A note on REIT bankruptcy and intraindustry information transfers: An empirical analysis

Journal

of Banking

and

Finance

15 (1991)

I171-1182.

North-Holland

A note on REIT bankruptcy and intraindustry information transfers: empirical analysis

An

Cliff Asness* ufliversiry of Chicago, Chicago, IL 60637, USA

Michael

Smirlock*

The Wharton School, University of Pennsylcania, Philadelphia, PA 19104, USA Received

May 1990, final version

received

March

1991

This paper examines the capital market response to the bankruptcy of Residential Resources (Res Res), a Real Estate Investment Trust (REIT). We find a significant event day value decline for a broad portfolio of REITs. REITs whose portfolios are most similar to Res Res experienced both a significant value decline and an increase in bankruptcy risk on the event day. REITs with dissimilar portfolios experienced neither of these effects. Among the REITs with similar portfolios to Res Res, leverage ratios explain 84% of the event day value declines. Our findings suggest that ignoring intraindustry firm differences can lead to spurious conclusions.

1. Introduction

Examination of the capital market reaction to an information announcement by one firm on firms in the same industry can provide valuable insights into the economics of information asymmetry and flows and the price setting behavior that most financial economists consider consistent with a rational market [Clinch and Sinclair (1987)]. As a result, there is a growing empirical literature that examines intraindustry information transfers, including studies that have investigated the effects of earnings releases [Foster (1981), Firth (1976), Morris (1980), Clinch and Sinclair (1987)], managerial forecasts of earnings [Bagninski (1987), Han, Wild and Ramesh (1989)], news of a nuclear accident [Bowen, Castanias and Daley (1983), Hill and Schneeweis (1983)] and bankruptcy announcements [Aharony and Swary (1983), Swary (1986)]. These empirical studies have provided modest evidence of intraindustry *The authors would like to thank Peter Linneman Eugene Fama for his comments on an earlier draft. Wharton Real Estate Center for financial support. 0378-4266/91/503.50

0

1991-Elsevier

Science Publishers

for his comments on this paper, The authors would like to thank

B.V. (North-Holland)

and the

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C. Asness and M. Smirlock, REIT bankruptcy

information transfers. These studies can be classified along two broad margins: (1) the type of event or, more speciticaliy, whether the event announcement might be largely predictable (e.g., earnings release) or largely unanticipated (bankruptcy) and (2) whether some effort was made to distinguish between the reactions of the cohort firms. The strongest evidence of intraindustry information transfers is from unexpected events where the cohort firms were discriminated among to some extent. These studies, however, do not systematically consider the bias that may be introduced by not discriminating among cohort firms, so that its importance in evaluating intraindustry information transfers is only suggested. The purpose of this paper is twofold. First, to add to the growing empirical literature on intraindustry information transfers. Second, to provide a systematic study of the importance of differentiating among cohort firms in such analyses. To the extent this differentiation is relevant, many previous studies may draw spurious conclusions. To do this, we examine the capital market intraindustry information transfer or spillover of the bankruptcy announcement in January 1989 of Residential Resources Mortgage Investment Corporation (RES RES), a Real Estate Investment Trust (REIT). In the case of bankruptcy, such an intraindustry information transfer has also been referred to as a contagion effect [Aharony and Swary (1983)]. REITs must establish, at time of formation, the type of assets they will purchase and maximum leverage positions. Accordingly, REITs lend themselves to intraindustry classification via portfolio composition and thus provide an excellent vehicle for examining how firms in the same industry might differ in response to an information announcement. This paper is organized as follows. Section 2 presents a discussion of the REIT industry and classifies a given REIT into one of three distinct categories depending on its asset portfolio, The RES RES bankruptcy announcement is also described in this section. Section 3 describes the stock price data used in the analysis. Section 4 contains our methodology and empirical results. We find a statistically significant value decline for the entire REIT portfolio at the time of the RES RES bankruptcy. Once classified by asset composition, however, only those REITs with a portfolio similar to RES RES experienced a significant vafue decline. Further, while the entire portfolio experienced no large change in solvency risk, the REfTs categorized similarly to RES RES had a significant increase in solvency risk. Finally, even within the cohort of firms most similar to RES RES we find a systematic difference in capital market response related to portfolio leverage. These findings suggest that ignoring intraindustry firm differences can confound information spillover effects and lead to spurious results and conclusions. Section 5 provides a summary and conclusions.

