Initial public offerings of equity securities

Journal of Financial Economic; 31 (1992) 331-410. North-Holland zyxwvutsrqponmlkjihgfedcbaZYXWVU Initial public offeringsof equity set Anomalous evidence using REITs* Ko Wang and Su Han Chan California State University at Fullerton, Fulierton. CA 92434, USA George W. Gau ihiversity of Texas at Austirt, Austin, TX 78712. USA Received April 1991, final version received August 1991 In contrast with numerous studies that find significant underpricing for initial public offerings of industrial firms, we document a statistically significant average return of - 2.82% on the first trading day for a sample of 87 initial public offerings of real estate investment trusts during the 1971-1988 period. Qur overpricing result is invariant to offer price, issue size, distribution method, offer period, and underwriter reputation. Newly issued REITs, on average, substantially underperfoml a matching sample of seasoned REITs during the first 190 trading days. Interestingly, buyers of overpriced REITs are predominantly individual or non-13(f) institutional investors. 1. Introduction It is well documented that investors, on average, earn large initial returns on initial public offerings (IPOs) of equity securities. Smith (1986) surveys five studies of initial public equity offerings and concludes that the average underpricing appears to exceed 15%. In a more recent study, Ibbotson, Sindelar, and Ritter (1988) document a 16.37% average initial return using a sample of 8,668 IPOs during the 1960-1987 period. For a predictable event such as an IPO, an expected return of this magnitude over a short period (often one day) seems in conflict with market efficiency. Recent theoretical models attempt to develop *We acknowledge helpful comments from Michael Brennan, Lena Chua, John Erickson, John Martin, Anthony Sanders, Laura Starks, Theodore Stemberg, Michael Vetsuypens, and especially Michae! Jensen (the editor), Chris Muscarella, and Seha Tinic. We wish to thank Janet Payne for providing us with data from the SEC’s Registered Offerings Statistics tapes. The research assistance of Jimmy Cheng. Steve Donovan, Greg Hallman, and Laura Jacobson is gratefully acknowledged. Finally, we are indebted to Jay Ritter (the referee) who provided specific suggestions that greatly improved this paper. 0304-405X/92/$05.00 0 1992-Elsevier Science Publishers B.V All rights reserved 382 conditions K. W ang et al., Initial public oflerings qf REITs under which the systematic underpricing of IPr)s could be an equilibrium phenomenon. 1 However, Ibbotson (197%)and others find that the median initial return is close to zero, suggesting that a significant number of firms experience overpricing of their zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFED IPOs tven if the average return is positive. Several studies report emI,+irical evidence that cannot be finllv explained 5y existing IPO models. Ibbotson and Jaffe (1975) and Ritter (19&4,,for example, find that the degree: of underpricing of new issues varies srt certain times in particular industries. Muscarella (1988) reports no significant underpricing for a sample of 55 IPOs of master iimited partnerships (MLPs). For his various subsamples, Muscarella finds statistically significant average initial returns of - 0.53% and - 0.19% for eight hotel/motel MLPs and eight oil/gas MLPs, respectively. Loderer, Sheehan, and Kadlec (1991) find that the initial offerings of 251 new issues of preferred stock do not appear to be underpriced. The inability to explain this conflicting evidence casts some doubt on the completeness of IPO pricing models. Our study extends the existing empirical literature on initial public offerings by providing new evidence using IPOs of real estate investment trusts (REITs). Previous empirical studies of IPOs generally do not include REITs and closedend mutual funds in their samples [see, for example, Ibbotson, Sindelar, and Ritter (1988)]. More recently, Weiss (1989) and Peavy (1990) document that the mean initial-day returns of closed-end fund IPOs are not significantly diKerent irom zero, but substantially underperform the market during the next 100 [Peavy) or 120 (Weiss) trading days. Peavy as well as Ibbotson et al. (1988) argue that the insignificant initial-day return is supportive of the information asymmetry hypothesis because there is little uncertainty about the underlying value of the funds’ assets. In contrast to closed-end funds, REITs invest in infrequently-traded real estate assets (properties and mortgages) and there is much uncertainty regarding their values, especially when compared to a fund investing in stocks with observable market values. There are instances where REITs do not specify, at the initial offering stage, the assets they will be acquiring with the IPO funds; investors in the IPOs of these unspecified REITs are unable to value the as-yet-unidentified real estate acquisitions. Even in cases where the REIT’s prospective investments are fully or at least partially specified at the time of the IPO, the underlying assets generally have an uncertain market value because no price information is generated on the properties and mortgages by the real estate or capital markets. Given this valuation uncertainty, there is little reason to believe that REIT IPO pricing behavior should be similar to that of closed-end fund stocks. ‘The theoreticalmodelsincludeargumentsbasedon informationasymmetry[Baron (1982) and Rock (1986)J legal liability and litigation risk [Tinic (1988) and Hughes and Thakor (1991)], signalling [Allen and Faulhaber (1989), Grinblatt and Hwang (1989), Welch (1989), and Benveniste and Spindt (1989)], and an informational cascade etiec‘ect [Welch (1992)]. K. W ang et al., hitial public offerings oj' RElTs zyxwvutsrqponmlkjihgfedcbaZYXWVU 383 In this paper we document, using a sample of 87 REIT IPOs in the 1971-1988 period, that initial public oflerings of REITs are systematically overpriced (the average initial-day return equals - 2.52%). Like Weiss’s and Peavy’s findings on the performance of closed-end fund IPOs, REIT stocks substantially underperform the market during the first 190 trading days after the IPO. However, unlike Peavy’s closed-end fund sample, the price drop in our REIT sample begins immediately on the first t*adir:g day rather than being delayed more than 20 days. Peavy takes the position that, on average, the aftermarket price of the shares of closed-end funds should fall because of the deduction of the offe+g expenses from the IPO proceeds and the fact that less-informed investors may overpay for the shares of the new funds. He further argues that initial restrictions on short sales as well as underwriters’ support of the security’s price in the aftermarket may delay the share price decline. If these explanations are reasonable, the same arguments should apply to all IPOs, including REITs. A significant price drop on the initial trading day would be inconsistent with Peavy’s argument. Clearly, neither Peavy’s argument nor any of the existing IPO theories can fully exzjlain the significant negative mean initial-day return in our REIT sample. The paper is orgariized as follows. The next section discusses the charac:eristics of REITs and the real estat; industry. S,ection 3 describes the sample collection procedures and provides descriptive statistics for the REITs making initial public oRerings. Section 4 examines the initial-day re=drns of REIT IPOs for the full sample and various subsamples partitioned by offering characteristics, offer date, and underwriter reputation. Institutional participation and subsequent stock performance of these REIT IPOs are also examined. Section 5 provides an explanation of the overpricing result, and section 6 presents the conclusions. 2. REITs and the real estate industry REITs became a popular investment vehicle after Congress passed the Real Estate Investment Trust Act of 1960. This act exempts business trusts from corporate income taxes if they comply with certain requirements. The key requirements are restrictions on asset selection., ownership structure, and Jividend pay jut policy. [See Allen and Sirmails (1987) for a detailed discussion on the institutional background of REITs.] The principal Internal Revenue Code provisions aiso require that a REIT must be a corporation, business trust, or association managed by a board of trustees or directors. Other aspects of the corporate form, such as stockholders’ voting rights, transferability of stock, and limited shareholder liability are retained. Investors in REITs are the residual claimants t.o the firm’s revenues and ought to face the same difficulties in valuing their claims as investors in common stocks. 