The impact of 9/11 on US REIT returns: fundamental or financial?

ABSTRACT. Following the attack on the World Trade Center on 9/11 volatility of daily returns of the US stock market rose sharply. This increase in volatility may reflect fundamental changes in the economic determinants of prices such as expected earnings, interest rates, real growth and inflation. Alternatively, the increase in volatility may simply reflect the effects of increased uncertainty in the financial markets. This study therefore sets out to determine if the effects of the attack on the World Trade Center on 9/11 had a fundamental or purely financial impact on US real estate returns. In order to do this we compare pre- and post-9/11 crisis returns for a number of US REIT indexes and in general we find that the effect of the attack on the World Trade Center on 9/11 had only a financial effect on REIT returns and therefore was transitory.

KEYWORDS: 9/11; REITs; Fundamental or financial effects

SANTRAUKA

RUGSEJO 11-OSIOS POVEIKIS JAV NEKILNOJAMOJO TURTO INVESTICIJU GRAZAI: FUNDAMENTALUS AR FINANSINIS?

Andrea GHENO, Stephen L. LEE

Po Pasaulinio prekybos centro rugsejo 11-aja ataku pries JAV vertybiniu popieriu birzose eme staigiai kisti kasdiene investiciju graza. Sis augimas gali rodyti, kad fundamentaliai pakito tokie ekonominiai kainas lemiantys veiksniai, kaip laukiamas pelnas, palukanu normos, realus augimas ir infliacija. Kita vertus, augantis kitimas gali tiesiog perteikti didesnio finansiniu rinku netikrumo poveiki. Todel siame darbe siekiama nustatyti, ar Pasaulinio prekybos centro ataku pasekmiu poveikis JAV nekilnojamojo turto investiciju grazai buvo fundamentalus, ar tik finansinis. Siekiant tai issiaiskinti, palyginta keliu JAV nekilnojamojo turto investiciju indesksu graza pries rugsejo 11-osios krize ir po jos. Nustatya, kad sios atakos pasekmes padare finansini poveiki nekilnojamojo turto investiciju grazai, ir del to sis poveikis buvo laikinas.

1. INTRODUCTION

The volatility of daily returns of the US stock market rose sharply following the terrorist attack on the World Trade Center. This increase in volatility may reflect changes in the fundamental economic determinants of stock prices such as expected earnings, interest rates, real growth and inflation. Alternatively, the increase in market volatility after the 9/11 terrorist attacks may simply reflect the effects of increased uncertainty in the financial markets.

For instance, Baen (2003) argues that the terrorist attack added another dimension to property investment risk in the US that is likely to have serious implications for the future capital values and net operating income (NOI) to institutional, investment-grade real estate. Indeed, Kelly (2001) argues that the impact of 9/11 on real estate markets would be felt across the whole of America. This suggests that the effects of the attack on the World Trade center are likely to be fundamental and long lasting for real estate securities.

In contrast, in an analysis of the causes of large daily price changes, Kaminsky and Schmukler (1999) argue that the largest daily changes seem to be driven in part by herding or an overreaction to bad news. While, Wrolstad and Kreuger (2003) find that, as expected, when catastrophic events such as the attack on the World Trade Center, occur, investor risk aversion increases dramatically but that the increase was only short lived as within a month the market had regained the losses incurred immediately after the 9/11 events. In other words, the 9/11 attacks had only a financial impact on real estate security returns and was therefore short lived as the assessment by investors of the effects of the terrorist action on the economic prospects of the economy evolved. In support of this view Miller et al (2003) find that there was no significant increase in vacancy rates in tall and trophy buildings across the major cities of the US, even though New York showed modest and negative effects on vacancy rates. While, survey evidence reported by Miller et al (2003) indicated that the impact on tall and trophy buildings should show little lasting effects, although the truly famous buildings have suffered as a consequence of 9/11 (Dermisi, 2005).

In order to sort out whether the effects of the attack on the World Trade Center on 9/11 had a fundamental or purely financial impact on US real estate securities we compare pre- and post-9/11 crisis returns for the US Real Estate Investment Trusts (REITs) using an approach suggested by French and Roll (1986), as extended by Tuluca et al (2003). In general, we find evidence that the effects of 9/11 did not have a fundamental effect on real estate stock prices. In other words, the effect of the terrorist attack was financial and so transitory.

The remainder of the paper is organised as follows. The next section discusses the economic impact of the attack on the World Trade Center had on the US in general and real estate markets in particular. Section 3 describes the methodology and data used in this study to test whether the effect of 9/11 on REITs was fundamental or purely financial. Section 4 reports the empirical findings and Section 5 concludes the study.

