On the dynamic interactions between sector-level REITs, their direct real estate counterparts and the stock market in Japan

Despite their short history of existence, Japanese REITs (J-REITs) play an increasingly important role as a vehicle for property investment. In this paper we examine the long-run relationship and short-run dynamics between REITs, direct real estate assets, and the stock market in Japan. Using a vector error correction model, we explore whether J-REITs behave like direct real estate assets or like common stocks. Our study is based on general and sector specific appraisal-based monthly real estate indices covering the retail, office, residential and hotel sectors. Cointegration as well as exclusion, and weak exogeneity tests indicate that in the long run J-REITs are good substitutes for direct real estate assets but not for stocks. That is, they are a liquid alternative to unsecuritised real estate which offers diversification benefits to long-horizon investment in the Japanese stock market. These findings are robust and hold across all real estate sectors. Analysis of forecast error variance decompositions and impulse responses shows that shocks to the J-REITs market have a substantial impact on the direct real estate market and the stock market. In contrast, shocks these two markets contribute substantially less of the forecast error variance of J-REITs. Further, Granger causality tests reveal a unidirectional causal relationship from J-REITs to the other asset classes providing evidence that information aggregation and price discovery occurs predominantly in the J-REITs market.