384 K. Wang et al., Initial public oferings of REITs It is a popular belief that the uncertainty about the value of real estate stocks is greater than that for stocks of most industrial firms with operating assets. Palmon and Seidler (1978) and Hite, Owers, and Rogers (1987) observe that real estate companies complain that the stock market underestimates their ‘real value’ more often than that of companies of other industries. They point out that such complaints may not be entirely baseless: several real estate firms have liquidated some or all of their real estate assets under the belief that the firm’s common stocks did not reflect the underlying value of the assets. In addition, Brennan (199G)cites real estate holdings with relatively low yields as nn example of a class of 1~; :rcir’ assets (assets whose values are not reflected in share price). Similar arguzlc- :E. proffered by practitioners can be found in, for example, the Wall Street zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA ic,x~ ~r,t c ? / 17/90) and the New York Institute of Finance’s publication on R~~i’E’~ L : : ‘2%‘. p. 18). There are others, however, who believe that real estate stocks are >!i: underpriced [Chan, Hendershott, and Sanders (1990)-j,and might even be overpriced.2 Regardless of whether the stock market undervalues or overvalues real estate stocks, the differing views demonstrate that there is substantial uncertainty regarding the value of real estate companies. Howe and Shilling (1988) state that ‘as a general rule, REIT operating cash flows are difficult to forecast’ (p. 984). Firstenberg, Ross, and Zisler (1988) point out that the information flows in the real estat:. Imarket are complex because it is not an auction market offering divisible shares in every property. Titman and Warga (1986) examine the risk and perfol-nlance CL38 mortgage and equity REITs and conclude that ‘ . . . because of the very high volatility of these investment trusts, it is very difficult to obiaih an accurate measure of performance using any of the performance measures’ (p. 428) Based on the evidence, it is plausible to maintain that REIT IPOs are. on average, associated with a greater level of uncertainty than industrial firm IPOs. Given a higher level of uncert_tinty and existing IPO theories, we might expect REIT IPOs to be, on average, significantly underpriced. We might also expect that they wou!d be distributed by less prestigious underwriters using best-efforts contracts [see Ritter (1987), Bower (1989), and Titman and Trueman (1986)]. Practitioners in the real estate stock market, however, have a different view. The New York Institute of Finance (1988) advises investors to avoid newly-issued REITs, observing that in 1985 the aftermarket prices of most new issues of REITs fell below their offering prices (p. 47). It also seems that some ZFor example, Jeffrey Lynford (associate director of Bear, Stearns &Co.), observing what seems to be imprudent real estate underwriting practices, charges: ‘For many decades people have said Wall Street doesn’t understand real estate. Well, it still doesn’t understand it as well as it should.’ He warns: “There is substantially increased risk for individual investors who buy the securities’ (Wall Street Journal, 3/4/86). Bruce Garrison, director of real estate securities analysis at Lovett Mitchell Webb & Garrison, remarked that new equity REITs invariably trade at a discount to their offering prices. He attributes this phenomenon partly r~ the fact that the market has difficulty valuing these companies (Barrens, g/29/88). K. W ang et al., Initial public o&rings of REITs 385 underwriters are aware of the situation; in at least two zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQP REIT IPO prospectuses, the underwriters specifically mentioned that the shares of many REITs have traded below the current value of their real estate assets. Some practitioners suggest that new REITs are worth investing in only if they are trading at a big discount to their initial offering price. In fact, two very successful real estate stock funds attribute their success to a strategy of avoiding stocks of newer REITs until after their prices have dropped to attractive levels (Wall zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Street Journal, 7/30/f%). Kenneth Campbell of Audit Investment Inc. said: ‘If I can buy acceptable property at 10 percent to 20 percent discount, why should I pay full price? (wall Street Journal, 6/25/85). It is interesting to note that these comments were made after finance researchers had rigorously documented large positive initial returns for IPOs of industrial firms. The popular press also notes that there is a lack of institutional interest in investing in REITs and that the shares of several REITs are aggressively sold to individual investors. (See, for example, Barron’s, 8/29/88, and Business W eek, 2/26/90, p. 89.) While information on the: number of investors in an IPO is rarely published, the REIT IPO prospectus of VMS Mortgage Investment Fund reports that four REIT IPOs of affiliated companies issued shares totalling $475 million to 33,600 investors (approximately $14,000 per investor). Therefore, similar to Weiss’s (1989) contention about closed-end fund shares, it may seem that REIT shares are also aggressively sold. It is interesting to note that closed-end funds and REITs share a similar pattern: their IPOs are not underpriced. 3. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Sample design and descriptive statistics The initial sample consists of all initial public equity offerings by REITs listed in annual editions of the REIT Fact Books.’ This source identifies a total of 322 REIT IPOs from 1961 to 1988. Of these 322 observations, 132 have initial offering prices and offering characteristics published in various sources: the REIT Fact Books, the Securities and Exchange Con-mission’s Registered Offerings Statistics tape, the W all Street Journal, the Dow Jones News Retrieval Service Database, the Standard and Poor’s Stock Reports, the Investment Dealer’s Digest, the Directory of Corporate Financing, and the Corporate Finance Sourcebook. (Data published in the Corporate Finance Sourcebook is provided by Securities Data Company, New York, NY.) We also obtain IPO prospectuses (from Disclosure Info Centers) for those IPOs offered on a best-efforts basis and 3The REIT Fact Book contains data derived from information provided to the National Association of Real Estate Investment Trusts, Inc. by member and nonmember tax-qualified REITs. For 1987 and 1988, data on REIT public offerings are contained in a publication entitled The State and Course of the 1987 Real Estate Investment Trust Industry and a companion publication entitled REIT Facts. Although the REIT Fact Book lists the names of REITs that have gone public sinz 1961, it only began publishing initial offer prices in 1985. 386 K. W ang et al., Initial public oflerings of REITs for those offerings that cannot be verified in at least two sources. For the bestefforts offers, we gather information on their offering periods and completion dates from their prospectuses., from Standard and Poor’s Stock Reports, and from the firms’ annual reports. For each REIT, we use the Standard and Poor’s Daily Stock Price Record for NYSE, AMEX, and OTC firms to obtain aftermarket price data for the first trading day. The first day’s price is taken to be the closing transaction price (NYSE, AMEX, and NASDAQ National Market stocks) or the bid price (OTC stocks) on the first day of public trading, which is the first day for which transaction volume is noted. (In our sample, there are six cases with no transaction volume on the first trading day.) Only 112 of our initial 132 REITs have aftermarket price data from this source. From this reduced list, 25 IPOs are eliminated for the following reasons: (a) The first trading day and the offering date (prospectus date for firm commitment offerings and end of offering period or completion date for best-efforts offerings) are more than two months apart (five firm commitment offerings and five best-efforts offerings are eliminated). (b) The offering is through a stock exchange or a stock distribution by the issuing corporation (six eliminated). (c) The common stock offering is combined with free warrants that are issued in varying amounts during the offering period (six eliminated), althotlqh we do include three such oilers in our final sample because the size of the free warrant is insignificant and the aftermarket price of the warrant is quite low when compared to the aftermarket price of the common share. (d) The offering is a unit (common share plus warrant) offer, but the common share trades 74 days earlier than the unit (one ehminated). (e) The unit offer specjl’iesthe price for the unit (common share plus warrant) as well as the price for the warrant, but the common share cannot be purchased separately and the common share trades 127 days earlier than the unit (one eliminated). (f) The offer cannot be verified with at least two sources and its prospectus is not available (one eliminated). The final saimple consists of 87 REITs with offering dates spanning the period 1971-1988. Table 1 compares the annual distribution of IPOs in our sample to that for the REIT industry as reported in annual editions of the REI T Fact Book for this 1%vear period; the yearly distribution of IPOs in our sample is fairly 0 representative of the RUT industry in terms of number of issues and size of offerings. For both the SCxple and the industry, the number of IPOs is greatest in two periods., from !971 to 1973 and from 1985 to 1988. Compared to the REIT industry, our REIT sample has a higher percentage of offerings (59.8% of the total) in the later period (1985-1988). Table 1 Annual summary of initial public equity offerings for the REIT sample and the REIT industry in the period 1971-1988. _~__ _ __ __- --___ --____ ____REIT sample REIT industry” _~__ __ Number of Total Number of Total number Total Total proceeds Number Total proceeds Number of initial public amount issuedC best-efforts of initial of best-efforts of other of other offerings proceeds best-efforts offerings (million) offerings offeringsd (million) offerings offerings (million) offerings’ (million) ..