2. THE IMPACT 9/11 ON REAL ESTATE MARKETS

On the morning of Tuesday 11 September 2001, the United States was hit by a set of unprecedented terrorist attacks, calculated to inflict massive civilian casualties and damage. Four hijacked commercial jets crashed, into the World Trade Center towers in Manhattan, which collapsed shortly thereafter, one on the Pentagon in Washington DC, and the last one in Pennsylvania. Over 3,000 people were killed, including hundreds of rescue personnel, Lenain et al (2002).

The 9/11 attacks inflicted casualties and material damages on a far greater scale than any terrorist aggression in recent history. The destruction of physical assets was estimated in the national accounts to amount to $14 billion for private businesses, $1.5 billion for State and local government enterprises and $0.7 billion for Federal government. Rescue, cleanup and related costs have been estimated to amount to at least $11 billion. Lower Manhattan lost approximately 30 percent of its office space and scores of businesses disappeared. Close to 200,000 jobs were destroyed or relocated out of New York City, at least temporarily (DRI-WEFA (2002)).

Beyond the direct property losses of $20-$30 billion, 300 businesses were directly affected by the attack. Buildings that were destroyed, structurally damaged and non-structurally damaged buildings or buildings requiring expensive cleaning for asbestos dust, totalled between 27-29 million square feet, however, this comprised less than four percent (<4%) of the Manhattan, New York office market (Insignia/ESG, 2001). When viewed only from the loss of office space from a national and international standpoint, in absolute terms, the loss was even less significant. Available vacant and subleaseable space in the area roughly equalled the amount of space destroyed or damaged, with many companies choosing to relocate in the same office market. For instance, the local vacancy rate in Manhattan in September 2000 was approximately 25.5 million square feet with additional sublease space expected to be available as subleaseable/available space due to the failure of dotcom companies to take up space.

However, the impact on the financial markets was swift and pronounced, stock prices tumbled, spreads between corporate and government bond yields, as well as spreads between emerging market and US bond index yields widened. Implied volatility as derived from traded options on stock market indices, government bond prices, short-term interest rates, exchange rates and commodities spiked upwards. Nonetheless, by the end of 2001, and not unlike during earlier wartime episodes, equity prices had bounced back vigorously, in many cases to well above their pre-9/11 levels, spreads generally narrowed and implied volatility declined significantly (Lenain et al, 2002). All of which suggests the impact on returns was short lived.

Baen (2003) argues that the terrorist attack added another dimension to property investment risk in the US and has serious implications for the future value and net operating income (NOI) to institutional, investment-grade real estate. Kelly (2001) supports this argument but suggests that the impact of 9/11 would be felt across America to a greater or lesser extent depending on the economic base of the MSAs. The author arguing that the impact of 9/11 will have a pronounced effect on the national economy and so the impact on real estate, in a given area, depends on the exposure of the MSA to economic cycles. For instance, the author predicted that tourism cities, such as Las Vegas and Orlando, and high-tech localities, including Austin, San Jose, San Diego, will experience an immediate and steep contraction into 2002, with a sharp rebound in 2003. In contrast, some MSAs including Detroit, St. Louis, Kansas City, and Miami with significant import/export exposure or ties to manufacturing industries will face a sever and prolonged downturn. In particular, Kelly (2001) sees New York City facing a long lasting contraction, where the local economy does not recover to its 2001 level of employment until 2004. However, by the first quarter of 2002 Insignia/ESG reported that the New York real estate market was showing signs of recovery following the short recession of 2001.

Baen (2003) also suggests that the reduced demand for real estate due to 9/11 will be accelerated particularly in the high-rise CBD "trophy" office buildings that could be possible targets in the US or the world. Indeed, Grant (2002) predicted that landlords and/or tenants in "Trophy Property" high-rise buildings will be forced to pay much higher insurance costs (300%) to stay in the central business districts. However, Miller et al (2003) find that there was no significant increase in vacancy rates in tall and trophy buildings across the major cities of the US although New York showed modest and negative effects on vacancy rates. The survey evidence by Miller et al (2003) indicating that the impact on tall and trophy buildings should show little lasting effects, although the truly famous buildings have suffered as a consequence of 9/11. Miller et al (2003) also found that sublease activity increased in famous buildings and since increases in sublease activity leads to increases in vacancy rates the authors argue that 9/11 had a negative effect on tall and trophy office markets. This is supported by Dermisi (2005) who finds that in Chicago which contains three of the four tallest buildings in the US (Sears Tower (first); Aon Center (third) and the John Hancock Center (fourth)) that although security measures were immediately heightened in the buildings after the terrorist attacks some tenants still vacated their office space as a direct consequence of the increased risk, with the terrorist attacks having a continuing and significant impact on vacancy and sublease vacancy rates in all three buildings. Additionally, even though gross rental rates have been kept stable, in an effort to increase demand and lower vacancy levels, the three buildings are still suffering. Dermisi (2005) concludes that "the psychological and economic effect of terrorist attacks on tenants of high-rise office buildings and their immediate areas is significant".