Capital structure feng ghosh sirman


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Capital structure feng ghosh sirman

  1. 1. On the Capital Structure of Real Estate Investment Trusts (REITs) Zhilan Feng, Chinmoy Ghosh and C. F. Sirmans* Abstract Much of the literature on capital structure excludes Real Estate Investment Trusts(REITs) due mainly to the unique regulatory environment of these firms. As such, the issue ofhow REITs choose among different financing options when they raise external capital is largelyunexplored. In this paper, we examine the capital structure of REITs to answer two questions: isthere a relationship between market-to-book and leverage ratios? and, does market-to-book havea temporary or a long-term impact on leverage ratios? Our results suggest that REITs with highmarket-to-book ratios have high leverage ratios, and historical market-to-book has long-termpersistent impact on current leverage ratio. We interpret these findings as supportive of peckingorder theory. When financing costs of adverse selection exceed costs of financial distress,pecking order is more relevant in explaining the cross-sectional variation in capital structure.Zhilan Feng is at School of Management, the Graduate College of Union University, Chinmoy Ghosh and C. F.Sirmans are at the Center for Real Estate and Urban Economic Studies at the School of Business, University ofConnecticut, Storrs, CT, USA. All correspondence may be addressed to Zhilan Feng at
  2. 2. On the Capital Structure of Real Estate Investment Trusts (REITs)I. Introduction and Motivation This paper explores how the capital structure of Real Estate Investment Trusts (REITs)evolves over time. Much of the traditional literature in finance tends to exclude regulated firmsbecause regulation is often designed to address the very same market imperfections that theoryfocuses on. The first motivation of our paper primarily draws from the unique regulatoryenvironment REITs operate in. REITs were primarily created as an investment vehicle forinstitutions that tended to avoid investing in real estate assets because of lack of transparency andliquidity. In essence, the regulation on REITs are geared more to induce investment than toprevent neglect of fiduciary responsibility. There are mainly three good reasons to issue debt. One, it raises cash. Two, interestpayments are tax deductible so that the tax shield adds value to the firm. Three, the mandatoryinterest payment on debt mitigates the agency cost of managerial proclivity to waste cash on poorinvestments. On the negative side, borrowing exposes the firm to bankruptcy costs; and, leveragemay prompt managers to avoid profitable investments to minimize transfer of wealth tobondholders. Like debt, equity raises cash, but issue costs can be significant if investors discountthe value of shares out of concern that managers issue shares only when they are overvalued. Onbalance, debt appears to be the less costly alternative. Over the years, the search for an optimalcapital structure has been largely empirical, albeit elusive. A second, and potentially more interesting, motivation of our research is the recentcontroversy about which theory best describes the prevalent practice in firms’ financing choices.The trade-off theory states that an optimal capital structure exists and this is characterized by thetrade off between benefits and costs of borrowing. Among the benefits, the most significant is thetax deductibility of interest payments, but costs of financial distress can be substantial. Whilefirms deviate from the optimum capital structure in the short term, the long term capital structureis invariant. The theory implies that adjustments in capital structure in response to fluctuations invaluation of the firm, and capital needs are temporary; capital structure regresses to the optimallevel in the long run. The evidence on actual capital structure choices lends only scant support tothe trade off theory. 1
  3. 3. The pecking order theory developed by Myers and Majluf (1984) is more potent simplybecause it provides a better description of actual managerial behavior. The model, based oninformation asymmetry between shareholder and managers, says that if managers are moreinformed than shareholders about the firm’s prospects, they would be tempted to sell new sharesonly when they are overvalued. Wary shareholders will anticipate this and revalue sharesdownwards. Under this scenario, stock prices will always react negatively to equity issues.Consequently, managers who act in shareholders’ interest will always avoid issuing new stock,and prefer issuing less risky debt instead. This implies that high growth firms, particularly thosewith insufficient free cash flow will have high debt ratios. A more dynamic version of the theorystates that high growth firms may reduce leverage and use retained earnings for currentinvestment to avoid issuing equity if and when need for additional funds arises in the future. Animportant implication of the theory is that no optimal capital structure exists, rather capitalstructure evolves in response to the firm’s investment opportunities. Shyam-Sunder and Myers(1999) report evidence consistent with the pecking order theory. A third theory, known as the market timing theory [Baker and Wurgler (2003)], is morebehavioral in nature and scope and simply states that long-term capital structure is merely amanifestation of manager’s attempts to time equity issues to coincide with high market valuation.According to this theory, firms with high growth and investment opportunities have high marketvalues and tend to issue equity more often, resulting in low leverage ratios. The idea is that ifmarket associates high market values with low adverse selection costs, that presents high growthfirms with the opportunity to issue equity at an advantage. It is noteworthy that the market timingtheory and the simple pecking order theory have opposite implications for the relation betweenmarket values and debt ratios. Neither theory identifies an optimal capital structure, however. A final question that has attracted considerable attention is whether changes in capitalstructure are permanent. Trade off theory implies that any change in capital structure istemporary and firms regress to the long term optimum over time. There is no such implicationunder the pecking order or the market timing theories. An evidence of a permanent relationbetween the need (investment opportunities) and sources (financing choices) of capital issufficient to unequivocally reject the trade off theory. While the theoretical underpinnings of the theories are well developed, the empiricalevidence is mixed, at best. It is only recently that the empirical enquiries have focused on thedynamics of the evolution of capital structure over time. Shyam-Sunder and Myers (1999) claimsupport for the pecking order theory, Frank and Goyal (2002) refute it, and Fama and French(2002) report findings consistent with, and contrary to both trade off and pecking order stories. In 2
  4. 4. the most comprehensive analysis of market timing theory to date, Baker and Wurgler (2002)interpret the evidence to be in conformity with the market timing theory to the exclusion of theother two. It is worth noting all studies of capital structure decisions over time reject trade offtheory unequivocally. Because of their unique regulatory environment, we contend, REITs are an ideallaboratory setting to provide additional evidence on these competing theories. First, REITs donot pay any taxes if 95% of taxable earnings are paid out as dividends. Second, high payoutimplies that REITs have low free cash flow, such that managers have little opportunity to wastecash on non value-maximizing acquisitions. REITs face the usual costs of financial distress,however. Absence of tax deductibility of interest payments, and reduced agency conflict,immediately suggest REITs should have no debt in their capital structure. The anecdotalevidence is clearly inconsistent with this notion.1 The requirement that 95% of the taxable earnings be paid out as dividends forces REITsto raise funds from the capital market where debt is a less attractive alternative than taxable firms,and the agency cost benefit of debt is also muted. Turning to equity, however, entails the costs ofadverse selection which must be borne by the existing shareholders. We argue that these costsare particularly severe for REITs. For example, monitoring REIT managers calls for specialskills and knowledge about general and local economic trends, conditions of comparableproperties, complex financing arrangements, other specialized skills, and even inside information[Han (2004)]. In addition, since REITs are involved in real property transactions that include awide range of heterogeneous, illiquid assets, it is difficult for shareholders to determine the fairmarket values of these transactions. This results in lack of transparency which makes monitoringof managers critical. As Ghosh and Sirmans (2001, 2003, 2004), and Han (2004) observe,however, REITs must abide by special regulations that can weaken or render ineffective thestandard governance mechanisms. To elaborate, to qualify as a REIT, the firm must maintain adiversified ownership with at least 100 shareholders, the five biggest of which may not own morethan 50 percent of the total shares outstanding. Campbell et al. (2001) contribute the lack ofhostile takeovers among REITs to this regulation. This unique ownership structure diminishesthe effectiveness of monitoring by the market for corporate control, and exacerbates the lack oftransparency. In essence, issuing equity is a particularly costly proposition for REITs. Underthis scenario, pecking order theory predicts financing first with retained earnings, then debt, and1 Brown and Riddiough (2003) reports that over the period September 1993 to March 1998, REITs made a 120 debtofferings of $133m each, on average. 3
