Does Inflation Illusion Explain the Relation between REITs and Inflation?

  • Gwangheon Hong
  • Bong Soo LeeEmail author


We examine whether the observed negative relations between real estate investment trust (REIT) returns and inflation can be explained by the inflation illusion. We identify the mispricing component in REIT prices based on present value models, both linear and loglinear, and then we investigate whether inflation can explain the mispricing component. When we allow for time-varying interest rates, inflation no longer explains the REIT mispricing component. Instead, we find that behavioral factors such as consumer sentiments contribute to the mispricing of REIT prices.


REIT returns Inflation hedge Mispricing 

JEL Classifications

G12 R31 E44 C32 



We would like to thank an anonymous reviewer for the valuable comments and suggestions. This project was supported by WCU (World Class University) Program funded through Sogang University, Seoul, Korea.


  1. Barber, C., Robertson, D., & Scott, A. (1997). Property and inflation: the hedging characteristics of U.K. real estate. Journal of Real Estate Finance and Economics, 15(1), 59–76.CrossRefGoogle Scholar
  2. Bodie, Z. (1976). Common stocks as a hedge against inflation. Journal of Finance, 31, 459–470.CrossRefGoogle Scholar
  3. Brandt, M. W., & Wang, K. Q. (2003). Time-varying risk aversion and unexpected inflation. Journal of Monetary Economics, 50, 1457–1498.CrossRefGoogle Scholar
  4. Brueggeman, W. B., Chen, A. H., & Thibodeau, T. G. (1984). Real estate investment funds: performance and portfolio considerations. AREUEA Journal, 12(3), 333–354.Google Scholar
  5. Brunnermeier, M. K., & Julliard, C. (2008). Money illusion and housing frenzies. Review of Financial Studies, 21(1), 135–180.CrossRefGoogle Scholar
  6. Campbell, J. Y. (1991). A variance decomposition for stock returns. The Economic Journal, 101, 157–179.CrossRefGoogle Scholar
  7. Campbell, J. Y., & Shiller, R. J. (1987). Cointegration and tests of present value models. Journal of Political Economy, 95(5), 1062–1088.CrossRefGoogle Scholar
  8. Campbell, J. Y., & Shiller, R. J. (1988a). Stock prices, earnings and expected dividends. Journal of Finance, 43, 661–676.CrossRefGoogle Scholar
  9. Campbell, J. Y., & Shiller, R. J. (1988b). The dividend-price ratio and expectations of future dividends and discount factors. Review of Financial Studies, 1(3), 195–228.CrossRefGoogle Scholar
  10. Campbell, J. Y., & Ammer, J. (1993). What moves the stock and bond markets? A variance decomposition for long-term asset returns. Journal of Finance, 48(1), 3–37.CrossRefGoogle Scholar
  11. Campbell, J. Y., & Vuolteenaho, T. (2004). Inflation illusion and stock prices. American Economic Review Papers and Proceedings, 94, 19–23.CrossRefGoogle Scholar
  12. Case, K. E., & Shiller, R. J. (1989). The efficiency of the market for single-family homes. American Economic Review, 79, 125–137.Google Scholar
  13. Case, K. E., & Shiller, R. J. (1990). Forecasting prices and excess returns in the housing market. AREUEA Journal, 18, 253–273.Google Scholar
  14. Chatrath, A., & Liang, Y. (1999). REITs and inflation: a long-run perspective. Journal of Real Estate Research, 16(3), 311–325.Google Scholar
  15. Chen, C. R., Lung, P. P., & Wang, F. A. (2009). Stock market mispricing: money illusion or resale option? Journal of Financial and Quantitative Analysis, 44(5), 1125–1147.CrossRefGoogle Scholar
  16. Cohen, R., Polk, C., & Vuolteenaho, T. (2005). Money illusion in the stock market: the Modigliani-Cohn hypothesis. Quarterly Journal of Economics, 120, 639–668.Google Scholar
  17. Darrat, A. F., & Glascock, J. L. (1989). Real estate returns, money and fiscal deficits; Is the real estate market efficient? Journal of Real Estate Finance and Economics, 2, 197–208.CrossRefGoogle Scholar
  18. Falk, B., & Lee, B. S. (1998). Fads versus fundamentals in farmland prices. American Journal of Agricultural Economics, 80(4), 696–707.CrossRefGoogle Scholar
  19. Falk, B., & Lee, B. S. (2004). The inventory-sales relationship in the market for new single-family homes. Real Estate Economics, 32, 645–672.CrossRefGoogle Scholar