C. Asnrss and M. Smirlock, REl T bankruptcy

1173

2. REIT classification and analysis

REITs are financial institutions that invest virtually entirely in real estate related assets. These institutions must pass 95% of income through to investors and are limited to a leverage position of 300’? (each dollar in equity can support three dollars in borrowings). REITs pay no taxes at the firm level. When a REIT is established, its corporate bylaws also state its permissible investments. Based on these bylaws and the actual REIT investment portfolio, these firms are often referred to and can be classified into one of three groups: equity, financial and residual REITs.’ An equity REIT makes direct investments in real estate. Financial REITs, on the other hand, invest in commercial, residential and industrial mortgages as well as bonds collateralized by such mortgages. A residual REIT is a relatively new structure and gets its name from its investment in Collateralized Mortgage Obligation (CMO) residuals.’ A CM0 is a bond structure collateralized by mortgages, where classes (or tranches) of bonds are issued with different principal paydown priorities. The sum of the principal amounts on the CM0 bonds equals that of the underlying mortgage. The average coupon on the CM0 bonds, however, is at all times equal to or less than the average coupon rate on the mortgages. The CM0 residual is entitled to the difference between the interest payable on the mortgages and the interest payable on the CM0 bonds. The (1) higher this spread and (2) slower are prepayments on the underlying mortgages, the greater the cash flow to the residual holder.3 CM0 residuals can further be divided into two types: fixed-rate and floating-rate. A fixed-rate residual is the result of a CM0 structure comprising only fixed-rate bond tranches. Its cash flow tends to increase as rates rise and prepayments slow, but can entirely disappear in rapid prepayment environments. These residuals are typically short volatility and offer the holder high current yield. Floating rate residuals characterize CM0 structures that have at least one tranche with a coupon that changes with interest rates. These residuals offer high current yield to compensate for their extreme short volatility position: as rates rise, so does the floater coupon so that

‘The classification of REITs into tinancial and equity REITs is also used in Titman and Warga (1986). While REITs are often described in industry analysis as either equity, mortgage or residual, such a classification is a little more ambiguous for statistical purposes. Specilically, when classified by an industry analyst, a REIT can have a mixed equity/financial/residual portfolio and still be classified in one sub-category. For our purposes, as stated later in the text, REITs with mixed portfolios are eliminated from the sample. *CMOS are also referred to as Real Estate Mortgage Investment Conduits (REMICs) and the residual in either CMOS or REMICs is sometimes referred to as the structure’s equity. For a complete description of CMOS and residuals, see Roll (1987) and Alterescu (1987). 3For a description of the cash flow properties and valuation analysis of CM0 residuals, see Alterescu (1987).

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C. Asness and hi. Smirlock, REITbankruptcy

residual cash flow falls; as rates decline, prepayments increase so that residual cash flow also falls. Given the above, it is straightforward to see that these three REIT ‘types’ can have a substantially different risk profile and each may not be affected at all by some event that affects another type. For example, an across the board decrease in prepayments will significantly raise residual REIT values, but may have only minor effects on financial REITs and no effect on equity REITs. Alternatively, increasing short-term rates and a yield curve inversion should significantly lower the value of residual REITs, while the effect on financial and equity REITs is uncertain. RES RES was a highly levered residual REIT. RES RES, founded in June 1988, invested $55 million of its $65 million initial stock sales proceeds in floating rate residuals. By year end short-term rates were 200 basis points higher and RES RES’s portfolio earnings were severely reduced. RES RES tried to maintain portfolio yield by borrowing and using the borrowed funds to purchase additional floating rate residuals. It borrowed until it reached its maximum 300% leverage. As short-term rates continued to rise, RES RES was unable to meet margin calls on its borrowings. On January 10, 1989, RES RES declared bankruptcy, attributing its insolvency to ‘severe liquidity problems primarily as a result of continuing market interest rate increases combined with the inability of the company to borrow funds and satisfy margin requirements under certain loan agreements’.4

3. Data and analysis overview To investigate contagion effects in the REIT industry we examine the stock market response to the RES RES bankruptcy for a sample of 35 REITs. The sample firms, all of which are listed on the NYSE or AMEX, were selected because their portfolio consisted either (1) entirely of direct real estate investments, (2) entirely of mortgage assets, or (3) predominantly CM0 residuals. Using the portfolio classification described in the previous section, our sample consists of 18 equity, 8 financial and 9 residual REITs. These 35 firms are listed in the appendix. For the sample firms daily common stock returns were obtained from the Wall Street Journal for the 60 trading days immediately prior to and following the event day, as well as the event day itself (January 10, 1989). Our empirical analysis will proceed as follows. First, we examine the effect of the RES RES bankruptcy on the entire sample of REITs. We then consider the effects of the bankruptcy announcement on each REIT subgroup. We expect the strongest effect to be among residual REITs. Given the %e Askin and Henderson RES RES bankruptcy.