  5. 5. equity last. Since retained earnings are very low for REITs, pecking order leans heavily towardsdebt financing. Finally, market timing theory suggests that managers look for opportunities to timeequity issues when adverse selection costs are low. It may be argued that these opportunities arerelatively scarce for REITs because of lack of transparency and incomplete monitoring. Insummary, the trade off prediction of all equity contradicts anecdotal evidence, pecking order callsfor predominantly debt financing, and market timing suggests selling equity if opportunities exist.We suggest that REITs will prefer to issue debt whenever the cost of discounted equity exceedsthe cost of financial distress, and equity otherwise. The choice of financing is essentially anempirical issue. The clear advantage with REITs is that because of low retained earnings, thefinancing decision may come down to a simple choice between debt and equity. To determine how capital structure evolves over time, and the persistence of capitalstructure change, a time series analysis of the relation between needs and sources of financingmust be conducted. Baker and Wurgler (2002) study the firms’ financing decision from the initialpublic offering (IPO). Conceivably, issuing debt is not appealing at the IPO stage because youngfirms are considered more risky. As the firm matures, financing decisions reflect both pureadjustments (if any) in capital structure and need for investment funds. It is generally assumedthat need for funds is a function of the firm’s investment and growth opportunities and thestandard sources of capital include retained earnings and security issuances. The standard proxyfor need for funds is the market value to book value ratio, the assumption being that high marketvalue reflects market’s assessment that the firm has access to profitable investment opportunities. We analyze the capital structure decisions of REITs over the period 1992 to 2003 usingthe same approach as Baker and Wurgler (2002). Over this period, we follow the REITs from theyear they go IPO to the last surviving year. The sample size is therefore driven by the IPOactivity of REITs. The most active years were 1994, 1995 and 1996 when over 50 REIT IPOsraised capital. The smallest sample size is 4 in 1992, steadily growing to the largest sample sizeof 108 in 2003. We use market to book ratio as a proxy for investment opportunities and firm’sneed for capital. The analyses based on contemporaneous data reveal a weakly significantpositive relation between M/B ratio and leverage, strongly negative relation between M/B ratioand net equity issues, and weak relation between M/B and retained earnings. The long termweighted average M/B ratio is a strongly significant determinant for leverage ratio whichsuggests that the effect on M/B ratio on leverage is not transient and firms do not adjust theirleverage ratios to a target level. The long-term persistence of leverage decisions is inconsistentwith the trade off theory. The long-term as well as the contemporaneous evidence is not 4
  6. 6. consistent with the market timing theory. We find weak evidence in favor of the pecking ordertheory from the yearly analysis, but strong support from the long-term regressions results. The findings for REIT are intriguing in that they are contrary to the recent evidence inBaker and Wurglar (2002) for a broader data set, and subject to interpretation vis-a-vis theconclusions in Brown and Riddiough’s (2003) analysis of REIT capital structure. Baker andWurglar find evidence in line with the market timing theory. A potential explanation for thedifferential findings is that the window of opportunity when adverse selection costs are low is lessfrequent and narrower for REITs. The lack of transparency of real estate assets, and theconsequent information asymmetry is a contributing factor. Reinforcing the problem is therestrictive ownership requirements in REITs which makes it difficult for blockholders to formownership stakes, and diminishes their incentive to monitor management. A shelteredmanagement widens the credibility gap between shareholders and managers. Brown and Riddiough (2003) analyze public issues by REITs over the years 1993-1998and document several stylized characteristics of these offers. An important finding is that offerspreads are positively related to maturity, which suggests that if performance improves andmarket value increases over time, market expects REITs to sell more debt so that, ex ante, offerspreads are higher for longer maturity issues. The authors further report that REITs use publicissue proceeds primarily for investment purposes so that security sales often induce capitalstructure changes. These findings are consistent with the existence of a target leverage ratio assuggested by the trade off theory. However, testing the theories of capital structure requires that atime series analysis of financing decisions be undertaken. In the short run, trade off and peckingorder (market timing) theories make similar predictions for firms that are underleveraged(overleveraged). Long run analysis facilitates separating the alternative theories. The paper proceeds as follows. Section II summarizes the prior research on capitalstructure. Section III develops the hypotheses under the regulatory environment of REITs.Section IV describes the data. We present and discuss our models and results in section V, andconclude in section VI.II. Literature ReviewA. Tradeoff Theory Tradeoff theory posits that the firm has a target debt ratio which is determined by thetradeoff between the costs and benefits of borrowing, with the firm’s assets and investment plansheld constant. The most significant benefit of debt financing is the tax shield of interest 5
  7. 7. payments. Mandatory interest payment reduces free cash flow which mitigates the agencyconflict between securityholders and managers. This implies higher leverage and payout ratiosfor profitable firms, and the opposite for firms with more investments. The cost of financialdistress is the major downside of debt financing. Further, from the shareholders’ perspective,leverage may induce managers of struggling firms to avoid profitable investments because mostof the benefit accrues to the debtholders. Marsh (1982) studies the security issuances by UK companies between 1959 and 1974.He documents that companies which are below their long term or above their short term debttargets are more likely to issue debt. Firm size, cost of financial distress and asset compositionwere the significant determinants of firm’s leverage ratio. He also finds some evidence for themarket timing theory. Specifically, the results demonstrate that firms with large share priceincreases tend to issue equity, and prevailing market conditions influence firms’ financedecisions. Titman and Wessels (1998) find that debt ratio is negatively related to the‘uniqueness’ of a firm’s line of business, and interpret this result as supportive of tradeoff theory.They also report that transaction costs are an important determinant of leverage ratios, and pastprofitability tends to reduce a firm’s debt level. The latter evidence is more in line with thepecking order theory. Rajan and Zingales (1995) use a sample of corporations from G-7countries to investigate the capital structure choices across countries. They find some evidenceconsistent with tradeoff theory. For example, tangibility