  20. Fama, E. F. (1981). Stock returns, real activity, inflation and money. American Economic Review, 71, 545–565.Google Scholar
  21. Fama, E. F. (1983). Stock returns, real activity, inflation and money: reply. American Economic Review, 73, 471–472.Google Scholar
  22. Fama, E. F., & Schwert, G. W. (1977). Asset returns and inflation. Journal of Financial Economics, 5, 115–146.CrossRefGoogle Scholar
  23. Feldstein, M. (1980). Inflation and the stock market. American Economic Review, 70(5), 839–847.Google Scholar
  24. Gentry, W. M., Charles M. J., & Christopher J. M. (2004). Do stock prices really reflect fundamental values? The case of REITs, NBER Working Papers, 10850, National Bureau of Economic Research, Inc.Google Scholar
  25. Geske, R., & Roll, R. (1983). The monetary and fiscal linkage between stock returns and inflation. Journal of Finance, 38, 1–33.CrossRefGoogle Scholar
  26. Glascock, J. L., Lu, C., & So, R. W. (2002). REITs returns and inflation: perverse or reverse causality effects? The Journal of Real Estate Finance & Economics, 24(3), 301–317.CrossRefGoogle Scholar
  27. Glascock, J. L., Feng, L., Fan, L., & Bao, H. X. (2008). Inflation hedging characteristics of real estate assets in Hong Kong (July 27, 2008). SSRN:
  28. Goebel, P. R., & Kim, K. S. (1989). Performance evaluation of finite-life real estate investment trusts. Journal of Real Estate Research, 4(2), 57–70.Google Scholar
  29. Goetzmann, W., & Peng, L. (2006). Estimating housing price indexes in the presence of seller reservation prices. The Review of Economics and Statistics, 88(1), 100–112.Google Scholar
  30. Gultekin, N. B. (1983). Stock market returns and inflation: evidence from other countries. Journal of Finance, 38, 49–65.CrossRefGoogle Scholar
  31. Gyourko, J., & Linneman, P. (1988). Owner-occupied homes, income-producing real estate and REIT as inflation hedges. Journal of Real Estate Finance and Economics, 1(4), 347–372.CrossRefGoogle Scholar
  32. Hansen, L. P., & Sargent, T. J. (1980). Formulating and estimating dynamic linear rational-expectations models. Journal of Economic Dynamics & Control, 2, 7–46.CrossRefGoogle Scholar
  33. Hardin III, W. G., Jiang, X., & Wu, Z. (2011). REIT stock prices with inflation hedging and illusion. Journal of Real Estate Finance and Economics (forthcoming).Google Scholar
  34. Hartzell, D., Hekman, J. S., & Miles, M. E. (1987). Real estate returns and inflation. AREUEA Journal, 15(1), 617–637.Google Scholar
  35. Hess, P. J., & Lee, B. S. (1999). Stock returns and inflation with supply and demand disturbances. Review of Financial Studies, 12, 1203–1218.CrossRefGoogle Scholar
  36. Hoesli, M., MacGregor, B. D., Matysiak, G. A., & Nanthakumaran, N. (1997). The short-term inflation-hedging characteristics of UK real estate. Journal of Real Estate Finance and Economics, 15(1), 27–57.CrossRefGoogle Scholar
  37. Hoesli, M., Lizieri, C. M., & MacGregor, B. D. (2008). The inflation hedging characteristics of U.S. and U.K. investments: a multi-factor error correction approach. Journal of Real Estate Finance and Economics, 36, 183–206.CrossRefGoogle Scholar
  38. Jaffe, J. F., & Mandelker, G. (1976). The ‘Fisher effect’ for risky assets: an empirical investigation. Journal of Finance, 31, 447–458.CrossRefGoogle Scholar
  39. Lee, B. S. (1989). Solving, estimating and testing a nonlinear stochastic equilibrium model with an example of the asset returns and inflation relationship. Journal of Economic Dynamics and Control, 13, 499–531.CrossRefGoogle Scholar
  40. Lee, B. S. (1998). Permanent, temporary, and nonfundamental components of stock Prices. Journal of Financial and Quantitative Analysis, 33(1), 1–32.CrossRefGoogle Scholar
  41. Lee, B. S. (2010). Stock returns and inflation revisited: an evaluation of the inflation illusion hypothesis. Journal of Banking and Finance, 34(6), 1257–1273.CrossRefGoogle Scholar
  42. Lee, M. L., & Chiang, K. C. H. (2004). Substitutability between equity REITs and mortgage REITs. Journal of Real Estate Research, 26(1), 95–103.Google Scholar