----- Yearh _. 1971 4 $125.8 0 32 Sl,M3.4 3 1972 9 167.4 0 29 563.2 6 1973 6 1974 0 59.5 NA NA NA N.4 NA NA 130.0 50.0 145.0 0 0 0 0 0 0 0 1 0 1 18 5 1 0 0 3 4 4 5 3 156.8 1.5 0.0 0.0 0.0 8.4 0.0 30.0 100.0 315.0 1975 0 1976 0 1977 1978 1979 1980 1981 1982 0 0 0 2 I *> L 1983 1984 1985 1986 1987 1988 TO kil ‘) 3 ?:f . 11 6 10 222.5 417.5 2,457.9 593.4 463.6 979.4 1 4 4 1 2 2 4 9 29 20 15 13 159.0 374.2 2,79 1.9 1,204.4 1,026.4 1,374.3 87 5,811.9 16 _______- 194 9,288.5 6 4 1 0 0 2 4 3 3 2 NA NA NA NA NA NA NA NA NA NA NA $215.0 29 23 12 1 0 6) 0 1 0 1 2 1 3 5 6 9 6 3 136.5 215.0 513.2 632.9 216.4 329.6 1 4 23 11 9 10 66 2,258.6 128 $1,183.4 563.2 156.8 1.5 0.0 0.0 0.0 8.4 0.0 30.0 100.0 100.0 22.5 159.2 2,278.7 571.5 810.0 lJM4.7 zyxwvutsrqp 7,209.9 aData is obtained from annual editions of the REIT zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Fact Book and REIT Facts. These sources did not report the gross proceeds from best-efforts offerings in the period 1971-1981 (indicated by NA). bThe annual count of the number of IPOs for the REIT sample is based on :he prospectus date, while the REIT industry numbers are based on both the prospectus date (for firm commitment underwriting) and the completion date (for best-efforts offering). ‘For best-efforts offerings, we calculate the total amount issued using the maximum number of shares offered. The total proceeds of best-efforts offerings for the REIT industry are based on the number of shares actually sold at the completion of the offering. dThe number includes both public offerings and private placements by REITs. “Other refers to offerings other than best-efforts, specifically firm commitment underwritings plus private placements. K. W ang et al., Initial public zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIH oflerings of REITs 388 For periods prior to 1971 (not reported in the table), the volume of REIT industry IPQs is relatively high in the 1969-1970 period (54 IPOs with total $2.3 billion) and relatively low in the 1961-1968 period (74 IPOs with $0.2 billion in total proceeds). Fig. 1 shows that during the 1961-1987 period, both REIT industry IPOs and industrial firm IPOs [as reported by Ibbotson, Smdelar, and Ritter (1988)] exhibit a similar offering trend. As a single industry, the total proceeds of REIT initial offerings represent a significant share of the total initial offerings in the stock market. Data compiled from annual editions of the zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG REIT Fact Book or REIT Facts indicate that, between 1961 and 1988,322 REITs raised a total of about $12 billion from initial public equity offerings and private placements. Ibbotson, Sindelar, and Ritter (1988) report that the total proceeds of the 8,668 IPOs of industrial firms (this sample excludes REITs) during the 196&1987 period is approximately $84 billion. Megginson and Weiss (1991) document that the 2,644 offers listed in the ealers’ Digest Corporation Data Base (January 1983 to September 1987) raised approximately $70.3 billion. The total dollar amount of IPOs listed in REZT Facts during 1983-1987 is approximately 7.4% of that amount. In our REIT sample, 43 IPOs are common stock offerings, 26 are offerings of shares of beneficial interest, a;d 18 are unit offerings. A unit offering is a package consisting of common shares with warrants or shares of beneficial interest with warrants. Shares of beneficial interest are tradeable shares of a REIT organized as a business trust. The shares are analogous to common shares ofcorporations. Eighty-two percent of the IPOs in the REIT sample (compared to 66% in the REIT industry) are firm commitment offerings. Forty-two REITs began trading over-the-counter after the offering, and 45 traded on the NYSE and the AMEX. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA 14.00 T GI Indus!rial g 12.00 & % 10.00 S g m ; 5 iii 8.00 6.00 4.00 g) z! 2.00 $j 0.00 It firm 61 62636465666768697071 72737475767778798081 828384858687 Year Fig. 1. Percentage of REIT and industrial firm offerings by year (number of olTerin?s in each year divided by the total sample offerings in the period 1961-1987) for 309 REIT IPOs [REfTFact Book data] and 8,399 industrial firm IPOs [data based on Ibbotson et al. (1988)J K. Wang et aL, Initial zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIH public o$Eings of zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPON RElTs 389 The sampled IPOs have an average offering price per share of $15.69. The minimum offering price is $5 and the maximum offering price is $25; 78 IPOs have offering prices between $10 and $20. Table 2 provides summary statistics on the offering size of the full sample and various subsamples. The average issue size of the full sample is approximately $67 million. This amount is significantly larger than that repored for IPOs of industrial firms, but is smaller than that for closed-end fund IP6s. (Weiss reports that the average offering sizes of U.S. stock funds and bond funds are $202 million and $326 million, respectively, for her sample period.) Within the various subsamples, the average offering size is lower for REITs traded over-the-counter, for REITs with unit offerings, and for REITs distributed using the firm commitment method. The average offering size ($90 million), measured using the maximum number of shares, of the 16 best-efforts REITs is approximately 38 times larger than the average gross proceeds ($2.4 million) for best-efforts 1PC:s of industrial firms as reported by Ritter (1987). To ensure that the use of offering size does not bias the comparison, we check the firms’ annual reports and Standard and Pmr’s Stock Reports for the gross proceeds at the completion of the 16 best-efforts offers. We find that the mean of the gross proceeds ($81 million) does not deviate much from the average offering size. In the REIT industry between 1971 and 1988, approximately 34% of the IPOs Table 2 Summary statistics on the issue size (in thousands of dollars) of 87 REIT IPOs in the period 1971-1988. Sample Full sample Sample partitioned by stock exchange: NYSE and AMEX OTC Maximum issue size Sample size $3,750 $750,000 87 112,048 36,889 18,362 3,750 750,000 200,000 45 42 51,796 200,008 750,000 100,000 26 43 18 Average issue size -. - Standard deviation $66,804 $89,048 93,765 37,917 Minimum issue size Sample partitioned by type of security: Shares of beneficial interest (SBT) Common stock (CS) Unit 64,020 85,232 26,803 115,045 24,356 10,000 10,000 3,750 Sample partitioned by distribution method: Best efforts (BE) Firm commitment (FC) 90,012 61,574 73,303 92,084 15,197 3,750 300,000 750,000 16 71 22,497 16,605 102,153 3,750 10,000 60,000 750,000 17 54 partitioned by type of security: Unit SBI and CS ?3.876 390 K. W ang et al., Initial public oflerings of REITs were on a best-efforts basis (refer to table 1). This percentage does not deviate too much from that reported for iudustrial firm IPOs [see Ritter (1987) and Johnson and Miller (1988)-j. 4. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA IEmpirical results Table 3 reports the summary statistics of the initial-day returns for the full sample and various subsamples. The initial-day return is measured from the offer price to the close (or bid) price at the end of the first trading day. The mean initial-day return for the full sample is - 2.82% (t-statistic = - 4.36), with a maximum return of 7% and a minimum return of - 30%. On the first trading day, ten IPOs (12% of our sample) show positive returns, 55 (63% of our sample) show negative returns, and 22 (25% of our sample) experience zero returns. Using the sign test and the Wilcoxon signed rank test, we find that the median initial-day return Q - 1.25%) is also significantly different from zero (z-statistics are - 2.47 and -- 4.66, respectively). This median test result, which is unaffected by the observed skewness in the distribution of the initial-day returns, provides additional evidence of overpricing. The result also seems robust to the influence of a few outliers: after we arbitrarily excluded nine observations with initial-day returns of less than - 7%, we still find a significant average initial-day return of - 1.12% (t-statistic = - 3.58). The overpricing result would be made even stronger by including the 25 deleted IPOs, whose mean and median initial-day returns are - 7.8% and - 5%, respectively. Finally, to adjust for market movements, we subtract the contemporaneous daily percentage price change of the Standard and Poor’s 500 Composite Index from the inittal-day return. The mean and the median of the marketadjusted initial-day return are - 2.99% (t-statistic = - 4.54) and - 1.55%, respectively. The significant initial-day overpricing result is in sharp contrast to the consistent underpricing results reported by previous empirical studies using industrial firms, nor does it change when the full sample is partitioned by stock exchange, type of security, offering price per share, issue size, aind distribution method. The mean initial-day returns for all of the subsamples are negative and significant at the 10% level and all but three median initial-day returns are negative. The firm commitment subsample that consists of only common shares and shares of beneficial interest (commonly used in previous IPO studies) shows a significant average initial-day return of - 1.09% (t-statistic = - 2.51). These results indicate that the overpricing result is not sensitive to the offering characteristics of the IPOs. There is no significant difference (at the 10% level) among the average initial-day returns of the subgroups partitioned by type of security, ofleering price, and issue size. REIT IPOs traded OTC, however, are more overpriced (by 2.99u percentage points) than REITs traded on the NOSE and the AMEX Table 3 Summary statistics on the initial-day returns of 87 REIT IPOs traded on the NYSE, the AMEX, and OTC in the period 1971-1988. Sample - ---. - _ .