is positively correlated with leverage inall countries. Consistent with market timing, the market-to-book ratio has a significant andconsistently negative relationship with leverage in all countries. Size is positively correlated withleverage and profitability is negatively correlated with leverage in all countries except Germany.These can be interpreted as generally consistent with the tradeoff theory. As the authors pointout, however, a deeper examination of the evidence suggests that the current capital structuremodels fail to fully explain the observed patterns. Under the tradeoff theory, deviations from target capital structure are only temporary. Ina dynamic setting, firms make financing choices to adjust the debt ratio to the long-term optimumwhich implies that no systematic relation between debt ratio and the firm’s investmentopportunities is predicted. However, if costs of financial distress varies across firms, a crosssectional variation in optimum capital structure is expected. For example, high-growth firms thatare more sensitive to fluctuations in business outlook and are therefore more vulnerable due to thecosts of financial distress, choose to use less debt financing. Highly profitable firms, on the otherhand, can risk higher debt ratios. The findings in Smith and Watts (1992) and Barclay, Morellec,and Smith (2001) are consistent with this notion. 6
  8. 8. B. Pecking Order Theory Developed by Mayers (1984) and Mayers and Majluf (1984), the pecking order assumesthat managers have privileged information regarding the firm’s value that investors do not have.This raises the potential that opportunistic managers will sell equity only when it is overvalued.New shareholders will therefore avoid or discount equity which implies that only poorlyperforming firms will have the incentive to issue equity. The avoidance of adverse selection costis the main motivation for firms to prefer the safest security available, which means that firmsalways choose debt over equity if bankruptcy costs are not an immediate concern. Hence, highgrowth firms that need more external capital end up with high leverage ratio. The dynamicpecking order theory, however, predicts that, holding profitability constant, firms with moreinvestment opportunities keep payout low to conserve funds, and maintain low leverage topreserve debt capacity so as not to be forced into high debt in the future. These firms are forcedto have high leverage only if adjustments in dividend payout are difficult, and investmentcommitments are persistently large. On the other hand, holding investments fixed, moreprofitable firms have higher payout ratios and lower leverage ratios because they have larger cashreserves, and can withstand adversities better. Shyam-Sunder and Myers (1999) study a sample of mature corporations with continuousdata on flow of funds between 1971 and 1989. They find that pecking order theory has muchgreater time-series explanatory power than a static tradeoff model. They conclude that peckingorder is an excellent first-order descriptor of corporate financing behavior. Clearly, if companieshave well-defined optimal debt ratios, managers are not much interested in getting there. Onecriticism of the Shyam-Sunder and Myers (1999) study is that the inferences are based on a rathersmall sample. Fama and French (2002) present a comprehensive analysis of the complementary andcontrasting implications of the tradeoff and pecking order theories for both dividend payout andleverage ratios. They identify profitability and investments and the interaction thereof as the keydeterminants of financing and dividend decisions. Consistent with both trade off and dynamicpecking order theories, they find firms with more investments are less levered. Next, theirfinding that more profitable firms have less leverage supports the pecking order, and contradictsthe trade off story. Further support for the pecking order theory draws from the evidence that fordividend paying firms, short-term variation in investment and earnings is mostly absorbed bydebt. Finally, the authors report that the least-levered and non-dividend paying firms (typically 7
  9. 9. small, growth firms) make the largest net new issues of equity which is contrary to the peckingorder theory. Among other authors to report evidence inconsistent with pecking order theory areHelwege and Liang (1996) and Frank and Goyal (2002). Using a panel of IPO firms, Helwegeand Liang (1996) find no relationship between the decision to raise external funds and theshortfall of internally generated funds. Studying the financial activities of US firms from 1971 to1988, Frank and Goyal (2002) conclude that new equity issues track the financing deficit moreclosely than debt issues, a clear contradiction of the pecking order model.C. Market Timing Theory Market Timing Theory suggests that firms tend to issue stock when the market conditionis favorable, and issue debt when the stock market is under the cloud. Graham and Harvey(2001) report that most CFOs agree that prior stock price movement and perception of under- orover-valuation of firms’ stock play important roles in their decision to raise external funds.Assuming that the ratio of market value to book value reflects investment opportunities, themarket timing theory [Baker and Wurgler (2002)] asserts a negative relation between marketvalue to book value ratio and the firm’s leverage ratio. This is contradictory to the simple form ofthe pecking order theory, but consistent with the more dynamic form. Baker and Wurgler (2002)demonstrate that leverage is negatively related to ‘external finance weighted-average’ market-to-book ratio which implies that past market valuation has a significant and persistently negativeimpact on firm’s leverage ratio. Their data further reveal that most of the financing is done byissuing equity, not through retained earnings. The authors reject the trade off and pecking ordermodels and interpret the result as supportive of the notion that current leverage ratio is acumulative outcome of firm’s previous attempts to time the market. In summary, while the three theories have several overlapping implications, they alsomake some predictions that can be useful to infer which one best fits observed capital structurechoices. We highlight the aspects of each theory that is unique. The trade off theory predicts atarget capital structure that firms regress to in the long run, implying that any relation betweencapital structure and profitability or investments is transient. Neither the pecking order theory northe market timing theory identifies an optimum capital structure. For dividend-paying (nondividend-paying) firms, the pecking order theory predicts a long run positive (negative) relationbetween market to book value ratio and leverage ratio. The market timing theory leads to a longrun positive relation between market to book value ratio and leverage ratio for all classes of firms; 8
  10. 10. the difference between the two is that under pecking order, funds are drawn from retainedearnings while for market timing, equity sales is the source for capital.III. REIT Regulatory Environment and Capital Structure In this section, we explore the implications of the various theories of capital structurefrom the perspective of REIT regulatory environment, and develop the hypotheses. In addition,we provide a review of the extant evidence on capital structure of REITs.A. Theoretical considerations REITs are not required to pay corporate taxes if they distribute 95% of taxable income asdividends. This nullifies two significant benefits of debt financing. One, the tax deductibility ofinterest payments and the tax shield is non-existent. Second, since most of the earnings isdistributed, debt servicing has only limited impact on agency cost of free cash flow. Accordingly,REITs should have one hundred percent equity under the trade off theory. Costs of financialdistress further reinforce the preference for equity. The only effect that induces less than allequity capital is that asymmetric information between shareholders and managers causesvaluation discounts. In the aggregate, if REITs have an optimum capital structure, it includesrelatively low level of debt. The main motivation to prefer debt over equity issues is that managers may useprivileged information to sell overvalued equity and shareholders are aware of it. So, an equityissue is always discounted by the market. Greater the information asymmetry, higher is thediscount. Information asymmetry is particularly severe in REITs because the transparency of theunderlying assets is less than perfect. For example, analysis of REIT assets may require specialskills and knowledge about general and local economic trends, conditions of comparableproperties, and complex financing arrangements. In addition, shareholders may find it difficult todetermine the fair market values of real estate transactions because they often includeheterogeneous, and illiquid assets. Restrictions on REIT’s income sources and investment options may further exacerbatethe information asymmetry. The restrictions that REITs derive their income largely from realestate activities, and that acquisitions and combinations be restricted to the real estate sector,allow managers but limited opportunity to acquire inter industry skills, makes them lessemployable, and induces them to avoid hostile takeovers [Campbell, Ghosh, and Sirmans]. The 9
