The Ex‐Day Price Behavior of REITs: Taxes or Ticks?

Abstract

Taxes and microstructure constraints are often cited as possible explanations for why stock prices drop by less than the dividend on their ex-dates. Using a sample of real estate investment trusts, which have no significant correlation between dividend size and yield, we find that close-to-open ex-dividend price drops are related to dividend size as suggested by the microstructure models, but close-to-close price drops are related to dividend yield as predicted by the tax theory. These results imply that overnight price drops are primarily determined by microstructure, but that trading during the ex-day causes prices to adjust to reflect individual tax preferences.Empirical research has firmly established that on ex-dividend days stock prices drop by less than the full dividend amount. While there is no clear consensus about why this occurs, there have been several plausible explanations. Elton and Gruber (1970, hereafter EG) attribute the anomaly to the fact that dividends are taxed more heavily than capital gains for most investors. Their pricing model further predicts that there will be a positive relation between the ex-day price drop ratio ( P/D) and the dividend yield due to the formation of taxmotivated dividend "clienteles," where investors in higher (lower) tax brackets tend to select lower (higher) dividend yield stocks. More recent explanations for the ex-day anomaly are based on market microstructure. Bali and Hite (1998, hereafter BH) argue that the effect is driven by the fact that stock prices historically have been constrained to discrete tick multiples, and Dubofsky (1992) also incorporates disparate treatment of buy and sell limit orders at the ex-day open. In both of the microstructure models, P/D is a sawtooth-shaped function of the dividend amount (D), but the dividend yield (D/P) has no special importance.In this article, we test for the specific patterns implied by the tax and microstructure hypotheses using both close-to-close and overnight price drops.

The Ex‐dividend Day Behaviour of REITs: Tax or Market Microstructure Effects

“…Thus, doing our study across three tick size eras helps us to test not only for the presence of the microstructure effects but also the tax effects, and the possible interaction between the two. Although Cloyd et al (), Hardin et al (), Li and Weber () and Whitworth and Carter () are closely related to our paper, our study differs in several important ways, which we explain more fully in section 2.…”

“…(), Hardin et al . (), Li and Weber () and Whitworth and Carter (). Li and Weber () use REITs dividend data from the 2001–2005 period.…”

“…Whitworth and Carter (, WC hereafter) work with REIT dividends and find that in both the 1/8 th and 1/16 th tick size eras, the close‐to‐open ex‐day price drops are better explained by the microstructure theory, whereas close‐to‐close price drops are better explained by the tax theory. Though WC also work with REIT dividends over different tick size eras, there are significant differences between their study and ours.…”