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Ultimate Sources of Asset Price Variability : Evidence from Real Estate Investment Trusts 1

We take advantage of the existence two parallel asset markets for a set of cash flows, to assess the performance of dividend pricing models. We show that better measurement of cash flows can significantly improve the performance of such models. In order to do this, we study returns on Real Estate Investment Trusts (REITs) and REIT dividends within a dynamic dividend discount model. We use a unique data set of directly held commercial real estate and augment information in REIT dividends with information from cash flows in this parallel market. In this study we demonstrate the improvement that the addition of this information gives to traditional dividend pricing models. First, we estimate the fraction of the variation in asset returns that can be attributed to various types of cash flows and economic news. We find that innovations in dividends are a central component in explaining return variation in our data set. When we supplement REIT dividends with direct property dividends as state variables, we find that innovations in economic variables explain approximately 24% of REIT return variation. This number is higher than the approximately one-fifth of total variation explained in the stock market as reported in the classic study by Cutler, Poterba and Summers (1989). In the second part of the paper, we apply a dynamic dividend discount model to REITs. When only information from REIT dividends is taken into account, the model performs somewhat better than was previously found in the case of stock returns and stock dividends (Campbell and Shiller (1988)), which is generally congruous with the nature of REITs and the information content of their dividends. In addition, however, the results further improve dramatically when information from direct property cash flows is added to the model. Taken together, these findings suggest that the performance of dynamic dividend pricing models improves greatly with better measurement of cash flows (dividends), and thus contribute to the resolution of the excess volatility puzzle.