  11. 11. requirement that no single investor owns more than 10 percent of REIT shares deters blockholderformation. In conjunction, these regulations make managers less vulnerable to the discipline ofthe takeover market, and render the board weak. Weak monitoring allows opportunisticmanagers to reveal less information. Under this scenario, REITs would be expected to avoidequity issues and prefer funding investment from retained earnings first, then sell debt if morecapital is needed. A more complex form of pecking order, Myers (1984) notes, states that firmswith generous reserves of cash may avoid issuing debt to preserve debt capacity for future capitalneeds, implying a negative long-term relation between leverage and market to book value ratio.REITs, however, are not expected to have big accumulation of cash and retained capital becauseof the payout requirement, which implies that they have to resort to debt financing more often.Thus, the pecking order theory predicts a long term positive relation between leverage and marketto book ratio. Why would REITs issue equity despite the potential for high adverse selection costs?One reason, Baker and Wurgler (2003) assert, is that adverse selection costs vary over time andacross firms, and managers take advantage of these opportunities to favorably time equity issues.Opportunities for timing equity sales also arise as irrational investors periodically bid up shareprices to abnormally high levels. Because of the reasons narrated above, the opportunities of lowadverse selection costs may be relatively infrequent for REITs. Under this premise, the markettiming theory prediction of a long-term negative (positive) relation between market to book valueratio and leverage (equity issues) is questionable for REITs. The theories and hypotheses are summarized in table 1. Trade off theory predicts a lowlong term target debt ratio. The simple pecking order theory implies a positive relation betweendebt ratio and market value to book value ratio. The complex pecking order theory whichimplies a negative relation between market to book ratio and leverage for cash rich firms may nothold for REITs. The market timing theory predicts a negative relation between market value tobook value ratio and leverage and requires opportunities when adverse selection costs are low, aless likely event for REITs.B. Empirical Evidence The first attempt to analyze capital structure of REITs from the perspective of valuationwas made by Howe and Shilling (1988) who state that, under the trade off theory, as a non-tax-paying enterprise, the tax gain to corporate borrowing is strictly negative for REITs, such that anegative reaction to debt issues is predicted. A negative reaction is consistent also with the 10
  12. 12. pecking order implication that issuing a security constitutes a negative signal that it is overvalued,and the implied-cash-flow change hypothesis [Smith (1986)] which states that unexpectedsecurity offerings suggest that operating cash flows are lower than expected. A positive reactionto debt sales follows only from Ross’s (1977) assertion that debt issues convey the favorableinformation that future earnings will be sufficiently large to support the mandatory interestpayments. Extant literature [Mikkelson and Partch (1986), and Eckbo (1986)] documents non-positive to significantly negative reaction to debt offerings. Contrary to these studies, Howe andShilling (1988) find a significant positive reaction, which they interpret as weak support forRoss’s signaling hypothesis. In an important and comprehensive piece, Brown and Riddiough (2003) study the publicofferings by equity REITs between September 1993 and March 1998, and identify numerouspatterns in the issuance behavior. While the scope of the research seems limited to identifyingsome stylized facts about REIT capital structure, certain results have bearing on our analyses. Asignificant finding is that maturity of public REIT debt is positively related to offer spread. Theauthors point out that if credit market participants assess that REITs issue debt when they areaggressively leveraged, and if they anticipate that REIT balance sheets will strengthen in thefuture, then credit spreads should decline with maturity. On the other hand, if REITs issue publicdebt at long-term target leverage ratios, then credit spreads are predicted to increase withmaturity. The evidence therefore suggests the existence of a long-term target debt ratio. Two, the authors report that majority of the firms are clustered just above the investment-grade rating, and REITs that issue public debt are debt capital constrained. While this result alsosuggests a target long-run debt ratio, an alternative explanation – consistent with pecking ordertheory -- is that as long as REITs can attain minimum investment-grade credit rating, they preferto issue debt instead of equity to boost their credit ratings. Further, a significant number ofREITs that issue equity are highly leveraged and remain so subsequently. Apparently, firms issueequity only when bankruptcy threat looms large, and even at this juncture, they raise just enoughequity capital to mitigate the funding pressure. Finally, REITs with higher total assets andrevenues are more likely to issue debt, another indication that when bankruptcy risk is low,managers choose debt financing, just as pecking order prescribes. Also in conformity with thepecking order model, REITs largely fund investment with bank lines of credit and other sourcesof private debt. When these sources are exhausted, REITs access the public capital market anduse the issue proceeds to pay down credit lines in order to prepare for the next round of financing. Overall, Brown and Riddiough’s (2003) data suggest that despite no obvious taxadvantage, the standard deadweight costs of financial distress, and the pecking order and free 11
  13. 13. cash flow rationales being muted by the dividend payout requirements2, REITs prefer issuing debtand choose equity only as a last recourse. Howe and Shilling’s (1988) analysis demonstrates thatthe market approves of this choice. While this is powerful evidence, it is based on static analysis.To our knowledge, the evolution of capital structure over time has not been explored for REITs.Our paper fills the gap.IV. Data and Summary Statistics Our study includes REITs that went IPO during 1991 to 2003 and for which allaccounting and firm specific information required for analyses from 1991 to 2003 are available inthe SNL database. We collect each firm’s financial information, including total debt, total equity,total assets, total revenue, net income, depreciation, dividend amount, total investment in realestate, stock price, and the total number of shares outstanding. We also identify the IPO date foreach firm during 1991 to 2003. Table 2 shows the number of REITs in SNL database that wentIPO between 1991-2003, and number of REITs in the final sample by IPO year and calendar year.Most of REITs have accounting and financing information one year prior to the year of interest,and hence are included in the analysis to investigate the temporary impact of market-to-book onleverage ratio. However, missing values reduce the sample size when we test the long-termrelationship between market-to-book and leverage ratios. This limits the scope and interpretationof our results somewhat. As shown in panel A of table 2, the number of REITs in the sample is only 4 in 1992.The IPO activity picks up between 1994 and 1996 when the sample size jumps to 83 and thenstabilizes at 108 in 2003. That most firms survived during the entire period under study isapparent in the low attrition reported in panel B. By the tenth year after IPO, as many as 30 ofthe original 33 REITs remained in the sample. However, as evident in column 2, availability ofdata is very limited for young IPO firms during the early years of our study. For example, only68 of the eligible 107 firms have data in the first year after IPO. The proportion is much higheras the firms mature. Leverage is measured as the ratio of book value of debt to book value of assets. AsMyers (1977) points out, market values incorporate the value of the call option on firm’s future‘growth opportunities’. Debt issued against these values can distort future real investmentdecisions. As a result, in practice, managers have a good reason to calculate debt ratios using2 Free cash flow rationale of debt financing states that mandatory interest payment on debt mitigates the agency cost offree cash flow. This is muted for REITs by the regulatory requirement to payout 95% of taxable income as dividends. 12