- ___._ __ _ __. Mean return r-statrstic Sample size #: <o # # =o >o ~~-- Median return Minimum return --- Maximum return Full sample - 2.82% - 4.36” 87 55 22 10 - 1.25% - 30.00% 7.00% Sample partitioned by stock exchange: NYSE and AMEX OTC - 1.41% - 4.33% - 2.12” - 3.99” 45 42 22 33 18 4 5 5 0.00% - 2.50% - 22.50% - 30.00% 6.25% 7.00% Sample partitioned by type of security: Shares of benefical interest (SBI) Common stock (CS) Unit - 2.73% - 2.68% - 3.27% - 3.82” - 2.38” - 2.63” 26 43 18 20 20 15 4 16 2 2 7 1 - 2.19% 0.00% - 2.50% - 10.00% - 30.00% - 20.00% 7.00% 6.25% 6.88% Sample partitioned by offering price: $10 or less Between $10 and $20 $20 or greater - 3.90% - 3.21% - 1.77% - 3.01” - l.83b - 2.78” 34 13 40 21 7 27 9 4 9 4 2 4 - 1.25% - 1.67% - 1.22% - 30.00% - 20.00% - 16.259/o 5.00% 5.00% 7.00% Sample partitioned by issue size: $3.7 M - 25 M $26M65M $67 M - 750 M - 4.05%. - 2.38% - 2.16% - 2.69” - 2.84” - 2.22” 27 28 32 21 20 14 1 5 16 5 3 2 - 2.50% - 1.69% 0.00% - 30.00% - 20.00% - 22.50% 6.88% 5.00% 7.88% - 8.39% - 1.56% - 3.38” - 3.41” 16 71 14 41 1 21 1 9 - 5.63% - 1.19% - 30.00% - 20.00% 7.00% 6.88% - 3.06% - 1.09% - 2.35” - 2.51” 17 54 14 27 2 19 1 8 - 2.50% - 0.31% - 20.00% - 16.25% 6.88% 6.25% Sample partitioned by distribution Best efforts (BE) Firm commitment (FC) method: partitioned by type of security: Unit SBH and CS “Significant at the 0.05 level for a two-tailed test. bSignifica -t at the 0.10 level for a two-tailed test. 392 K. Wang et zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDC al., Initial public offerings of RElTs (t-statistics = 2.30). This evidence is inconsistent with Muscarella’s finding that master limited partnerships traded OTC exhibit greater underpricing than those traded on the NYSE and the AMEX. REIT IPOs exhibit the greatest overpricing level when best-efforts contracts are used. The mean initial-day return of the best-efforts IPOs is 6.83 percentage points lower than that of firm commitment IPOs (t-statistic = 4.51). This result contrasts with Ritter’s (1987) and Chalk and Peavy’s (1987) findings that the level of underpricing, on average, is greater for industrial firm IPOs using best-efforts contracts. 4.1. Initial-day return, contract choice, and ex ante uncertainty This section tests whether there is a relationship between initial-day returns and ex ante uncertainty for our IPO sample. Four proxies for ex ante uncertainty are employed. The first is the standard deviation of the daily aftermarket returns for day 2 through day 20. We call this proxy the aftermarket standard deviation. The initial-day return is excluded to avoid the correlation between the intial-day return and the aftermarket standard deviation. We regress the initialday return on the aftermarket standard deviation and find a significant negative relationship (t-statistic = - 3.33). This ratio explains approximately 12% of the variation in the initial-day returns. The result indicates that the greater the uncertainty (as measured by the aftermarket standard deviation) about the market clearing price, the greater the overpricing. This evidence is inconsistent with existing IPO theories. We employ the REIT asset type as a second proxy for the ex ante uncertainty of the m;!rket clearing price. REITs traditionally are classified as equity REITs (which hold at least 75% of their assets in real property), mortgage REITs (which hold more than 75% of their assets in mortgage debt instruments), and hybrid REITs (which invest in both real property and debt instruments). [See New York Institute of Finance (1988) for a detailed discussion on types of REITs.] Mortgages are typically created with fixed coupon payments and are secured by real properties, although some mortgage investors also participate in the cash flows from the operations of the real property. The future cash flows and the risk level of a mortgage REIT are relatively easy to forecast. However, the information concerning the future cash flows and profitability of direct property investments can be difficult to obtain. Howe and Shilling (1988) point out that it is much harder to forecast expected rents, vacancies, or selling prices of real property investments. The 1989 REIT Administrative Survey reports that the average compensation (measured as a percentage of total assets) to the advisor companies is higher for equity REITs than for mortgage REITs; the differential compensation may be partially due to the more complex nature of equity REITs. It is thus plausible that the ex ante uncertainty of market clearing prices for mortgage REITs should be less than the ex ante uncertainty for equity REITs. K. W ang et al., Initial public oflerings of REITs 393 We use zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA REI T Fact Books, REIT Facts, IPO prospectuses, and Standard and Poor’s Stock Reports to classify the REITs by asset type. Of the 87 REITs in the sample, the asset type of 73 REITs can be identified from these sources. The remaining 14 REITs (issued between 1971 and 1973) are classified as the unknown group. Fanel A of table 4 reports the initial-day returns partitioned by asset type. The result indicates a larger overpricing for IPOs with a higher level of ex ante uncertainty (in this case, equity REITs). The difference, however, is not significant at conventional levels (t-statistic = 1.50). The third proxy measures the investor’s uncertainty about management’s investment strategy. At the offering stage, certain REITs fully or at least partially specify the properties they intend to acquire with the IPO proceeds. Consequently, investors have less uncertainty regarding the underlying portfolio of the trust. REI T Fact Books (19851986), the State and Course of the 1987 Real Table 4 Summary statistics on the initial-day returns of 87 REIT IPOs classified by asset type, asset specification, and duration in the period 1971-1988. Subsample Sample size Average initial-day return Panel A: REIT Mortgage REIT Equity REIT Hybrid REIT Unknown REIT 35 IPOs partitioned - 1.69% 33 by asset type - 2.C7b - 0.63% 1.18% - 3.13b - 1.25% 1.41% - 0.75% - 1.18 - 1.25% 1.25% 14 - 3.72% - 2.29b - 3.00% 1.44% 1POs partitioned by asset specijicalion 36 - 1.62% - 2.11b - 0.63% 1.22% 34 - 3.78% - 3.03b - 1.77% 1.37% 17 - 3.42% - 2.54b - 2.50% 1.40% Panel C: REIT Finite-life REIT Infinite-life REIT Aftermarket standard deviation’ 5 Panel B: REIT Fully/partially specified REIT Unspecified REIT Unknown REIT t-statistic Median initial-day return 1POs partitioned by duration 23 - 5.55% - 3.26b - 2.50% 1.26% 64 - 1.83% - 3.0gb - 1.22% 1.33% aAftermarket standard deviation is defined as the standard deviation of the daily returns from day 2 to day 20 (initial-day return is excluded). bSignificant at the 0.05 level for a two-tailed test. 394 K. W ang et al., Initial public oflerings of RElTs Estate Investinent Trust Industry, and REIT Facts (1988) report whether a REIT IPO is specified or unspecified. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDC REZ T Fact Books published prior to 1985 do not contain this information. For those REITs that are not identified by the publications, we obtain the information from their IPO prospectuses and Standard and Poor’s Stock Reports. The information on 17 REITs issued during the period 1971-1973 cairnot be identified using these sources. For the 70 identified IPOs, 36 are fully or partially specified and 34 are unspecified. Panel B of table 4 reports the result based on this partitioning. Unspecified REIT IPOs, on average, are more overpriced than fully- or partially-specified IPOs, but the difference is not significant at conventional levels (r-statistic = 1.47). The last proxy measures investor uncertainty over whether the share price will reflect the underlying asset value of the trust (closed-end fund discount phenomenon). Finite-life REITs (with a plan to liquidate their holdings at some specified future date) are designed to ensure that their shares will eventually be liquidated at a price close to asset value. From REIT Facts, 23 of the 87 REITs in our full sample are identified as finite-life REITs. Panel C of table 4 reports the results based on this partitioning. Contrary to our expectation, finite-life REITs are more overpriced than infinite-life REITs by 3.72 percentage points (t-statistic = 2.61). This result might be driven by the fact that finite-life REITs have only been promoted in recent years, and the market is less familiar with this type of REIT. (Thirty-seven of the 55 finite-life REITs identified by the 1988 REIT Facts are issued after 1984.) 