The impact of leverage on the idiosyncratic risk and return relationship of REITs around the financial crisis

This paper examines the role that leverage plays in the relationship between returns and idiosyncratic risk for Real Estate Investment Trusts (REITs) where debt levels are characteristically high. Using a method to correct for a look-ahead bias when applying an EGARCH model to calculate expected idiosyncratic risk, we show that leverage distorts the relationship that it has with returns. We find that leverage has a significant, nonlinear relationship with returns and when we control for this leverage effect we find no evidence of idiosyncratic risk being priced before and during the global financial crisis. Only during the post-crisis period do we see a positive relationship emerges between returns and idiosyncratic risk. Our results suggest that investors should consider carefully the impact that leverage has on pricing REITs and the corresponding impact it has on the idiosyncratic risk and return relationship.