  14. 14. book values. Additionally, we investigate the impact of investment opportunities on leverageratios. Titman and Wessels (1988) and Fama and French (2002) suggest that a negativerelationship between market leverage and investment opportunities may simply be amanifestation of better investment producing higher market values, rather than the workings oftrade-off and pecking order models. The definition and measurement of key variables follows Baker and Wurgler (2002).Book debt is total assets minus book equity. Book equity is defined as total assets less totalliabilities and preferred stock plus deferred taxes and convertible debt. Book leverage iscalculated as the ratio of book debt to total assets (D/A). Market leverage is book debt divided bytotal assets minus book equity plus market equity. Market equity is the product of number ofshares outstanding and the stock price. Net equity issues (e/A) is defined as the change in bookequity minus the change in retained earnings divided by assets. Newly retained earnings(∆RE/A) is the ratio of net income minus dividend to total assets. We calculate the net debtissued (d/A) as the residual change in assets divided by total assets. Market-to-book value ratio(M/B) is defined as total assets minus book equity plus market equity divided by total assets. In table 3, we report the summary statistics of REITs leverage ratios and their financingby IPO year in panel A and by calendar year in panel B. Three patterns are worth noting. First,REITs have relatively high book leverage compared to non-REIT firms in the compustat database studied by Baker and Wurgler (2002). During 1991 to 2003, REITs maintain a debt ratio ofabove 50 percent. More recently, the book debt ratio is well above 60 percent. In contrast, non-REIT firms from 1974 to 1999 have an average debt ratio below 50 percent. Analyses overcalendar years reveal the same pattern. Higher leverage ratio for REITs is consistent with the pecking order theory, but contraryto tradeoff and market timing models. Tradeoff theory predicts lower book leverage for REITsdue to the tax exempt status and lower free cash flow problem. The business nature of REITsmakes it harder for their shareholders to discover the market values of investment transactions,which usually involves a wide range of heterogeneous, illiquid assets. According to the peckingorder model, firms with high asymmetric information tend to resort to debt when they needexternal funds, and are more likely to have high leverage ratios. Market timing certainly providesno rationale for this phenomenon. If REITs behave like other firms in choosing the source ofexternal capital, and raise equity under favorable market conditions and debt under unfavorablemarket conditions, it is hard to reconcile why REITs, on average, have higher leverage ratiosrelative to other types of firms. 13
  15. 15. Second, we observe an increasing trend in debt ratio as the maturity of REIT firmincreases. This trend is consistent with table 2 in Baker and Wurgler (2002). The average debtratio is 52 percent one year after IPO and steadily grows to 66 percent ten years later. If firmshave a target capital structure in mind, it is difficult to reconcile why debt ratio is growingcontinuously over the years. The average debt ratio also increases over the calendar years. Thistrend can be explained only as an age effect, not a survival effect. Most REITs in 2003 have atrading history of at least 4 to 5 years. This pattern contradicts the reversion to target capitalstructure over time prescribed by the trade off theory. Finally, REITs issue more debt than equity in nine out of ten years after IPO (seven outof ten years based on calendar year). Although the percentage of net debt issued is decreasingover the years, it is the driving force in the annual change in total assets. Consistent with theprediction of pecking order theory, this result suggests that REIT managers turn to debt financingfirst, before they consider equity financing. On the other hand, both tradeoff theory and markettiming theories predict firms depend on debt financing in some years and on equity financing inother years depending on leverage ratio and cost of adverse selection cost. In table 4, we report the correlation between various variables. Most interesting is thepersistently positive relation between book leverage ratio and market-to-book ratio over the pastten years. The 9-year back market-to-book ratio is still positively associated with the currentbook leverage ratio. The univariate analysis thus demonstrates a persistent and positive long-termimpact of market-to-book on leverage ratio, which constitutes strong evidence against trade offand market timing theories, and strong support for the pecking order story.V. Models and Empirical Results Implications of trade off, pecking order, and market timing theories are usually expressedin terms of how leverage ratio varies with profitability and investment opportunities. We usemarket-to-book value ratio as a proxy for investment opportunities. Brown and Riddiough’s(2003) finding that the market is more sympathetic to financing for investment purposes thanadjustments in capital structure provides some justification for the use of M/B ratio as adeterminant of debt ratio. Under trade off theory, bankruptcy costs are lower, and leverage higherfor more profitable firms. To minimize agency cost of free cash flow, profitable firms use higherleverage to disgorge more of firm’s excess cash. Conversely, firms with more investmentopportunities have less free cash flow and can have low leverage ratio. Pecking order theoryasserts that to avoid sale of discounted equity, firms fund investment with retained earnings first, 14
  16. 16. then debt, and finally equity. It follows that if profitability and investments are persistent,leverage is lower for profitable firms, and higher for firms with more investment opportunities.Dividend payment reinforces the relationship. Market timing theory predicts that managers timeequity issues when equity is overvalued. If investment opportunities are persistent, a long-termnegative relation between market to book ratio and leverage ratio is predicted.A. The relationship between market-to-book and leverage ratios In this section, we investigate the determinants of annual changes in leverage. FollowingBaker and Wurgler (2002) and Rajan and Zingales (1995), we include three variables that arecorrelated with leverage. ⎛D⎞ ⎛D⎞ ⎛M ⎞ ⎛ REinvestment ⎞ ⎛ EBITDA ⎞ ⎜ ⎟ − ⎜ ⎟ = a + b⎜ ⎟ + c⎜ ⎟ + d⎜ ⎟ ⎝ A ⎠t ⎝ A ⎠t −1 ⎝ B ⎠t −1 ⎝ A ⎠t −1 ⎝ A ⎠t −1 ⎛D⎞ + e log( S ) t − 1 + f ⎜ ⎟ + u t (1) ⎝ A ⎠ t −1The sign of coefficient b is the main focus of this equation. Both tradeoff and market timingtheory predict a negative sign, while pecking order suggests the opposite. A more complicatedversion of pecking order asserts that firms with larger expected dividends may keep currentleverage low to preserve debt capacity so as to avoid funding future investments with new riskysecurities [Myers (1984)]. For REITs, however, such a strategy may not be feasible because ofthe 95% payout requirement. We use percentage of real estate investment as proxy for asset tangibility in equation (1).Tangible assets may be used as collateral and hence may be associated with higher leverage.However, REITs are expected to have most of the assets as tangible assets, such that muchvariability is not expected in the data. Hence, we do not expect a relationship between tangibleassets and leverage ratios. Profitability is associated with the availability of internal cash flows,which implies lower leverage ratio under the pecking order theory. However, REITs are requiredto pay out 95 percent of the earnings as dividends. Hence, there is limited free cash flow and asignificant relationship between profitability and leverage may not emerge. The naturallogarithm of total revenue is used as a proxy for firm size. As large firms are less likely to sufferfinancial distress, they might be associated with high leverage if the financial distress costs areconsidered to be of first-order importance to the firms (as tradeoff theory suggests). Fama and 15