4.2. Initial- day return and ofleeringdate Ibbotson and Jaffe (1975) and Ibbotson, Sindelar, and Ritter (1988) find that the degree of underpricing is cyclical for the 1960-1987 period. They observe that underpricing appears to lead the number of new offerings by roughly one-half to one year and there is no evidence of underpricing in certain periods. Ritter (1984) also reports a 15-month ‘hot issue’ market starting in January 1980 for natural resource issues. Lee, Shleifer, and Thaler (1991) believe that the price of closed-end funds are driven below. net asset value in periods when noise traders become pessimistic about the future, and that closed-end funds are issued more frequently when investor sentiment is unduly optimistic. This section examines whether similar factors also affect the initial-day returns of REIT IPOs. Panel A of table 5 reports the average initial-day returns by prospectus year for REIT IPOs and compares them with those of industrial firm IPOs. Except for the years of 1980 (with two observations) and 1981 (with only one observation), all average initial-day returns for REIT IPOs in the period 1971-1988 are negative. Over the same period, overpricing is exhibited in only three years (1973-1975) for industrial firm IPOs. Between 1984 and 1988 (a period with a zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA r eht ively large number of observations in our sample), there is no observable K. W hy et zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA a l.,Initial public oflerings of REITs 39s Table S Annual distribution of the number of offerings. average initial-day return, and size of offerings of87 REIT IPOs in the period 1971-1988, together with industrial firm (IF) IPO comparative statistics calculated using data from Ibbotson, Sindelar. and Ritter (1988). REIT IPOs Year Number of offerings Average initial-day return (%) t-statistic IF IPOs Total amount issued’ ($ million) Average initial return (%)d Total proceeds ($ million) Panel A: REIT IPOs partitioned by year 125.8 167.4 59.5 NA NA NA NA NA NA 130.0 SO.0 145.0 222.5 4! 7.5 2.457.9 593.4 463.6 979.4 21.16 7.51 - 17.82 - 6.98 - 1.86 2.90 21.02 25.66 24.6 1 49.36 16.76 20.31 20.79 11.52 12.36 9.99 10.39 NA 1,655 2,724 330 51 264 237 151 247 429 1,404 3,200 1,334 13,168 3,932 10,450 19,260 16,380 NA 5,811.~ - 4.36” 87 - 2.82 Total zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA 15.07 75,217 10.04 18.44 21.12 10.68 4,709 1,379 23,038 46,090 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 4 9 6 0 0 0 0 0 0 2 1 2 2 9 2s 11 6 10 - 1.70 - 1.03 - 7.32 NA NA NA NA NA NA 0.58 0.00 - 2.50 - 0.62 - 3.4s - 2.7s - 1.1’ - 8.20 - 1.83 - 2.72b - 0.84 - 2.54” NA NA NA NA NA NA 0.09 NA - 1.00 -0.11 - 2.728 - 2.41” - 1.39 - 1.34 - 0.79 Panel B: REIT IPOs partitioned by period 1971-1373 1974-1979 1980-1984 1985-1988 19 0 16 52 - 3.16 NA - 2.26 - 2.86 - 2.578 NA - l.98b - 3.06” 352.6 NA 965.0 4,494.3 “Significant at the 0.05 level for a two-tailed test. bSignifican; at the 0.10 level for a two-tailed test. ‘For best-efforts offerings, we calculate the total amount issued using the maximum number of shares offered. din Ibbotson et al. (1988), initial returns between 1971 and 1976 arc computed as the percentage return from the offering price to the end-of-calendar-month bid price, less the market return. For 1977-1987, initial returns are calculated as the percentage return from the offering price to the end-of-first-day bid price, without adjusting for market movements. The returns reported for the REIT sample are computed using the latter method. pattern in the relationship between the average level of overpricing of REIT IP0s and the volume of new issues. In panel B of table 5, the sample is partitioned into subperiods. The average returns are negative in all subperiods for the REIT IP0s but positive for 396 K. W ang et al., Initial public ofierings of RElTs industrial firm IPOs. For the REIT sample, the 19851988 subperiod is comprised of 52 IPOs with a significant average initial-day return of - 2.86%. Only 16 REIT IPOs are observed in the 1980-1984 subperiod, with an average initial-day return of - 2.26%. Finally, the 19 REIT IPOs issued during the 1971-1973 subperiod exhibit an average initial-day return of - 3.16%. T-statistics show that the mean initial-day returns in the subsample periods are not significantly different from each other. Thus, for REIT IPOs during our sample period, there does not appear to be a distinct cyclical pattern of overpricing. 8.3. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Initial- day return and underwriter reputation Titman and Trueman (1986) and Carter and Manaster (1990) suggest that prestigious underwriters, on average, undertake IPOs with a low dispersion of possible firm values and price the securities more fully. To test this implication, we partition our firm commitment and best-efforts subsamples by underwriter reputation. The underwriter reputation of each IPQ is classified by the ranking of the lead manager. If the IPO is co-managed, we take the first name that appears on the various data sources to be the lead manager. To identify the ranking of underwriters, we first rely on the ranking of 117 underwriters assigned by Carter and Manaster (1990). If an underwriter cannot be identified from this ranking system, we check the Directory of Corporate Financing (DCF), which lists the top 15 underwriters in terms of their market shares in each year, to see if the underwriter is listed. A total of 41 different underwriters (both ranked and not ranked) for the 87 IPOs are identified. Nineteen of these underwriters, managing a total of 60 (56 firm commitment and four best-efforts) IPOs, are ranked by Carter and Manaster (CM) or DCF. Table 6 reports the summary statistics of the initial-day returns when the sample is partitioned by underwriter reputation. We find that most firm commitment REIT IPOs are underwritten by prestigious underwriters. Forty-one percent (29 of the 71 firm commitment IPOs) are underwritten by the top 20 underwriters in CM’s list (with the highest rankings of eight or nine). Only 21% (15 of the 7i firm commitment IPOs) are distributed by underwriters that are not ranked by CM or DCF. On the other hand, most of the 16 best-efforts IPOs are distributed j less prestigious underwriters; only three of the 14 underwriters are ranked by CM or DCF. We also find that prestigious underwriters, on average, are associated with less-overpriced REIT IPOs. The mean initial-day returns for the two top-tier underwriters (with a rank of eight or nine) are not significantly different from zero, although the mean initial-day return of - 1.15% for the 56 firm commitment IPOs managed by all 19 ranked underwriters is significant at the 5% level. We also observe that the mean initial-day returns of the subsamples are all negative, and all but three of their median initial-day returns are negative. Table 6 - Summary statistics of initial-day returns by underwriter (UW) reputation for 87 REIT lP0s in the period 1971-1998. ---_-_ __ -_- Sample Mean initial-day return (Oh) Sample # # # r-statistic size <o = 0 > 0 Full sample - 2.82 - 4.36” 87 55 22 10 Firm commitment underwritings partitioned by UW rankings: UW not ranked by DCF or CM’ UW ranked by CM or DCF Ranked 3.4, or 5 by CM Ranked 7 or 7.5 by CM Ranked 8 by CM Ranked 9 by CM Ranked by DCF UW partitioned by bracket:’ Minor bracket Major bracket Special bracket - 1.56 - 3.41” 71 41 21 9 - - 15 56 4 ‘15 13 16 8 11 30 4 11 4 8 3 1 20 0 1 8 6 5 Best-efforts contracts: UM not ranked by DCF or CM UW ranked 7 by CM UW ranked 9 by CM U W ranked by DCF __~ -__- --__-- 3.06 1.15 3.42 2.09 0.54 0.29 1.02 2.00b 2.80” 2.54b 1.80” 1.17 0.42 1.93b Median return (%) --.