The idiosyncratic risks of a Shariah compliant REIT investor

Abstract

This paper investigates the impact of Shariah compliant investment principles on the idiosyncratic risks of a Shariah compliant REIT investor. The importance of idiosyncratic risks in explaining cross-sectional returns of a constructed Shariah compliant REIT investor’s portfolio is further examined in this paper. In all constructed portfolios examined, there is a positive and significant relationship between expected idiosyncratic volatility and expected REIT returns of the constructed Shariah compliant portfolio (GCC Shariah compliance standards). This result is consistent and persistent after robustness tests are carried out. As such, idiosyncratic risks are an important factor to consider in the pricing of Shariah compliant REIT stock returns. On further examination, the significant relationship as seen in the constructed Shariah compliant portfolio can be explained from the firm-specific risks of the residential REIT sector which is the most dominant sector during the period of investigation. The implications of these results also point to the importance of Shariah compliance standards and screening methods which is a significant feature associated with the understanding of the relationship of idiosyncratic risks on expected REIT returns of Shariah portfolios. Results show contrasting results between a less-restrictive and restrictive Shariah compliant portfolio. We find a significant relationship between expected returns and the idiosyncratic risks specifically in the restrictive Shariah compliant portfolio.

Keywords:

• Shariah compliant REIT investor
• idiosyncratic risks
• asset pricing

Acknowledgements

We are grateful to the participants and the organisers of the 2011 Real Estate Conference sponsored by the Centre for European Economic Research, Mannheim Germany. We thank Professor David Downs of the Virginia Commonwealth University who reviewed our paper at the conference; his comments improved our work. We are also indebted to the two anonymous referees who reviewed our work; this improved our paper significantly. Finally, we acknowledge the Department of Real Estate, National University of Singapore for the grant provided to complete this research.

Notes

1. Non-permissible activities include alcohol, tobacco, pork products, ammunitions and pornography, financial services and gambling (casinos).

2. Our data analysis begins in 1998, as this is the period (1997–1998) in which the REIT IPO window reopened; therefore, this increased the number of REITs in the public financial markets (PricewaterhouseCoopers, 2011).

3. Synthetic Shariah compliant portfolios involve the conversion of conventional REIT into Shariah compliant portfolios through the applications of Shariah compliance standards. This method was first applied in the research work of Ibrahim and Ong (2008).

4. Shariah compliant Real Estate Investment Trust Portfolios are constructed from US REITs to mimic Shariah compliant investors who invest according to the Shariah compliance standards of the GCC Shariah compliance standards and the Shariah compliance standards of Malaysia.

5. In this paper, out of necessity, we construct Shariah compliant portfolios from the US REIT market and as an alternative to analysing Islamic REITs. Islamic REITs are still in their infancy including three Islamic REITs in Malaysia and only one in Singapore, therefore rigorous analysis could not be carried out on Islamic REITs.

6. Blume et al. (1974) find that 34.1% of their sample (17,056 individual income tax forms) holds one stock, 50% no more than two and 10.7% more than 10% (Levy, 1978). Barber and Odean (2008) find that the mean household portfolio consists of 4.3 stocks (worth 47,334 dollars) and the median household invests in 2.61 stocks (worth 16,210 dollars) (Goyal & Santa-Clara, 2003). Goetzmann and Kumar (2004) find that 25% of their sample (62,000 household investors) from 1991 to 1996 holds one stock, 50% with no more than three stocks and 10% of the sample with more than 10 stocks (Fu, 2009).

7. Shariah compliant public-listed property companies in the Gulf Cooperation Council (GCC) including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates follow the GCC Shariah compliance standards. In this instance, the GCC Shariah standard specifies a fully compliant (100%) interpretation of the Shariah law on real estate investments, particularly in the area of no debt financing (riba) and a zero tolerance on the non-permissibility of certain activities. These firms would typically have an internal Shariah board that regulates and gives advice on the permissibility of real estate investments.

8. Real Estate Investment Trust in countries like Malaysia follows requirements as set out by the Malaysian Securities Commission in order to be considered as Shariah compliant. Shariah compliant REIT is permitted to invest in real estate so far as the underlying real estate investment does not exceed a 20% threshold of non-permissible activities. For REIT with mixed asset portfolios, the rental area of non-permissible activities must not exceed 20%.

9. In Shariah compliance of stocks, it is generally accepted that any income from a haram (non-permissible) activity may be considered acceptable, provided that sufficient cleansing or income purification occurs in accordance with the guidelines set forth by the Shariah board.

10. Ibrahim and Ong (2008) create a strict Shariah compliant (SC) portfolio and less-restrictive SC portfolio.

11. In our screening method, we use the 20% criteria based on floor space, i.e. non-permissible activities must not supersede 20% of entire floor space or base rent, if provided, to be considered Shariah compliant. Our screening is based as at the end of December 2009, validated by the company accounts of the REIT; we do not consider the possible time-varying nature of change in asset/property use across the period of investigation.

12. The SC REIT represents the Shariah compliance standards of the GCC; there is an outright ban on non-permissible activities whilst the SCLR REIT represents the Shariah compliance standards of Malaysia which permits non-permissible activities of no more than 20% of the floor area space of the property. Our 20% permissible limit of REIT properties is as of December 2009 and does not control for changes in assets/properties over time.

13. Book-to-market ratio is measured as the ratio of the book value of the common stock of a firm to the market value or market capitalization in the stock market (Fama & French, 1992).

14. The three-factor model is measured as (i) the excess return of the market portfolio (R_m−r_f); (ii) the difference between the return on a small stock portfolio and a large stock portfolio (SMB); and (iii) the difference between the return on a high book-to-market stock portfolio and a low book-to-market stock portfolio (HML). The SMB and HML variables are downloadable from the website of Kenneth R. French: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

15. Although not reported in Table 3, we find that a negative correlation between one-month lagged idiosyncratic volatility and returns of the SC REIT portfolio is −.021 while for the All-REIT and SCLR portfolios, the correlation is −.011 and −.086, respectively.

16. In the study, we employ a 12-month rolling window to estimate expected beta in order not to reduce the timeline of the data in our paper. We also employ a 24-month rolling window as a robustness check and our results are consistent with earlier findings.

17. An alternative method of measuring idiosyncratic volatility is estimated according to Ang et al. (2006) in which a lagged idiosyncratic volatility is estimated and regressed on the Fama and French model (1993). Ang et al. find that there exists a negative relation between the lagged idiosyncratic volatility and expected return. Fu (2009) suggest that a lagged idiosyncratic volatility may not be a good estimate of expected idiosyncratic volatility; however, we use this technique as a reference point. Using the Ang et al. (2006) estimation (results can be produced upon request), results show a positive and significant relation between idiosyncratic volatility and expected return except for the SC REIT portfolio in which the relation was positive albeit insignificant. These conflicting results are contrary to the assertion of a negative relation between volatility and expected returns and highlight the inconsistencies of the Ang et al. (2006) technique for estimating idiosyncratic volatility.

18. The decision as to the total ban of prohibited activities (GCC standard) or the partial ban of prohibited activities as is the case in Malaysia (less than 20% of prohibited activities is tolerated, measured as a percentage of total space) has an effect on the explanatory power of idiosyncratic risks on REIT returns.