  17. 17. French (2002) argue that larger firms may have less volatile earnings which will also induce ahigher leverage ratio. Therefore, in accordance with trade off theory, we expect the coefficient offirm size to have a positive sign. Finally, we add the lagged leverage in our model, as Baker andWurgler (2002) suggest, to control for the fact that debt ratio is bounded from 0 to 1. It isexpected to have a negative sign3. Panel A of table 5 reports the regression results from equation (1). We run this model foreach year after IPO (IPO regressions). This allows us to study the changes (if any) in capitalstructure as the firm matures. We also construct the full 1991 to 2003 SNL sample forcomparison. The regression estimates for the sample with all firms contains multipleobservations on the same firm from different calendar year. First, the negative and significantcoefficient of real estate investment and non-significance of the coefficient of firm size do notsupport the implications of the tradeoff theory. The evidence on profitability is mixed. Second,the market-to-book ratio is significant only in three of the ten IPO years. When it is significant,the sign is positive. The market-to-book is positive and significant in the all firms regressionwhich is contrary to market timing and the trade off theory, but consistent with the pecking orderstory. It is also interesting to note that the non-negative coefficient for M/B is not consistent withthe Myers (1984) dynamic form of pecking order model which states that in anticipation offunding requirements for higher investments in the future, firms may preserve debt capacity byusing retained earnings for current needs. While regular dividend paying firms with stable cashflow are most capable of following this strategy, REITs are at a disadvantage because of highpayout requirements. In essence, the positive sign for M/B ratio allows us to unequivocally rejectthe trade off, market timing and the dynamic form of pecking order theory. The evidence,however, can be interpreted only as preliminary and weak support for the simple pecking ordertheory. Further confirmation for the model must await analysis of the different funding sources.B. Components of Leverage change Following Baker and Wurgler (2002), we further decompose the change in leverage intoequity issues, retained earnings, and the residual change in leverage, which depends on the totalgrowth in assets from the combination of equity issues, debt issues, and newly retained earnings.3 This coefficient is negative in 7 of 10 IPO years, as well as in the All Firms regression. When it is positive, it is neversignificant in any level. 16
  18. 18. ⎛D⎞ ⎛D⎞ ⎛e ⎞ ⎛ ∆REt ⎞ ⎡ ⎛1 1 ⎞⎤ ⎜ ⎟ − ⎜ ⎟ = −⎜ t ⎜A ⎟−⎜ ⎟ ⎜ A ⎟ − ⎢ Et −1 ⎜ − ⎟ ⎜ A A ⎟⎥ ⎟ (2) ⎝ A ⎠t ⎝ A ⎠t −1 ⎝ t ⎠ ⎝ t ⎠ ⎣ ⎝ t t −1 ⎠ ⎦This decomposition allows us to identify more specifically the driving force behind the leveragechange. We use each component as our dependent variable and run the same regressions for eachIPO year, as well as for all firms from 1991 to 2003. The results are presented in panels B, C andD of table 5. As Braker and Wurgler (2002) point out, the coefficients in panel A should equalthe summation of the corresponding coefficients from panels B, C and D. The results in panel B indicate that market-to-book ratio has impact -- through net equityissues -- on changes in leverage as predicted by market timing. In five out of ten IPO regressionsas well as in the regression for all firms, we find net equity issues help to reduce the leverage ratiowhen the market valuations of the firms are high. However, these effects are not significant inthe other half of the IPO regressions. Also, consistent with our expectation, panel C shows onlyweakly significant impact of internally generated funds on REITs’ leverage ratio. In contrast, wefind significant impact of market-to-book on changes in leverage through asset growth (panel D).In nine out of ten IPO regressions as well as the all firms regression, the coefficients of market-to-book are significant at the conventional levels. These coefficients are larger in terms of absolutevalue compared to those in panel B. In the all firms regression, the coefficient for market-to-bookis 12.88 in panel D compared to 8.66 in panel B. Hence, the dominant factor for change inleverage ratio is the growth of total assets. To put it in perspective simply, the growth in totalassets is mainly funded by net debt issues. Comparing panels B and D, we conclude that debtfunding is the major source for external financing for REIT firms. No other coefficient in the other columns of panels B, C and D is significant. As a result,we believe that market-to-book does have at least a temporary impact on leverage ratio. Firmswith higher growth opportunities are more likely to fund their investment through external debtissuance. This statistically and economically significant impact is predicted by pecking ordertheory, but not by tradeoff or market timing models.C. Long-term impact of market-to-book Next, we investigate whether the impact of market-to-book on leverage ratio is persistentover time as predicted by pecking order and market timing or just temporary as suggested bytradeoff theory. We use the three variables that were reported to be correlated with leverage ratioby Rajan and Zingales (1995) as control variables. 17
  19. 19. ⎛D⎞ ⎛M ⎞ ⎛M ⎞ ⎛ REinvestment ⎞ ⎜ ⎟ = a + b⎜ ⎟ + c⎜ ⎟ + d ⎜ ⎟ ⎝ A ⎠t ⎝ B ⎠ efwa ,t −1 ⎝ B ⎠t −1 ⎝ A ⎠t −1 ⎛ EBITDA ⎞ + e⎜ ⎟ + f log( S ) t −1 + u t (3) ⎝ A ⎠ t −1 ⎛M ⎞ t −1 e + ds ⎛ M ⎞where ⎜ ⎟ = ∑ t −1s .⎜ ⎟ (4) ⎝ B ⎠efwa ,t −1 s = 0 e + d ⎝ B ⎠ s ∑r r r =0The focus of this analysis is the ‘external finance weighted-average’ market-to-book ratio (eqn. 4)suggested by Baker and Wurgler (2002). We use this weighted average to capture the long termeffects of market-to-book on the leverage ratio. This variable takes high values for firms that raiseexternal finance when the market-to-book ratio is high and vice-versa. If firms tend to raiseequity when the market-to-book is high reflecting greater investment opportunities, as predictedby the market timing story, then we expect a negative relationship between this variable and theleverage ratio. If firms tend to raise debt when the market-to-book is high, as predicted bypecking order theory, then we expect a positive coefficient for this variable. If the market-to-book has only temporary impact on leverage ratio as suggested by tradeoff theory, then we shouldnot find the coefficient of this variable to be significant. Also, we follow Baker and Wurgler(2002) and allow the minimum weight to be zero in order to ensure the weights are increasing inthe total amount of external finance raised in each period. The lagged value of market-to-book isincluded to control for the current cross-sectional variation in the level of market-to-book. Whatis left for the weighted market-to-book ratio is the residual influence of past, within-firm variationin market-to-book. In panel A of table 6, we use only the traditional control variables from Rajan andZingales (1995). We find that current cross sectional market-to-book value has a positive impacton the leverage ratio in three of IPO regressions and the all firms regression. This result isconsistent with those reported in previous tables. We also find that other control variables do nothave a significant relationship with leverage ratios in most of our IPO regressions as well as theregression including all firms. As discussed previously, this finding is consistent with the uniqueregulatory characteristics of the REITs. In panel B, we add the weighted average market-to-book ratio in our models to test thelong-term relationship between market-to-book and the leverage ratio. We do not include this 18