- 1.25 Minimum return (?h) Maximum return (%) -- 30.00 7.00 41 - 1.19 - 20.00 6.88 30 3 6 0 3 1 2 0 - 2.50 0.63 2.81 2.50 0.00 - 0.31 0.00 - 20.00 - 16.25 - 6.82 - 16.25 - 5.83 - 5.05 - 3.75 6.88 6.25 - 1.25 5.00 1.25 6.25 0.00 11 19 4d 4’ 6’ 3” 2h 17 10” 3k - 3.38 - 0.63 - 0.29 - 3.26” - 1.69b - 0.42 26 29 16 21 12 8 2 13 6 3 4 2 - 2.29 0.00 - 0.31 - 20.00 - 5.83 - 5.05 6.88 5.00 6.25 - - 3.38” - 2.89” NA NA - 1.88 16 12 14 10 1 1 0 1 1 - 5.63 - 5.63 - 0.13 -- 0.63 - 14.69 - 30.0 - 30.00 - 0.13 - 0.63 - 22.50 7.00 7.00 - 0.13 - 0.63 - 6.88 8.39 8.58 0.13 c 53 - 14.69 1 1 2 1 1 2 ----____- 0 0 Number of UWs 0 0 0 -____ I4 11 I 1 ~_ 1 “Significant at the 0.05 level for a two-tailed test. bSignificant at the 0.10 level for a two-tailed test. ‘13CF refers to Directory of Corporate Financing; CM refers to Carter and Manaster (1990). dUnderwriters are Butcher and Singer Inc., First Equity Corp., Prescott, and Rauscher Pierce Securities Corp. ‘Underwriters are Alex Brown & Sons, Donaldson, Lufkin $r Jenrette, Drexel Burnham Lambert, and PaineWebber. ‘Underwriters are Bear, Stearns & Co., Dean Witter Reyno!ds, E. F. Hutton & Co., Lehman Brothers, McDonald & Co., and Smith Barney, Harris Upham & Co. gUnderwriters are Goldman, Sachs & Co., Merrill Lynch, and Salomon Brothers. hIJnderwriters are Prudential-Bathe Securities and Shearson Lehman Brothers. ‘Underwriter classification based on Hayes (197 1). ‘Underwriters are Bear, Stearns & Co., Dean Witter Reynolds, Drexe2 Burnham Lambert, Donaldson, Lufkin & Jenrette, E. F. Hutton, Lehman Brothers, PaineWebber, Prudential-Bathe Securities, Shearson/American Express, and Smith Barney, Harris Upham & Co. kUnderwriters are Goldman Sachs & Co., Merrill Lynch, and Salomon Brothers. K. W mg et ai., Initial public oflerings of REI Ts 398 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA As an ayditional test, we also partition our firm commitment sample based on the underwriter bracket categories used by Hayes (1971) and modified by Tinic (1988). Under this method of ranking, 16 REITs fall into the special bracket categorv (corresponding to a rating of nine under the CM ranking system), 29 are in the major bracket category, and 26 are in the minor bracket category. The result of this test reinforces the findings using the CM ranking system. The average initial-day returns of IPOs managed by prestigious underwriters (special bracket and major bracket) are significantly different from those managed by underwriters in the minor bracket (b-statistics are 2.60 and 2.16, respectively). This anaiysis demonstrates that there is a negative relationship between the magnitude of overpricing and the quality of the underwriter, supporting Tinic’s finding that prestigious underwriters price IPOs more fully than fringe underwriters. 4.4. Multivariate analysis of initial-day returns To further analyze the cross-sectional variance of the initial-day returns, we regress the initial-day return on selected variables. The regression sample consists of 70 REITs (after excluding 17 observations with no information on asset type and/o* asset specification). Table 7 reports the regression results. Regression (1) regresses the initial-day return on the logarithm of issue size and five dichotomous variables representing underwriter classification (special and major groups), infinite-life REITs, unspecified REITs, equity REITs, and bestefforts contracts. This regression equation explains approximately 3 1% of the cross-sectional variance in the initial-day returns, The sign of each coefficient is consistent with the results reported in previous sections; however, only two variables (equity REITs and best-efforts contracts) are significant at the 5% level. The negative 5.4% coefficient associated with the best-efforts contract variable is much larger than the coefficients of the other four dichotomous variables, suggesting that the distribution method might be the most important factor influencing the initial-day price performance. Because the commitments of underwriters of firm commitment IPOs differ from those of agents of best-efforts IPOs, we rerun the first regression without the best-efforts variable. Regression (2) reports the result using the reduced sample of 54 firm commitment IPOs. For this subsample, only the coefficient of the underwriter variable is significant at the 5!% level, suggesting that the initial-day returns of IPOs underwritten by more prestigious underwriters (special and major groups) are, on average, significantly less overpriced (bvD 2.94 percentage points) than those underwritten by less prestigious underwriters. This result indicates that underwriter reputation might play the most significant role in explaining the initial-day return of firm commitment IMW WCL Table 7 Cross-sectional Regression modelb regression estimates from regressing the raw initial-day return on selected independent 1971-1988 (t-statistics in parentheses).a Intercept __ _.. - UW classification -_ --_. Infinite-life Nonspecified REIT REIT __--- __ _. --.- -____ Sample of 70 REIT 1 _-- - 0.015 ( - 0.09) _-____ 0.014 (0.88) - 0.019 (- 1.33) - 0.025 ( - 1.68)d Equity REIT 0.098 (0.9 I ) 0.029 (2.69)’ - - -_--___-- - 0.002 (- 0.18) - 0.012 (- 1.15) Adjusted Best-efforts F-statistic R2 (% ) contact zyxwvutsrqponmlkjihgfedcbaZYXWVUTSR IPOc - 0.038 ( - 2.68) Sample oj 54 firm commitment 2 Issue size -_- variables for 70 REIT IPOs in the period - 0.0002 ( - 0.03) - 0.054 ( - 2.76) 31.0 6.18 9.4 2.10 I POs - 0.017 (- 1.78)” - 0.007 (- 1.09) “Seventeen REIT IPQs occurring in the 1971-1973 period are excluded from the full sample of 87 REIT IPOs because of missing information on some of the selected independent variables. ‘The first four independent variables and the best-efforts variable are dichotomous variables. UW classification is defined to be 1 for the special and major brackets, and 0 otherwise. ‘Significant at ihe 0.05 level for a two-tailed test. dSignifica n t at the 0.10 level for a two-tailed test. 400 4.5. K. Wang et al., Initial public offerings of REI 23 zyxwvutsrqponmlkjihgfedcbaZYXWV Initial-day returns and subsequent aftermarket price performance Ritter (1991) and Aggarwal and Rivoli (1990) examine the long-run price performance of IPOs. Ritter documents that issuing firms with high initial returns perform substanti;liy worse than a matched sample of firms over a three-year period, while Aggarwal and Rivoli find that market-adjusted gains from early price appreciation are more than lost in subsequent price declines over a 25O-trading day period. Weiss (1989) and Peavy (1990) also report that new issues of closed-end funds substantially underperform the market during the first 100 or 120 trading days. These studies indicate that, regardless of whether the initial-day return is significantly positive or not, the nev issues, on average, underperform the market in the longer run. This section analyzes whether REIT IPQs also exhibit a similar pattern of aftermarket stock performance. To analyze the stock performance of the REIT IPOs over a longer interval, we calculate their average daily returns for the 189 days after the first trading day. The daily returns are obtained from the CRSP AMEX-NYSE and NASDAQ daily return tapes. For REITs traded OTC b:it \.ot listed on the NASDAQ tape, we compute the daily returns using the bid pr <e and dividend information from S&P’s Daily Stock Price Record. Daily benchmark-adjusted returns are calculated as the daily raw returns minus the contemporaneous daily benchmark returns. The three benchmarks used are (1) the S&P’s 500 Composite index, (2) a seasoned REIT return index, and (3) seasoned REITs matched by REIT type and size. Returns on the S&P’s 500 index (not adjusted for dividends) are obtained from the CRSP daily return tape. The seasoned REIT return index is an equally-weighted daily returns index of 22 REITs (13 equity, six mortgage, and three hybrid) that trade prior to 1980 on the CRSP AMEX-NYSE daily returns file and are not included in our REIT IPO sample. We construct the third benchmark by matching a seasoned REIT (trading at least two years prior to the matched IPO date) listed on the CRSP AMEX-NYSE daily returns file with each IPO in our sample. The matching REIT is of similar REIT type to the 0 and has a year-end market value (in the year prior to the IPO date) that closely matches the market value of the sample REIT IPO. We obtain the year-end market values of the matching REITs from COMPIJSTAT, and we calculate the market values for IPQs using the post-offering number of shares multiplied by the reported closing market price on the first day of trading. ail;. raw (benchmark-adjusted) average returns are summed over ntervals to form raw (benchmark-adjusted) cumulative average daily s). The significance of the CARS is then computed using a methe also compute wealth relatives - 4.27% (r-statistic = - 1.83), respectively.] The performance pattern of the CAR over days 2 to 190 is consistent with the results reported b empirical studies dealing with closed-end fund and industrial firm results are similar when we use the wealth relative a4 an aftermarket performance measure. The average gross total return (one plus the holding period return) over days 2 to 190 on the REIT IPOs is only 94% of the return on the matched sample of seasoned REITs. The matching REIT-adjusted CARS of the 87 REIT IPOs over days 2 to 0 exhibit a pattern similar to that reported by Peavy for closed-end funds; Peavy finds the S&PSOO-adjusted CAR to be insignificant over days 2 to 20. Unlike Peavy’s findings, however, our REIT sample’s CAR of - 4.38% over days 1 to 20 is significant at the 5% level (t-statistic = - 3.20). This evidence is inconsistent with the market support (by underwriters) hypothesis advance The 190-day performance zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA of firm commitment REIT IPOs exhibi pattern from that of best-efforts REIT IPQs. Although both types of contracts show negative matching REIT-adjus?zd CARS over days 2 to 190, the efforts CAR ( - 15.26%) is 9.63 percentage points lower than that of the uch better over commitment CAR. In addition, the best-efforts IPQs perform days 2 to 20 (matching REI ment IPOs (matching REIT IPOs, however, perform much better REIT-adjusted CAR over days 21 to 190 for fir insignificant - 2.69%, while that for best-efforts I Table 8 Raw and matching REIT-adjusted cumulative average daily returns (CARS) and wealth relatives for selected intervals in the first 190 trading days after the initial public offerings of 87 REITs traded on the NYSE, the AMEX, and OTC in the period 1971-1988 (t-statistic- in parentheses). .