(1989)

for

an

excellent

description

of the

evolution

of the

C. Asness and M. Stnirlock, REI T bankruptcy

1175

very different portfolio composition and corporate by-laws, it is difftcult a priori to see why there should be any contagion effect among the equity and financial REITs. It is, of course, possible to find information spillover effects for the entire sample but not for either the equity or financial REITs if the capital market response of the residual REIT subsample is large enough. Such a finding would show the importance of discriminating across firm characteristics when investigating intraindustry information transfers. Third, the RES RES bankruptcy was largely caused by (1) the type of residual investment and (2) the amount of leverage. While the former is not readily available, the latter can be obtained. We estimate the effect of leverage on the stock price response of the residual REITs. A significant leverage-response relationship further supports the need to distinguish among firms in evaluating intraindustry information transfers. 4. Methodology

and findings

We begin our empirical analysis by examining the stock market response of the entire REIT sample to the RES RES bankruptcy announcement. Since all our sample firms are from the same industry and were affected simultaneously by the event of interest, returns are likely to be cross-sectionally correlated. This correlation implies that regression residuals are not independently and identically distributed, so the event study methodology pioneered by Fama et al. (1969) is not appropriate. To overcome this, we employ a seemingly unrelated regression (SUR) approach [Schipper and Thompson (1983, 1985), Smirlock and Saunders (1987)]. For our sample, testing the risk and return effects of the RES RES insolvency implies estimation of the following system of 35 equations over the 121 day sample period:

R2,= a2 + I-ML, + 14 + V&,

(1)

where Ri, is the return on the stock of firm i on day t, R,, is the return on the NYSE index on day t, D, is a dummy variable equal to one on the event day and zero otherwise, P, is a dummy variable equal to one on the event day and all post-event days and zero otherwise. Eq. (1) consists of a market model, ai + BiR,,,and an event portion ID,+gP,RMtthat measures the abnormal returns and change in systematic risk of the REIT sample due to

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C. Asness and M. Smirlock, REITbankruptcy

the RES RES bankruptcy announcement. 5 In the initial analysis, and as would be consistent with most event studies, we restrict the event parameters i. and y to be identical across sample firms. A priori, if there was an announcement effect, we expect a decline in value and an increase in the perceived riskiness of REITs. This corresponds to I<0 and y>O. The results of estimating eq. (1) are reported in tables 1 and 2. Table 1 reports the parameter estimates from the control portion of the equation as well as the mean coefficient estimations by REIT classification. The overall systematic risk is low but consistent with that reported by Brueggeman, Chen and Thibodeau (1984) in their analysis of REIT risk and return. The first row of table 2 reports the event parameters ;1 and y. As can be seen, the empirical results suggest a 1.42% decline in value for the portfolio of REITs on the day of the RES RES bankruptcy announcement. Additionally, there is a significant increase in the systematic risk of the REIT portfolio, with the average jI increasing from 0.14 in the pre-announcement period to 0.42 (0.14+0.28) in the post-announcement period. In and of itself, this finding suggests a significant contagion effect characterized by a decline in REIT valuation and an increase in the systematic risk of REITs. As previously noted, however, it may not be appropriate to restrict the event parameters to be equal across all sample firms. In particular, we expect a different capital market response by type of REIT, where those REITs most like RES RES (i.e., the residual REITs) experience the.most significant spillover effect and those that have little in common with RES RES’s portfolio structure and operating procedure (i.e., the financial and equity REITs), experience little if any negative capital market response. To examine this, we allow the event parameters to vary across REIT category although we restrict these parameters to be the same within a given REIT category.6 The resultant event parameters are reported in rows 2-4 of table 2. The only significant contagion effect is on the residual REITs, which experience an abnormal return of -3.82% on the announcement day. This

‘Following Smirlock and Saunders (1987), eq. system (1) was also estimated with a lagged market return variable in an attempt to account for nonsynchronous trading and an unexpected interest rate change variable (in this case, unexpected changes in LIBOR) to account for changes in the cost of leverage. The results concerning the magnitude and significance of the event parameters presented in this paper and the resultant conclusions were robust with respect to this specification. 6The event parameters were restricted to be the same within each REIT category because there is no a priori reason to expect the event response of the equiy and linancial RElTs to be different within type of lirm. There is some reason, however, to expect the response of the residual REITs to be dilIerent. We relax this assumption later on. Nonetheless, using the methodology developed by Schipper and Thompson (1983, 1985), we tested the restriction that the event parameters are equal across all equity REITs and are equal across all financial REITs. The null hypothesis of equal event response within the equity and linancial REIT category could not be rejected.

