Alternative Investment Strategies: When REITs Meet Options

Cao, Jay J.（曹杰）, Zhan, Xintong（戰昕彤）

CUHK research finds that prices of REIT options reflect the information of informed traders and can be used to predict future REIT returns.

By Song Linjia

An alternative investment is a financial asset that does not fall into one of the conventional investment categories, including stock, bonds, and cash. Alternative investments include private equity or venture capital, hedge funds, art and antiques, commodities, derivatives contracts, and real estate. By providing diversification to conventional investment, alternative investment has gained popularity in recent years. However, there is limited research on the trading strategies and return predictability for alternative investment assets. A group of researchers at The Chinese University of Hong Kong (CUHK) Business School sought to examine the link between two important alternative investment assets, namely that of options and real estate investment trusts (REITs), and to design potentially profitable trading strategies in the alternative investment universe.

This research, titled Option Price Implied Information and REIT Returns, was conducted by Cao Jie and Zhan Xintong, Associate Professor and Assistant Professor, respectively, at CUHK Business School’s Department of Finance; PhD student Song Linjia from CUHK Business School’s School of Hotel and Tourism Management; and Prof. Han Bing from University of Toronto. Moreover, Prof. Zhan’s expertise as a Chartered Alternative Investment Analyst (CAIA) adds to the team valuable insights to conduct and promote research on the alternative investment by focusing on derivatives and real assets.

Predictions, as an old proverb goes, can be hazardous, especially if it’s about the future. This is true in life, as it is in finance, where much effort has been devoted to predicting the movement of stock prices. Understandably, being able to accurately predict the future movement of share prices allows investors to make the best choices in their investments, and one of the more reliable indicators for those seeking outperformance has been to look to option market data.

The option market is informationally “superior”. That is, options typically attract better informed investors who are drawn because the inherent properties of the market amplify both profits as well as losses. Another reason is that in most stock markets, share prices do not fully reflect all publicly available information. Is it true for REITs? Do REIT options also contain useful information to predict REIT return?

Growing Popularity of REITs

A REIT is a company that owns, operates or finances income-producing real estate properties. Most REITs are traded on major stock exchanges and investors can buy or sell REITs like common stocks. REITs, as alternative investment class, provide diversification benefits and have become an increasingly important part of investment portfolios for both institutions and individuals. In U.S., publicly traded REITs own around 2.5 trillion in gross assets. Around 145 million Americans own REITs through their retirement savings and other investment funds.

In China, REITs are also attracting attention from both investors and policy makers. In August 2020, China Securities Regulatory Commission (CSRC) for the first time issued a guidance on the public offering of real estate investment trusts (REITs) in the infrastructure sector and China nears approval of its first public REITs . Considering the huge size of real estate market in China, the market cap of REITs in China can be considerably large.

As investor demand for REIT investment rises, the option market of REITs also grows rapidly in the past two decades. Specifically, the ratio of REITs with options has increased from 10 percent to 88 percent from 1996 to 2017 in the U.S. CUHK researchers find that there is “diffusion” of information from REIT options to underlying REITs and prices of REIT options reflect the information of informed traders and can be used to predict future REIT returns.

The Study

The researchers constructed several option price implied measures using data from OptionMetrics, a data provider, and examined their return predictability in both REITs and common stocks.

Options are derivatives of underlying securities. Theoretically, in perfect markets options are just derivatives and cannot affect underlying assets. However, prior research has shown that they are not “redundant” assets, and that they contain information on the underlying securities from which they derive. There are two types of options. A call option gives the buyer the right but not the obligation to buy an underlying asset. A buyer of a call option profits when the price of this underlying asset rises. Its counterpart, a put option, gives the right to sell an underlying asset, and they increase in value as the price of the underlying asset falls.

Options attract informed investors because of their higher “embedded” leverage – that is, their trading profits or losses are typically amplified compared to their stock market counterparts. Thus option prices can contain valuable information on underlying securities which is not incorporated in stock prices. The team conducted a range of analyses and found that option price implied measures are able to predict future REIT returns.

The results show that difference between the change in implied volatility in call and put options positively predicts REIT return in the next week. A long-short trading strategy, where an investor buys and holds stocks that are expected to appreciate in value while shorting stocks that are expected to fall, based on this measure produces meaningful profits.

The implied volatility on an option is the value of the volatility, when input in an option pricing model (such as the classical Black–Scholes model), that will return as a theoretical value equal to the market option price. Implied volatility goes up when option prices rise. An increase in implied volatility for a call option means higher price for the option and signals favorable information about the underlying firm while an increase put implied volatility for a put option signals unfavorable information. The difference between call implied volatility change and put implied volatility change captures the net positive information about future cash flows and hence positively predicts future REIT returns.

They show that the return predictability is not explained by the characteristics of stocks (such as its market capitalization or book-to-market ratio, a measure of whether a security is over- or underpriced) or option trading volumes. This suggests that option prices contain implied information not yet captured by other REIT characteristics. Further, they find that the return predictability diminishes quickly and disappears in several weeks. They argue that the transmission of information from derivatives to REITs is very fast.

Difference in Predictive Power

This study finds significant differences in return predictability by option price-based predictors in REIT and common stock market. In the common stock market, all option price-based predictors significantly predict future stock returns. However, in the REIT market, only implied volatility changes work while other measures fail.

They document that the REIT market is of higher quality compared with common stocks in general, when taking into account factors such as the likelihood of errors in pricing, the spread between bid and ask quotes, and market trading volumes. A higher market quality usually means more efficient and lower cost trading for participants. On the other hand, the market quality of REIT options is lower than that of the options on common stocks. Thus the incentives to gather information by REIT option traders may not be as strong as common stocks. Compared to stocks, if the option market is of lower quality and the trading cost is higher, this will make investors less willing to trade.

So the return predictability by option price implied measures is weaker for REITs. Moreover, evidence suggests that the weaker predictability by option price-based predictors is due to the absence of price pressure mechanism. In other words, the underlying REITs market is typically more efficient than the typical stock market and therefore market information is more fully reflected in the price of REIT assets. They find that in the REIT market, the deviation of the implied price of an option from the traded stock price documented in prior research did not predict future stock returns.

They further explore whether availability of market information and limits to arbitrage affect the documented predictability. Results show that the return predictability is more pronounced among younger REITs, REITs with lower analyst coverage, and REITs with higher limits to arbitrage.

Most REITs own income-producing properties like apartment buildings, offices, data centers and so on across different regions. The information environment of REITs also differs across REIT types and locations, so the informational advantage of informed traders may differ accordingly. They show the effect of informed trading is found to be more pronounced for REITs located in less transparent real estate markets and those focused on nontraditional property types such as datacenters and infrastructure. These findings imply that the information from its option market may be particularly important if the underlying REIT suffers from lower transparency.

REITs is an important asset class but still relatively underexplored compared with common stocks and bonds. REITs historically have delivered competitive total returns, based on steady dividend income and capital appreciation. Their comparatively low correlation with other assets also makes them a supplement to traditional asset classes. This study explores a new venue that contains information on REIT fundamentals and has implications for investments in REITs.