The Relationship between Tenant Quality and REIT Risk & Performance

Abstract

This paper studies the micro-foundations of commercial real estate risk and performance. Specifically, we analyze the linkage between tenant quality and the performance of commercial real estate. A commercial real estate asset can be valued as the sum of the discounted future cash flows of commercial lease contracts. The value of leases is in turn determined by the financial stability and business growth of the tenants. Ex-ante, the operating and capital market performance of real estate having higher quality tenants e.g., AAA tenants should exceed the performance of properties having riskier tenants, ceteris paribus. Alternatively, we expect that tenant defaults or deterioration of tenant credit profiles will negatively impact the propertys performance. Real Estate Investment Trusts, a transparent ownership structure, regulated to hold commercial properties, provide a venue to test this hypothesis. We construct a metric to measure tenant quality by combining tenant credit information, such as credit rating, Altman Z-score, the earnings per share (EPS) forecast and the price performance of publicly traded tenants, as well as a tenant mix index. Using risk-adjusted stock returns and the corresponding betas of all equity REITs between 2000 to 2010, we show that tenant quality plays a significant role in explaining the cross-sectional variations of REIT returns and market exposure, even after controlling for other factors that influence REIT performance such as capital market conditions, firm characteristics, and REIT management.

JEL Classification: G1