C. Asness and M. Smirlock,

REIT bankruptcy

1177

Table 1 Firm-specific parameter estimates of control variables for eq. system (l).’ REIT type

Firm no.

Equity

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Mean 1 2 3 4 5 6 7 8 Mean

Bi 0.3413 - 0.0009 0.0217 - 0.0002 0.2873 -0.0006 -0.0356 -0.CCQ6 0.6813* 0.0011 0.5718* -O.cQlO 0.0468 0.0003 -0.0176 O.cOlO -0.1532 - 0.0020 - 0.2047* 0.0002 0.2617 -0.0011 0.1416 0.0007 0.9728* - 0.0006 0.1536 -0.OcO7 0.2586 0.0000 -0.1711 - 0.0020’ 0.4032* - 0.0009 0.1217 -0.OuO4 0.2045 -0.0012 0.2800 -0.0014 0.2428 -0.0003 - 0.0326 -0.0104 0.1598 -0.0010 0.3360 O.OOQ8 0.4034 o.ooo2 0.0354 -0.0019 -0.4903 -0.0019 0.1168

1 2 3 4 5 6 7 8 9 Mean

-0.0085’ -0.0016 -0.0101 -0.0017 - 0.0055 -0.0036 - 0.0072 - o.cQO2 -0.0017 -0.0044

Financial

Residual

Mean

zi

0.0000

-0.0018

-0.2756 0.3486 0.0947 0.5360’ 0.0568 0.3161 -0.1988 0.1656 - 0.6508 0.0436 0.1430

‘The control

portion of eq. system (1) is Rir=ai +BiRnr where Ri, is the firm’s return on day t and R,, is the market return on day t. *Estimated coeflicient significant at the 5percent level (two-tailed test).

decline in value is significant at the one percent level. The financial and equity REITs experienced a 1.2% and 0.32% decline in value on the event day but neither coefficient is significant at any reasonable level. The announcement effect of the RES RES bankruptcy on the risk of the

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C. Asness and M. Smirlock, RElTbankruptcy Table

2

Event parameter estimates equation system 1.’ Row

REIT type

I

7

(1)

All Equity Financial Residual

-0.0142** -0.0032 -0.0120 -0.0382**

0.2832* 0.1487 0.1389 0.6801**

(2) (3) (4)

‘The coefficient A: measures the effect of the event on firm returns, by type, and the coefficient y measures the effect of the event on lirm systematic risk, by type. ‘CoeNtcient significant at the IO-percent level (two-tailed test). **Coefficient signilicant at the Spercent level (two-tailed test).

REIT sample is examined in two ways. First, financial theory implies that investors focus on the effects of systematic risk on their portfolios. This effect is captured by the coefficient y in eq. (1). The first row of table 2 reports the estimate of y assuming yi=yj for all firms in the REIT sample. This coefficient is positive and significant at the ten percent level, implying a significant increase in the systematic risk of REITs due to the RES RES bankruptcy.’ As noted above, however, we might expect the capital market response to be different across the type of REIT. We expect the largest effect to be on residual REITs and a lesser or even no effect on other REITs. To examine this we once again restrict y to be the same within each REIT category but differ across REIT classifications and reestimate eq. (1). These results are reported in rows 2-4 of table 2. While y is positive for all the REIT sub‘To investigate leakage effects and to further test the informational efficiency of the market, eq. (1) was estimated for each REIT category incorporating six additional dummy variables corresponding to the three trading days immediately prior to the event day and the three trading days immediately after the event day. None of the individual coefftcients on any of these six event variables is significant for any of the REIT categories. The sums of the pre- and postevent dummy variable coeficients are (t-statistics in parentheses): REITtype Residual Property Financial

Pre-event 0.232% (0.83) 1.403% (1.37) 0.622% (0.48)

Post-event -0.358% (0.67) - 0.200% (0.58) - 0.020% (0.27)

The market response in each instance is quite small, not always in the expected direction, and never significant at even the lW/, level. These results provide strong evidence of no information leakage and, once announced, rapid market adjustment to the RES RES bankruptcy.

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C. Asness and M. Smirlock, REITbankruptcy Table 3 Effects of event on solvency

risk of sample

REITs.