-. -~Full sample Dayrs l-10 I-20 ! --30 l--60 Matching REITadjusted CAR(%) -.-__ Wealth relativeb Sample sizec - 3.21 ( - 4.20)d 0.96 87 - 4.38 - 3.50 0.96 85 ( - 3.20)d ( - 3.20)d - 4.08 ( - 4.26)d - 6.01 - 3.95 ( - 3.58)d ( - 2.95)d - 6.99 ( - 2.95)d I -90 I-120 l-150 I-190 Raw CAR(%) _Firm commitment contact --- _- Matching REITadjusted CAR( %) - 3.21 (- 3.01)d Raw CAR( %) ____--__ Subsample Sample sizec Best-efforts contact ?r Raw CAR( %) Sample size ? $ Q 2 _k Matching REITad_justed CAR( %) - 2.34 (- 2.66)d 71 - 7.96 ( - 3.82)d - 7.04 (- 5.19)d 16 - 3.18 2.52)d 69 (- - 3.99 (- 1.36) - 4.97 (- 2.59)d 16 ( - 2.93)d (-- 2.89)d 5.40 3.27 (-- 2.12)d 69 8.66 ( - 2.40)d 6.97 (-- 2.97)d 16 8 LI. - 6.03 - 3.04 (- 1.39) 69 - 11.16 (- 2.19)d 16 ( - 2.28)d 3 e 16 R - 4.48 0.94 85 - 3.24 (- 1.71) 0.93 85 0.93 85 - 5.91 (- 1.82) - 1.86 ( - 0.69) 69 - 12.60 (- 2.02)d - 4.17 (- 1.26) - 2.33 (- 0.57) - 7.16 - 1.93 ( - 2.46)d ( - 0.83) - 7.65 ( - 2.27)d - 1.10 (- 0.41) 0.92 84 - 6.10 (- 1.62) - 0.66 (- 0.21) 68 - 14.35 ( - 1.99)d - 3.08 (- 0.66) 16 0.92 84 - 6.93 (- 1.65) - 1.24 (- 0.35) 68 - 20.68 ( - 2.57)d - 5.89 (- 1.12) 16 0.92 83 - 7.17 (- 1.50; 1.12 (0.28) 67 - 2~76 (- 2.51)d - 8.20 (- 1.39) 16 - 9.52 - 2.10 ( - 2.52)d ( - 0.70) - lii.11 ( - 2.37)d (- - 0.64 0.19) 2 5 F3’ Gg Z c, 5 2-20 2-60 - 1.75 (- 1.31) - 0.68 - 4.36 1 85)e (- 0.55) - 0.84 - 7.48 1.76)’ 2.18 (0.64) 0.94 - 5.74 1.42) 2.86 (0.89) 0.96 (- 2-190 (- 21-190 0.98 (- 85 -- 0.96 85 83 -_ -___ - - --~__-_-_.~___ 83 _ _ _~_ 3.42 (1.83) 16 2.27 (0.85) 16 ( - 0.73) 67 - 15.26 (- 1.69) 0.19 (0.03) 16 67 - 18.78 (- 2.19)d - 3.23 (- 0.58) i6 - 1.62 (- 1.31) 69 ( - 1.98)d - 4.50 (- 1.72)’ - 1.55 69 (- 0.88) - 2.94 ( - 0.64) - 5.63 (- 1.18) 2.68 (0.68) - 2.69 4.30 (1.15) ( - 0.60) --- 3.51 (1.231 - 3.66 - “The zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA CAR from day ti to day f2 is computed as the sum of the cross-sectional average daily returns (AR,) from day ti through day f2; the matching RElT-adjusted AR, is adjusted for market movements using the returns on a matching seasoned REIT. The t-statistic of CAR in the interval (zl, t2) is computed as CAR,,_,,-v6,/CSD,, where N, is the number of REITs trading in each day, and CSD, is computed as (tz - r, + 1). var + 2(t, - t,)~cov]. The variance (var) is the average cross-sectional variance (from day 2 to day 190), and the covariance (cov) is the first-order autocovariance of the AR, series. This methodology assumes that the measures cf performance are independent and identically distributed in the cross-section of securities. Since the securities in our sample are in the same industry, the assumption of independence might be violated and the t-statistics might be biased. See footnote 9 of Peavy (1990) for a discussion of this issue. hThe wealth relati\: is the ratio of one plus the mean RElT IPO r-period holding period return divided by one plus the mean matching REIT t-period holding period return. The t-period (day 1, to day tz) holding period return is computed as Ri = nit_,, (1 + Tit)where ri, is the raw return on firm i on event day t. ‘The sample size varies because four REITS do not have price data for all 190 days after the offerings. dSignificant at the 0.05 level for a two-tailed test. ‘Significant at the 0.10 level for a two-tailed test. ?c 3 g 2 WY 2 s G& Q. % T -. 5 % K. W ang et al., Initial public oflerings of REiTs 404 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA To test whether REIT IPOs associated with larger initial-day price declines tend to underperform the market more over days 2 to 190, we regress the matching REIT-adjusted initial-day return on the matching REIT-adjusted CAR over days 2 to 190, finding an insignificant relationship (regression results are not shown). We further include an additional best-efforts dummy variable to the regression, finding that only the best-efforts dummy is significant. This evidence seems to indicate that the market does not overreact on the first trading day. 4.6. Institutional participation in REIT IPOs Peavy (1990) contends that investors in closed-end funds are more likely to be uninformed. Weiss (1989) documents, using a sample of 64 closed-end funds, that the average percentage of equity owned by 13(f) institutional investors at the end of the first quarter following the IPOs is only 3.5%. Elton, Gruber, and Rentzler (1989) also believe that investors in publicly offered commodity funds systematically receive biased information and have no ability to evaluate its accuracy. In this section, we provide direct evidence on institutional participation in REIT IPOs. We use Spectrum 3: 13(f) Institutional Stock Holdings Survey to obtain data on the percentage of equity held by 13(f) institutions at the end of the first, second, third, and fourth quarter following each REIT IP0.4 Nineteen of the 87 IPOs issued prior to 1975 in our sample could not be considered because Spectrum 3 reports are available only after 1975. Table 9 shows the average institutional holdings (as a percentage of common shares outstanding) in the first four quarters following the initial public offerings of the 68 post-1975 REITs. In the first quarter following the IPO, 13(f) institutional investors, on average, hold 7.7% of the common shares of the newlytraded REITs (the average number of institutional holders per REIT is 3.7). The percentage holdings seem to increase as the stock market has more time to observe the REITs or, alternatively, as the stock prices of the REITs drop further from their offering prices. The average holding rises from 7.7% in the first quarter to 12% by the end of the fourth quarter following the IPO (the average number of institutional investors per REIT increases to 8.4). In general, the evidence on institutional participation in REIT IPOs is similar to Weiss’s finding that few institutional investors are interested in closed-end fund IPOs. Although the 7.7% average institutional holding of REIT IPOs is slightly higher than that of closed-end fund IPOs (3.5%), it is much smaller than 4Spectrum 3, published by Computer Directions Advisors, Inc., is derived from quarterly reports filed with the SEC by 13(f) institutional investors. 13(f) inst5tutions are institutions with combined equity assets exceeding $100 million and include banks, insurance companies, investment companies, investment advisors, pension funds, endowments, and foundations. All NYSE and AMEX stocks are included in the report, along with approximately 3,000 OTC stocks, K. W ang et al., Initial public oferings of RElTs 405 Table 9 Summary statistics on the average institutional holdings (as a percent of common shares outstanding) of 68 REIT IPOs in the first four quarters of public trading in the period 1980-1988. Average institutional holdings Sample First Second quarter quarter (%) (“/) Third quarter (%) Fourth Average of quarter first four quarters (ND) (%) Sample of 68 REIT IPOs (average number of holders) 7.69 (3.69) 9.71 (5.74) 10.93 (7.04) 12.06 (8.37) 10.10 (6.21) IPOs partitioned by prospectus year: 1988 1987 1986 1985 1984 1980-83 2.05 9.51 1.98 12.85 9.23 5.73 2.58 14.84 10.35 14.90 3.98 3.23 3.09 14.88 13.73 14.79 6.35 5.76 4.01 14.33 13.45 16.28 9.74 8.39 2.93 13.39 9.88 14.71 7.32 5.78 IPOs partitioned by issue size: $12M-4OM S45M-75M %76M-750M 6.46 5.33 10.60 6.07 8.17 13.90 7.31 9.39 15.09 11.32 9.75 14.53 7.79 8.16 13.53 IPOs partitioned by distribution method: 0.47 0.41 0.39 0.08 Best efforts 0.60 13.09 14.15 15.65 Firm commitment zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA 9.88 12.68 IPOs partitioned by duration: Finite-life Infinite-life 2.73 10.23 3.04 13.12 3.74 14.60 3.18 16.61 3.17 13.64 IPOs partitioned by asset type: Mortgage Equity Hybrid 4.12 11.50 7.00 4.16 15.33 10.40 4.20 17.64 12.40 5.36 18.64 14.20 4.46 15.78 11.09 IPOs partitioned by asset specification: Fully/partially specified Unspecified 11.41 3.5: 15.67 3.01 17.99 2.98 19.13 4.11 16.05 3.40 IPOs partitioned by underwriter classification:” Special Major Other 16.09 5.75 4.23 18.59 7.34 6.49 21.16 7.35 8.37 20.69 9.81 8.86 19.13 7.56 6.99 Weiss’sfindings (1989, exhibit 6): Closed-end fund lPOs Control sample of equity IPOs 3.50 21.82 5.00 26.02 4.68 28.59 NA NA NA NA ‘Based on Hayes (1971). 