  20. 20. weighted average for IPO+1 and IPO+2 regressions due to the high correlation between thisvariable and the lag market-to-book ratios. We find that weighted average market-to-book is themost significant variable in determining the cross sectional variation in leverage ratio of REITs.The coefficient of this variable is positive and highly significant in seven out eight IPOregressions and also in the all firms regression, indicating REITs with historically higher market-to-book ratios tend to have persistently higher leverage ratios. The impact of market-to-book isnot temporary and capital structure is not mean reverting as suggested by tradeoff theory. REITmanagers do not balance their capital structure over a 10-year period. In summary, the market-to-book ratio has a positive and long-term impact on REIT leverage ratios. Pecking Order Theorydoes a better job predicting this relationship compared to the other two capital structure theories.VI. Synthesis and Discussion The main findings may be summarized as follows: 1. The significantly negative coefficient for tangible assets and the non- significance of size and profitability in the contemporaneous regression contradicts the trade off theory. The persistently significant relation between market to book value ratio and leverage in the long-term regression is inconsistent with the trade off theory as well. 2. Pecking order theory receives weak support from the contemporaneous regression in the positive relation between leverage and market to book ratio. The strongest support for the pecking order story draws from significant relation between market to book ratio and change in leverage through asset growth. The persistent impact of market to book value ratio in the long term regression also shows REITs follow pecking order in financing decisions. 3. In the contemporaneous model, the negative coefficient for market to book ratio contradicts the market timing theory. The evidence of persistently positive impact of weighted market to book in the long term regression strengthens the conclusion.VII. Conclusion The main contribution of this paper is to explore if and how unique regulatory provisionsof REITs influence their capital structure decisions. Trade off theory predicts that capitalstructure represents a trade off between costs and benefits of debt financing; pecking order theorystates that under asymmetric information, managers choose to fund investment with retained 19
  21. 21. earnings first, then debt, and lastly equity; market timing theory asserts that managers issue equitywhenever conditions are favorable. In the long run, trade off theory predicts no relationshipbetween leverage ratio and market to book ratio, pecking order suggests a persistent positiverelation, and market timing theory a persistent negative relation between these variables. The tax-exempt status of REITs eliminates the tax shield advantage of debt financing.The requirement that ninety five percent of taxable earnings be paid out as dividends mitigatesthe agency cost of free cash flow. With no special benefit to debt financing, bankruptcy costsimply one hundred percent equity financing under trade off theory. High payout has anadditional effect -- it forces REITs to raise investment capital externally where valuation isuncertain due to information asymmetry between securityholders and managers. REITshareholders are especially vulnerable because real estate assets tend to be illiquid and lesstransparent. Regulatory restrictions on sources of income and choices of assets that REITs areallowed to invest in further exacerbate the information asymmetry. To elaborate, regulationlimiting managers’ investment options narrows their experience to sector specific assets. Toprevent job loss, these entrenched managers may collude to forestall hostile takeover threats, andcreate an environment where discipline and monitoring by the market corporate control isweakened. Finally, regulatory restriction on ownership size makes takeovers difficult and acts asa disincentive to institutional investors and blockholders. Thus protected, REIT managers areunder little pressure to reveal full information. If shareholders recognize this agency problem tobe persistent, new share issues would be deeply discounted, and opportunities to sell equityscarce. Under this scenario, debt financing is the preferred choice so that the pecking ordertheory rather than the market timing theory provides a more apt description of expectedmanagerial behavior in REITs. We analyze REITs’ financing choice over a number of years following their IPO. Theobjective is to explore how REIT capital structure evolves in response to needs for investmentcapital. The data reveal no indication of regression to a long term optimum capital structure, astrade off theory would suggest. Rather, REITs with historically high market-to-book ratio tend tohave high leverage ratio. In essence, REITs with high growth opportunity and high marketvaluation raise most of their needed funds through debt issuance. This finding is contrary to thefinancing decisions of non-regulated firms. We attribute it to the special regulatory environmentof REITs where, despite no apparent benefits to debt financing, management prefers issuing debtto equity to raise funds because the adverse selection costs due to information asymmetry exceedsthe potential costs of financial distress. This analysis has significant implications for theliterature on corporate capital structure decisions. 20
  22. 22. 21
  23. 23. ReferencesBaker, Malcolm and Jeffrey Wurgler, 2002, Market Timing and Capital Structure, Journal of Finance, Vol. LVII, No. 1, pp 1 – 32.Barclay, Michael J., Clifford W. Smith, Jr., and Ross L. Watts, 1995, The Determinants of Corporate Leverage and Dividend Policies, Journal of Applied Corporate Finance, 7, pp 4 – 19.Brown, David T. and Timothy J. Riddiough, 2003, Financing Choice and Liability Structure of Real Estate Investment Trusts, Real Estate Economics, V31, pp 313 – 346.Frank, Murray Z., and Vidhan K. Goyal, 2003, Testing the Pecking Order Theory of Capital Structure, Journal of Financial Economics, pp 217 – 248.Fama, Eugene F. and Kenneth R. French, 2002, Testing Trade-Off and Pecking Order Predication about Dividends and Debt, Review of Financial Studies, Vol. 15, No. 1, pp 1 – 33.Graham, John R. and Campbell R. Harvey, 2001, The Theory and Practice of Corporate Finance: Evidence from the Field, Journal of Financial Economics 60, pp 187 – 243.Harris, Milton and Artur Raviv, 1991, The Theory of Capital Strucuture, Journal of Finance, Vol. XLVI, No. 1, pp 297 – 355.Helwege, Jean and Nellie Liang, 1996, Is There A Pecking Order? Evidence from A Panel of IPO Firms, Journal of Financial Economics 40, pp 429 – 458.Marsh, Paul, 1982, The Choice Between Equity and Debt: An Empirical Study, Journal of Finance, Vol. XXXVII, No. 1, pp 121 – 144.Myers, Stewart C., 1977, Determinants of Corporate Borrowing, Journal of Financial Economics 5, pp 147 – 175.Myers, Stewart C., 1984, The Capital Structure Puzzle, Journal of Finance, Vol. XXXIX, No. 3, pp 575 – 592.Myers, Stewart C. and Nicholas S. Majluf, 1984, Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have, Journal of Financial Economics 13, pp 187 – 221.Rajan, Raghuram G. and Luigi Zingales, 1995, What Do We Know about Capital Structure? Some Evidence from International Data, Journal of Finance, Vol. L, No. 5, pp 1421 – 1460.Shyam-Sunder, Lakshmi and Stewart C. Myers, 1999, Testing Static Tradeoff Against Pecking Order Models of Capital Structure, Journal of Financial Economics 51, pp 219 – 244.Titman, Sheridan and Roberto Wessels, 1988, The Determinants of Capital Structure Choice, Journal of Finance, Vol. XLIII, No. 1, pp 1 – 19. 22
  24. 24. Table 1: Theories of capital structure and REIT regulatory environment Theory Impact Variables Debt and M/B ratio Real Estate RegulationTrade-off: A long-term Tax-deductibility of interest payments Firms with high M/B ratio (high growth and REITs are exempt from corporate taxes if 95% of current earnings areoptimum capital structure exists encourages high debt levels. investment) have low free cash flow and tend to paid out as dividends. High payout reduces free cash flow. Loss of tax-where benefits of debt be risky. To avoid financial crisis in a downturn, deductibility and low free cash flow imply low debt ratios.financing are traded off against Bankruptcy costs force low debt levels. high M/B firms choose low debt ratios.the costs Implication: Trade-off theory predicts low debt ratio for all REITs, Mandatory interest payments on debt reduce To maintain capital structure at the long-term regardless of M/B ratios. The long term adjustment to optimum capital free cash flow, and mitigate agency costs; but, optimum level, firms adjust capital structure to structure holds. high debt levels induce shareholder value- changes in M/B ratio. So, no long-term maximizing managers to reject profitable relationship exists between M/B and capital investments to prevent transfer of wealth to structure. debtholders.Pecking Order: Managers Information asymmetry between shareholders High M/B firms require investment capital. To Real estate assets are difficult to value which implies REITs wouldalways prefer issuing debt to and managers implies preference for debt over avoid issuing discounted equity, they issue debt. prefer to finance investment through debt issues, or