  43. Levitt, S. D., & Syverson, C. (2008). Market distortions when agents are better informed: the value of information in real estate transactions. The Review of Economics and Statistics, 90(4), 599–611.CrossRefGoogle Scholar
  44. Limmack, R. J., & Ward, C. W. R. (1988). Property returns and inflation. Land Development Studies, 5(3), 7–55.Google Scholar
  45. Marshall, D. A. (1992). Inflation and asset returns in a monetary economy. Journal of Finance, 47, 1315–1342.CrossRefGoogle Scholar
  46. Mei, J., & Saunders, A. (1997). Have U.S. financial institutions’ real estate investments exhibited “trend-chasing” behavior? Review of Economics and Statistics, 79(2), 248–258.CrossRefGoogle Scholar
  47. Miles, M., & McCue, T. (1982). Historic returns and institutional real estate portfolios. AREUEA Journal, 10(2), 184–199.Google Scholar
  48. Modigliani, F., & Cohn, R. (1979). Inflation, rational valuation, and the market. Financial Analysts Journal, 35, 24–44.CrossRefGoogle Scholar
  49. Murphy, A. J., & Kleiman, R. T. (1989). The inflation hedging characteristics of equity REITs: an empirical study. The Quarterly Review of Economics and Finance, 29(3), 95–101.Google Scholar
  50. Nelson, C. R., & Schwert, G. W. (1977). Short-term interest rates as predictors of inflation: on testing the hypothesis that the real rate of interest is constant. American Economic Review, 67, 478–486.Google Scholar
  51. Newell, G. (1996). The inflation-hedging characteristics of Australian property. Journal of Property Finance, 7(1), 6–20.CrossRefGoogle Scholar
  52. Park, J., Mullineaux, D. J., & Chew, I. K. (1990). Are REITs inflation hedges? Journal of Real Estate Finance and Economics, 3(1), 91–103.CrossRefGoogle Scholar
  53. Piazzesi, M., & Schneider, M. (2007). Inflation illusion, credit, and asset pricing. NBER Working Paper, No. W12957.Google Scholar
  54. Ritter, J. R., & Warr, R. S. (2002). The decline of inflation and the bull market of 1982–1999. Journal of Financial and Quantitative Analysis, 37, 29–61.CrossRefGoogle Scholar
  55. Rosental, S. S. (1999). Residential buildings and the cost of construction: new evidence on the efficiency of the housing market. The Review of Economics and Statistics, 81(2), 288–302.CrossRefGoogle Scholar
  56. Seck, D. (1996). The substitutability of real estate assets. Real Estate Economics, 24, 75–95.CrossRefGoogle Scholar
  57. Shiller, R. J. (2005). Irrational exuberance (2nd ed.). Princeton: Princeton University Press.Google Scholar
  58. Simpson, M. W., Ramchander, S., & Webb, J. R. (2007). The asymmetric response of equity REIT returns to inflation. Journal of Real Estate Finance and Economics, 34(4), 513–529.CrossRefGoogle Scholar
  59. Sirmans, G. S., & Sirmans, C. F. (1987). Real estate returns: the historic perspective. Journal of Portfolio Management, 13(3), 22–31.CrossRefGoogle Scholar
  60. Stevenson, S., & Murray, L. (1999). An examination of the inflation hedging ability of Irish real estate. Journal of Real Estate Portfolio Management, 5(1), 59–69.Google Scholar
  61. Suleyman, B., & Yan, H. (2010). Equilibrium asset prices and investor behaviour in the presence of money illusion. Review of Economic Studies, 77(3), 914–936.CrossRefGoogle Scholar
  62. Thomas, J., & Zhang, F. (2007). Inflation illusion and stock prices: Comment. Working paper, Yale University.Google Scholar
  63. Titman, S., & Warga, A. (1986). Risk and performance of real estate investment trusts. AREUEA Journal, 14(3), 414–431.Google Scholar
  64. Vincent, L. (1999). The information content of funds from operations (FFO) for real estate investment trusts (REITs). Journal of Accounting and Economics, 26, 69–104.CrossRefGoogle Scholar
  65. Wei, C., & Joutz, F. (2009). Inflation illusion or no illusion: What did pre- and post-war data say? Working paper, George Washington University.Google Scholar
  66. Wurtzebach, C. H., Mueller, G. R., & Machi, D. (1991). The impact of inflation and vacancy on real estate returns. Journal of Real Estate Research, 6(2), 153–168.Google Scholar

Copyright information

© Springer Science+Business Media, LLC 2011

Authors and Affiliations

  1. 1.College of BusinessSogang UniversitySeoulSouth Korea
  2. 2.College of BusinessFlorida State UniversityTallahasseeUSA

Personalised recommendations