Variance” REIT type

Pre-event

Post-event

Z-statistic

F-statisticb

All Equity Financial Residual

0.2379 0.2459 1.4280 0.6363

0.4000 0.2208 0.4140 3.2149

0.34 - 0.02 -0.10 1.998

1.68’ 1.11 3.458 5.05;

‘Variance multiplied by 10,000. %ar(Group A)/var(Group B)-F(59.59). In all cases, group (group B) refers to the group with the larger (smaller) variance. *Significant at the S-percent level.

A

samples, the only significant change in systematic risk, and therefore the only significant evidence of intraindustry information transfers, is on residual REITs. While presumably investors focus on systematic risk, a superior measure of the bankruptcy risk of firms is the variance of total stock returns [James (1984), Smirlock and Saunders (1987)].* To examine this issue, the return variance of each REIT was estimated for the sixty day period prior to and for the sixty days following the event date. The mean pre- and post-event variances for the entire sample and each REIT category are reported in table 3. Whether or not the change in total risk is significant is tested using a Wilcoxon rank test. The test yields a z-statistic, which is also reported in table 3. The null hypothesis of equal total return variance for the entire sample in the pre- and post-event period cannot be rejected at the five-percent level. When examining the firm subsamples, however, only the residual REITs demonstrate a significant increase in solvency risk.’ In fact, the total return variance of both the financial and property REITs declined in the post-event period. F-statistics that also test the null hypothesis that the pre- and postevent stock return variances are equal, are reported in the last column of table 3. The results of the F-tests confirm the previous findings, providing additional evidence that the contagion effect experienced by REITs due to the RES RES bankruptcy announcement was not widespread but concentrated among REITs most similar to RES RES. ‘As Kahane (1977) demonstrates, in a risk of ruin framework the probability of failure (1) can be written as Pr(d W-c -C) =x where W is firm wealth (value) and C is its capital. Standardizing by the standard deviation of dw cd,,,, this expression can be rewritten as between the Z(a)= -C/u,,. As udW increases, OLwill increase. This implies a direct relationship probability of bankruptcy and the variance of equity returns. ‘It is important to note that the pre- and post-event market variances, and hence the market variance contribution to total risk, is virtually identical. In particular the pre-event market variance is 0.4392x 10e4, while the post-event market variance is 0.4392 x 10m4. Hence, any significant change in REIT solvency risk must be attributable to REIT-specific changes in systematic and/or nonsystematic risk.

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REITbankruptcy

We further investigate differential responses of firms within an industry to an event by relating the individual residual REIT stock price responses to their portfolio characteristics. As noted earlier, the RES RES bankruptcy was largely due to the residual portfolio held and its leverage. While data on the former is not obtainable, the latter is available.” Accordingly, we reestimate eq. (1) for the residual REITs allowing li to vary across firms. We then estimate the regression &=r+QLEI$+Ei,

(2)

where LEV is the book debt/equity ratio of residual REIT i.” If the strength of an information transfer is related to idiosyncratic firm characteristics within an industry, and not just a global uniform effect, we expect Q
C. Asness and M. Smirlock, REITbankruptcy

1181

Appendix: Firms in sample

Firm no.

Firm name

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

American Health Properties Duke Realty Investments EQK Realty Health Care Properties Meditrust Prudential Realty Santa Anita Realty Sizeler Properties Storage Equities Trammel Crow Real Estate Weingarten Realty Beverly Investment Properties Boddie-Noel1 Restaurant Burnham Pacific Copley Properties Koger Equity One Liberty Properties USP REIT BRT Realty Trust Lomas and Nettleton Mortgage Rockefeller Center Properties Wedgestone Financial Arizona Southwest Financial Lincoln N.C. Realty Fund Mortgage Investments Plus Realty South Asset Investors Countrywide Mortgage Emerald Mortgage Investments Lomas Mortgage RAC Mortgage Investment Corp. TIS Mortgage Investors American Southwest Financial Columbia RE Investments RYMAC Investors

Ticker symbol

Type of REIT

AHE DRE EKR HCP MT PRT SAR SIZ

Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Equity Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Residual Residual Residual Residual Residual Residual Residual Residual Residual

SEQ TCR WRI BIP BNP BPP COP KE OLP URT BRT LOM RCP WDG AZL LRF MIP RSI AIC CWM EIC LMC RMR TIS ASR CIV RM

References Aharony, J. and I. Swary, 1983, Contagion etIects of bank failures: Evidence. from the capital markets, Journal of Business 56, July, 305-322. Alterescu, H., 1987, Mortgage residuals, Mortgage securities research, Goldman, Sachs and Co., May. Askin, D. and J. Henderson, 1989, Anatomy of a failure, Secondary Mortgage Markets, Federal Home Loan Mortgage Corporation, Spring, 22-24.

J.B.F.-

F

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