;  jt 1 and  jt 1 are respectively the squared disturbance term and the
2 2

conditional variance for the series j. The null hypothesis H 0 :   0 indicates the lack of a

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spillover and is tested against the alternative hypothesis H1 :   0 . The Gaussian log-

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likelihood function of  it is used to get the score as xit it2  1 / 2 where xit are the derivatives

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of the likelihood function in terms of GARCH parameters. The test statistic is

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1  T   T 
 LM    ( it2  1) z jt V ( i ) 1   ( it2  1) z jt  (7)
4T  t 1   t 1 
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  T 
1 T
T
T  1 T 2
where V ( i )  
4T  t 1
z z 
jt jt   z jt it   xit xit 
x 
 t 1


 x z 
it jt


,   
T t 1
( it  1) 2 .
t 1 t 1

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 LM statistic has asymptotic chi-square distribution with two degrees of freedom.

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5. Empirical findings
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The results from the Toda-Yamamoto causality analysis based on equation (1) are

presented in panel A of Table 2. At a first glance, the null hypothesis of no-Granger causality
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from oil prices to REITs is strongly rejected with the exception of mortgage REITs. The

findings support information transmission from oil prices to REITs and provide evidence for

oil price information having predictive power for all REITs except mortgage REITs. The null

of no-causality from REITs to oil prices is rejected for hotel, mortgage, and residential REITs

indexes.

It is important to note that the results in panel A do not take into consideration the role

of possible structural shifts in the series. As we observe from Figure 1, both the oil prices and

REITs indexes seem to have different trend and volatility dynamics and fluctuate together

after the 2007/2008 financial crisis. In order take into account the role of such structural

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shifts, it is normally required to know the date, number, and form of shifts which challenge

researchers in practice. As previously discussed, the Fourier approximation does not require

any assumption and/or a priori knowledge regarding the date, number, and form of the shifts.

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This new approach we propose, is now able to accommodate structural shifts in any form and

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numbers in addition to advantages of the Toda-Yamamoto procedure.

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The results from the Fourier Toda-Yamamoto causality analysis are reported in panel

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B of table 2. Note that because F-statistic is now depended on the number of frequency in the

VAR model, we employ the bootstrap sampling and report the bootstrap p-values. We find

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out that the results from Fourier Toda-Yamamoto test are similar to that of Toda-Yamamoto
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approach. This finding implies that the causal linkages between oil prices and REITs are

robust to structural shifts in the series and thereby are stronger. In other words, although the

results do not differ between the two methodologies, the Fourier based model helped verify
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the robustness of the findings with the regular Toda-Yamamoto approach. Combining results

from Toda-Yamamoto and Fourier Toda-Yamamoto analyses, we find that there is a feedback
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relationship between oil prices-hotel REITs and oil prices-residential REITs, while there is
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one-way information flow from oil prices to healthcare, warehouse/industrial, and retail
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REITs indexes. Last but not least, we also observe a one-way causal flow from mortgage

REITs to oil prices.

Table 2: Results of mean spillover analyses

REITs  oil prices oil prices  REIT’s
Panel A: Asymptotic Asymptotic
Toda-Yamamoto test p F-stat p-value F-stat p-value
Healthcare 2 2.304*** 0.100 35.994*** 0.0000
Hotel 2 2.319*** 0.098 37.683*** 0.0000
W/I 6 1.473*** 0.183 4.747*** 0.0001
Mortgage 6 5.307*** 0.000 1.584 0.1476
Residential 3 2.110*** 0.096 18.007*** 0.0000
Retail 3 1.414*** 0.236 21.030*** 0.0000

Panel B: Bootstrap Bootstrap

Fourier Toda-Yamamoto test k p F-stat p-value F-stat p-value
Healthcare 3 2 2.294*** 0.100 36.449*** 0.000

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Hotel 3 2 2.368*** 0.089 38.115*** 0.000

W/I 3 6 1.468*** 0.168 4.788*** 0.005
Mortgage 5 6 5.237*** 0.000 1.612*** 0.123
Residential 1 3 2.112*** 0.097 18.038*** 0.000
Retail 1 3 1.400*** 0.251 21.148*** 0.000
Notes:
 denotes the null hypothesis of Granger non-causality. Maximum k and p are respectively set to 5 and 12, then

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optimal k and p are determined by Akaike information criterion. Bootstrap p-values are based on 1,000

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replications. TY test is based on equation (1) and Fourier TY test is based on equation (5).

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As we briefly mentioned before, mortgage REITs are unique in the REIT world. While

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most all REITs invest-in and hold real properties, mortgage REITs hold paper securities (i.e.

mortgage-backed securities). Their main business model includes borrowing short-term funds

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and purchase long-term mortgage-backed securities. When there is a financial crisis, short-
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term debt rates typically go down and mortgage REITs are positioned especially well to take

advantage of those low rates. However; during the 2007/2008 financial crisis, the Fed
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purchased large amounts of mortgage securities to ease the crisis which caused the mortgage
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bond prices to increase. This, in return, decreased the yields. In addition, their highly-

leveraged portfolios cause mortgage-REITs to be even more susceptible to fluctuations in

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interest rates. While typical REITs act similar to large cap companies in the market, our study
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also shows mortgage REITs to be a different breed. Causality from oil prices to mortgage
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REITs are not observed in our study as the combination of the unique dynamics of the

2007/2008 financial crisis and the differences in the underlying assets present differences for

these companies.