406 K. Wang et al., Initial public zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA oflerings of REITs the 21.8% average holdings of a control sample of equity IPOs reported by Weiss or the 35.9% average holdings for all firms in the 1980-1990 period reported by Spectrum 3. Table 9 also reports the institutional holdings for various subsamples of the 68 REIT IPOs. On average, institutional investors participate more in issues that are larger, issues distributed under firm commitment contracts, qnd issues underwritten by prestigious underwriters. They also seem to invest more in the traditional type of REITs (infinite-life REITs) and REITs with more observable assets (equity REITs and fully- or partially-specified REITs). There is little institutional participation in best-efforts REIT IPOs. If it is true that institutional investors are better informed than individual investors, then we should expect to find little or no institutional participation in overpriced IPOs. To examine this issue, we partition the 68 IPOs into two groups. The first group consists of 34 IPOs with less than 1% equity held by 13(f) institutions at the end of the first quarter following the IPOs. The second group consists of the remaining 34 IPOs with an average institutional equity holding of 15.32%. We find that the mean initial-day return of the first group (with little or no institutional holdings) is - 4.78% (t-statistic = - 3.75), while that of the second group is - 0.66% (t-statistic = - 1.04).The difference in the holdings is 4.12 percentage points and is significant at the 5% level (t-statistic = 2.86). This evidence suggests that, on average, institutional investors do not overpay for REIT IPQs. The buyers of the overpriced REIT IPOs are predominantly individual investors or non- 13(f) institutional investors. 5. An explanation Contrary to previous findings using the IPOs of industrial firms, our results show that the initial-day returns of REIT IPOs are significantly negative. This section attempts to offer a possible explanation for our results by drawing inferences from Rock’s (1986) model and Brennan’s (1990) latent asset argument. We argue that, under realistic conditions, there is no incentive for issuers (or underwriters) to systematically underprice REIT IPOs. Further, by recognizing the differential transaction costs between purchasing stocks at the initial offering stage and in the aftermarket, we show that investors could be indifferent to purchasing REIT stocks at the IPO stage or on the first aftermarket trading day. Rock’s model predicts that an IPO will not be underpriced if there are no informed investors in the market. Beatty and Ritter (1986) extend Rock’s model and show that, in equilibrium, the cost of information for informed investors equals the expected gain from the purchase of underpriced IPOs. This argument implies that if the expected gain in the aftermarket for the purchase of underpriced IPOs is minimal, then investors will be reluctant to incur information search costs to identify underpriced IPOs. Under this scenario, there will be no K. W ang et al., Initial public zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA offerings of RElTs 407 informed IPO investors and hence no reason for the issuer or underwriter to underprice the IPO. Brennan (1990) argues that, in a market of small investors, the rewards to an investor of collecting information on mispriced assets will depend on the number of other investors who collect information. If only a few investors participate in the information-gathering process, the gain from buying underpriced securities may not be realized because prices do not adjust rapidly to reflect the information acquired. His analysis suggests that it might be advantageous for small investors to delegate the information acquisition to a single entity (such as an investment bank) to ensure that the information acquired will be rapidly reflected in the market price. Following Brennan’s argument, we would predict that there will be no informed group in an IPO market comprised of small investors. Further, in this type of market, underwriters who are delegated to perform information acquisition will have no incentive to compensate the investors for adverse selection risks by systematically underpricing the IPOS. It is plausible to argue that the market for REIT IPOs is comprised primarily of small investors. REITs were created to provide a passive vehicle for small investors to invest in real estate. To qualify as a REIT, tax regulations require that a trust have at least 100 shareholders and that no morti than 50% of the shares be held by five or fewer shareholders. Data in the previous section shows that 13(f) institutions only hold, on average, 10.1% of the equity of the REITs in our sample during the first four quarters following the IPOs. If the REIT IPO market is comprised of small investors, it is possible that there is no informed group in the REIT IPO market and, therefore, REIT IPOs would not be systematically underpriced. While the small investor argument might explain why REIT IPOs are not underpriced, it does not provide a justification for why REIT IPOs are, on average, overpriced. Indeed, it seems irrational for investors to purchase REIT stocks at the initial public offering stage when they can do so in the aftermarket (the first trading day) at a lower price. To address this issue, we examine investors’ transaction costs associated with stock purchases from dealers in the aftermarket. We recalculate our raw initial-day returns using the asked price (the actual price that investors pay to purchase the stock in the aftermarket) ot the initial trading day for the 42 OTC stocks. The average initial-day return (using the asked price) for the 42 OTC stocks is an insignificant 0.05% (as compared to a significant - 4.33% using the bid price). If we further consider the commissions associated with purchasing stocks in the aftermarket, investors on average could be indifferent to purchasing REIT stocks at the IPO stage or on the first aftermarket trading day.’ This transaction cost argument, however, cannot justify why investors are willing to buy REIT IPOs at the offering price zyxwvutsrqpon ‘We tha nk Se ha Tinic fo r po inting o ut this po ssib ility. 408 K. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA Wang et al., initial public offerings of RElTs when these stocks significantly underperform a matched sample of seasoned REITs in the 190 trading days following the IPOs. Given the constant arrival of new information to the market and the possibility of change in the risk profiles of individual REITs, it is difficult (especially with our 17-year sample period) to explain wh;r the RUT:, in our sample underperform the matched sample of seasoned REITs from days 2 to 190 after their IPOs. However, since this underperformance result is consistent with the findings of Ritter (1991), Aggarwal and Rivoli (1990), Peavy (1990), and Weiss (1989), we rely mainly on their arguments of fads and offering expenses as possible explanations for this phenomenon. In addition, we also find that the long-run underperformance result of our REIT sample is partially attributed to the presence of outliers. There are two REITs with cumulative matching REIT-adjusted returns of less than - 100% during the 190 days examined. One of the REITs is Emerald Mortgage Investment Corporation, which initially issued its stock on July 20, 1988 at a $10 offering price (raw initial-day return = 0%). In less than a year (April 20, 1989), its share price dropped to $2.875. The other outlier is Residential Resources Mortgage Inc., which was issued on June 23, 1988 with a $10 offering price (raw initial-day return = 1.25%), but closed at $0.375 on March 15, 1989 and was subsequent!y delisted from the AMEX. The underwriters of these two issues receive seven and eight rankings under Carter and Manaster’s system. These dramatic price declines are more likely caused by the arrival of new information during the period than by fads in early aftermarket trading or offering expenses associated with the IPOs. If we delete these two observations from our full sample, the matching REIT-adjusted CAR over days 2 to 190 reduces to - 4.99% (t-statistic = - 2.23). For the reduced 66 firm commitment subsample (Residential Resources Mortgage Inc. does not have 190 days of trading), the matching REIT-adjusted CAR over days 2 to 190 reduces to an insignificant - 2.49% (t-statistic = - 1.03). 6. Conclusion In this study, we present empirical evidence on the initial-day returns for a sample of 87 REIT IPOs issued during the period 1971-1988. We document a significant average initial-day return of - 2.82%. This finding sharply contrasts with previous research that reports a significant positive initial-day return for the IPOs of industrial firms. The overpricing result is invariant to offer price, issue size, distribution method, offer period, and underwriter reputation. Given the large dollar amount of IPOs issued by the REIT industry, this overpricing phenomenon should not be neglected by finance researchers. Why new REIT stocks are, on average, priced above the market clearing price is unclear. An even more interesting question, as with closed-end mutual funds, K. Wang et al., lnitiai zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIH public oflerings of REITs 409 is why investors are willing to buy the stocks at the offering price. Although no existing IPO model can fully explain the significant negative initial-day return of REIT IPOs, we offer a possible explanation based on Rock’s model, differential transaction costs, and Brennan’s latent asset argument. 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