When we consider information transmission between markets, in addition to causality

in levels (mean spillover), there is also a risk transfer dimension which is referred to as

causality in variance (volatility spillover). The first dimension can be thought of as a gradual

adjustment which is due to long-run portfolio diversification. On the other hand, hedging

strategies require knowledge on volatility spillovers that may be more relevant in the short

run, as risk perceptions may change rapidly (Nazlioglu et al., 2015). The nature of risk

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spillover between oil market and different REITs are examined using the causality-in-variance

tests.

To investigate whether there is a volatility spillover between oil and REITs returns, we

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benefit from LM test proposed by Hafner and Herwartz (2006). The test is relatively simple to

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implement because it is based on estimating a GARCH(1,1) specification. The results from

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volatility spillover analysis are illustrated in Table 3. The null hypothesis of no volatility

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spillover from oil prices to REITs indexes is rejected. Similarly, the null of no volatility

spillover from REITs to oil prices is rejected. The volatility transfer between return series

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hence works in two directions. As several studies have previously showed, oil price shocks
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significantly impact a variety of markets. Volatility in oil prices can indicate current or future

turmoil in the overall world economy. In addition, especially after the financial crisis, oil

price shocks have been increasingly impacting the stock market (Du and He; 2015). While
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these two notes could possibly explain the spillover from oil-price volatility to REIT

volatility, the reverse spillover from the REITs is a different story. One explanation of this
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phenomenon could be the unique dynamics of the sample period. The 2007/2008 financial
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crisis essentially was tied to real estate. While the U.S. economy (therefore the world
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economy via close ties) struggled due to these real estates related crisis, the volatility of

REITs could’ve acted as a signal to other markets including the global oil market.

Table 3: Result for volatility spillover analysis

REITs  oil prices oil prices  REITs

LM-stat p-value LM-stat p-value
Healthcare 5.110*** 0.078 15.449*** 0.000
Hotel 6.339*** 0.042 21.928*** 0.000
W/I 5.699*** 0.058 9.860*** 0.007
Mortgage 39.667*** 0.000 8.542*** 0.014
Residential 5.257*** 0.072 20.910*** 0.000
Retail 4.895*** 0.086 23.100*** 0.000
 denotes the null hypothesis of non-spillover.

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6. Conclusion

The significant impacts of oil price changes on a variety of markets have been well-

established in literature. While these relationships show the value of studying oil-price shocks

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on all asset groups, the dynamics of REITs have never been studied in detail. In many

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respects including their holdings, management style, etc., REITs occupy a unique space in the

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market. It is, therefore, valuable to test these asset groups in their own right. In addition to

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filling a gap in literature, our study establishes a new econometric model that accounts for

smooth structural changes to test causal relationships between oil prices and different REIT

types.
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There are several reasons for our study to be important. While information related to

the risk transmission is valuable for policy makers evaluating systematic risk components of

the real estate market, investors utilize both the causal relationship and risk transmission
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information in portfolio decisions. In addition, our new methodological approach helps in

modeling the “elusive” smooth structural shifts in causality which has useful implications on
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a wide variety of future research.

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Our results show that oil prices do contain significant information in explaining REIT
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performance. While our Granger causality-type tests show significant interaction between oil

prices and healthcare, hotel, warehouse/industrial, residential and retail REITs, we also

observe a non-conformity from mortgage REITs. Essentially due to their unique underlying

holdings, mortgage REITs do not interact with oil prices like the others during our sample

period. In fact, the causality is reversed in the case of mortgage REITs. As for the volatility

spillover tests, we observe bi-directional spillovers between oil and REIT returns. One

possible explanation could be the combination of the company-size and the underlying causes

of the crisis period as we evaluated in this study. While REITs can react to outside shocks in a

similar fashion to large cap companies in the market (Clayton and MacKinnon, 2003), the

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reverse spillovers to oil prices could be unique to the sample period. The 2007/2008 financial

crisis was real estate related in nature. Therefore, it is comparatively difficult to establish

whether these spillovers are due to the asset structure of these companies or unique to the

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underlying drivers of the 2007/2008 crisis itself. Future research in this direction may provide

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further insight.

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Acknowledgements

We would like to thank the editor Dr. John Weyant and the two anonymous referees for their
invaluable suggestions and direction. Saban Nazlioglu gratefully acknowledges that his
contribution to this study is carried out under the Outstanding Young Scientists Award
Program-2015 of the Turkish Academy of Sciences (TÜBA-GEBİP 2015).

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Highlights
 Subsector REITs are evaluated against oil prices
 Interactions tested using causality and volatility spillover approaches
 A novel econometric model is proposed for causality
 Causality approach takes gradual structural shifts into consideration

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