retained earnings.avoid the potential valuation equity. This results in high debt associated with equity The 95% payout requirement results in low free cash flow in REITs. Inissues. This theory predicts a Alternatively, high M/B firms choose low debt conjunction with discount on equity issues due to informationpositive relation between M/B ratios to create slack such that they can avoid asymmetry and adverse selection, low free cash flow implies REITsratio and debt ratio, but, no issuing equity if and when they need funds in the must sell debt to raise funds, pushing debt ratios higher.long-term optimum capital future. This strategy requires access to high freestructure. cash flow and retained earnings. Implication: Low free cash flow and lack of transparency of real estate assets and investments imply high debt ratios, the effect being stronger for high M/B REITs.Market Timing: Managers Information symmetry between shareholders If high M/B ratio implies low adverse selection REITs must earn 75% of their earnings from real estate activities.issue equity when cost of and managers induces adverse selection costs cost, then managers can take advantage of high Investment options for REITs are also restricted mainly to sectorequity capital is low. Under in equity issues. These costs vary across time M/B ratio to time equity issues. specific assets. Finally, no single entity can own more than 50% stake.this theory, a negative relation and across firms.between M/B and debt ratio is Extreme values of M/B indicate extreme investor Restricting operations and acquisitions to the same sector deniespredicted, but no optimum Extremely high expectations by irrational expectations. Managers exploit extreme managers the opportunity to acquire inter industry experience whichcapital structure exists. investors periodically cause equity to be valuations by issuing equity when M/B ratios are shrinks their job market. This induces managers to collude against mispriced rendering cost of equity abnormally high. hostile takeovers. Ownership restriction deters formation of low. blockholders, which weakens monitoring by board and allows managers to withhold or conceal material information. Implication: Opportunities to time equity sales are relatively scarce. 23
  25. 25. Table 2 Missing Values and Sample Selection We show the number of REIT firms that are included in our study in this table. Firms are dropped out ofour sample due to missing accounting and financing information during the period of our study. In second column reports the number of firms in SNL database that went IPO during 1991 to 2003. The number of firms that are included in our models that are testing the temporary impact of market-to-book on leverage ratio is listed in third column. We report the number of firms that are included in testing the long-term relationship between market-to-book and leverage ratio in fourth column. Number of firms in SNL Number of firms with information Number of firms with accounting Year database that went IPO during available to calculate the weighted information available at (t-1) 1991-2003 average of MTB ratio Panel A: Calendar Year 1992 4 2 0 1993 8 7 3 1994 33 19 7 1995 68 38 22 1996 83 41 37 1997 85 54 41 1998 90 79 41 1999 99 91 46 2000 103 95 54 2001 104 96 54 2002 106 95 53 2003 108 98 52 Panel B: IPO Year IPO+1 107 68 68 IPO+2 102 68 68 IPO+3 101 80 67 IPO+4 100 88 64 IPO+5 93 89 61 IPO+6 87 82 52 IPO+7 74 71 39 IPO+8 66 63 34 IPO+9 61 57 32 IPO+10 30 29 17 24
  26. 26. Table 3: Summary Statistics of Capital structureIn this table, we report the summary statistics on current leverage ratio and the changes in current leverageratio. Book leverage is calculated as book debt to total assets. Market leverage is book debt divided by theresult of total assets minus book equity plus market equity. Market equity is the product of number of shareoutstanding and the stock price. Net equity issues (e/At) is defined as the change in book equity minus thechange in retaining earnings divided by assets. Newly retained earnings (∆RE/At) is the ratio of the resultof net income minus dividend amount and total assets. We calculate the new debt issues (d/At) as theresidual change in assets divided by assets. Book Leverage % Market Leverage d/At % e/At % ∆RE / At % %Year N Mean S.D. Mean S.D. Mean S.D. Mean S.D. Mean S.D. Panel A: IPO YearIPO+1 68 51.63 18.66 46.54 18.60 16.15 17.24 11.45 16.53 -1.08 2.68IPO+2 68 55.18 18.51 50.39 19.57 14.39 14.46 8.87 13.73 -1.12 3.38IPO+3 80 56.28 17.00 50.10 18.29 13.60 12.35 8.56 11.25 -0.72 2.75IPO+4 88 59.22 18.80 52.79 17.55 12.69 16.57 5.93 16.86 -0.88 2.91IPO+5 89 62.37 17.42 56.54 16.53 9.14 14.79 4.45 10.39 -0.60 4.48IPO+6 82 65.34 17.13 59.91 16.81 5.28 15.13 0.87 7.62 0.17 3.43IPO+7 71 65.72 18.90 60.15 17.40 3.30 9.97 1.45 12.26 -0.90 2.74IPO+8 63 66.09 16.94 59.86 16.57 0.86 17.56 2.36 11.03 -0.71 2.24IPO+9 57 66.11 16.80 56.81 16.30 3.00 9.13 1.57 5.19 -0.86 1.79IPO+10 29 65.58 17.48 53.38 16.23 5.14 12.60 2.24 7.13 -1.40 3.95 Panel B: Calendar Year1994 19 52.01 26.50 43.60 22.40 13.79 14.43 11.91 18.66 -2.03 1.741995 38 50.19 21.14 42.10 18.53 10.06 12.21 10.35 16.11 -1.98 1.681996 41 51.50 18.17 40.86 17.80 12.12 11.06 14.16 14.14 -1.22 1.881997 54 55.12 17.41 44.49 16.07 18.65 12.85 15.10 13.35 -0.90 1.621998 79 59.76 15.90 56.23 14.90 24.43 16.24 9.39 18.36 -0.31 2.151999 91 61.87 15.01 61.63 14.23 8.27 11.15 1.58 5.90 0.03 2.942000 95 62.49 16.76 60.82 16.63 3.00 11.25 -0.25 5.11 -0.23 4.522001 96 64.21 17.25 58.38 16.96 3.50 11.42 0.69 8.06 -0.64 2.662002 95 65.44 18.91 58.98 16.86 3.78 10.71 1.08 7.29 -0.85 3.612003 98 64.65 18.90 52.27 16.88 2.19 17.70 4.21 12.50 -1.05 3.66 25
  27. 27. Table 4: Correlation between Leverage and Past Market to Book RatioIn this table, we present correlations between leverage ratio and past market-to-book ratios. Book leverageis calculated as book debt to total assets. Market leverage is book debt divided by the result of total assetsminus book equity plus market equity. Market equity is the product of number of share outstanding and thestock price. Market-to-book is defined as total assets minus book equity plus market equity then divided bytotal assets. We include all firms. The numbers in parentheses contain multiple observations on the samefirm from different calendar years for which past values of market-to-book ratio are available in SNLdatabase. Book Market MTB MTB MTB MTB MTB MTB MTB MTB MTB MTB Leverage Leverage t-1 t-2 t-3 t-4 t-5 t-6 t-7 t-8 t-9 t-10Book 1.00 0.73*** 0.23*** 0.25*** 0.23*** 0.26*** 0.23*** 0.21*** 0.18*** 0.20** 0.24** 0.26Leverage (715) (713) (715) (641) (567) (485) (396) (308) (225) (154) (93) (39)Market 1.00 -0.35*** -0.25*** -0.18 *** -0.15*** -0.17*** -0.18*** -0.07 -0.03 0.09 0.04Leverage (713) (713) (639) (565) (483) (394) (306) (223) (152) (92) (39)MTB t-1 1.00 0.84*** 0.66*** 0.59*** 0.64*** 0.58*** 0.33*** 0.31*** 0.33*** 0.35** (715) (641) (567) (485) (396) (308) (225) (154) (93) (39)MTB t-2 1.00 0.81*** 0.65*** 0.56*** 0.60*** 0.40*** 0.33*** 0.33*** 0.42*** (641) (566) (484) (395) (308) (225) (154) (93) (39)MTB t-3 1.00 0.83*** 0.61*** 0.45*** 0.44*** 0.40*** 0.32*** 0.44*** (567) (484) (395) (307) (225) (154) (93) (39)MTB t-4 1.00 0.81*** 0.53*** 0.39*** 0.52*** 0.42*** 0.31* (485) (395) (307) (224) (154) (93) (39)MTB t-5 1.00 0.74*** 0.48*** 0.55*** 0.59*** 0.31* (396) (307) (224) (153) (93) (39)MTB t-6 1.00 0.81*** 0.68*** 0.64*** 0.56*** (308) (225) (154) (93) (39)MTB t-7 1.00 0.79*** 0.64*** 0.66*** (225) (154) (93) (39)MTB t-8 1.00 0.82*** 0.75*** (154) (93) (39)MTB t-9 1.00 0.84*** (93) (39)MTB t- 1.0010 (39) 26
  28. 28. Table 5: Determinants of Annual Changes in Leverage and ComponentsWe investigate the impact of market-to-book on temporary change in leverage ratio in table 4. Thedependent variable in Panel A is annual change in book leverage. Besides the market-to-book ratio, wealso add percentage of real estate investment to total assets as proxy for asset tangibility, EBITDA to totalassets as proxy for profitability and logarithm of total revenue as proxy of firm size. These variables areproven to be connected with leverage ratio in Rajan and Zingales (1995). We run this model for each IPOyear as well as for all firms in SNL database between 1991 and 2003. We further decompose the change inleverage ratio into equity issues, retained earnings, and the residual change in leverage, which depends onthe total growth in assets from the combination of equity issues, debt issues, and newly retained earnings.We run the same models for each component and reported the results in Panel B, C and D. (M/B)t-1 (Reinvestment/A)t-1 (EBITDA/A)t-1 Ln (Revenue ) t-1Year N B t(b) c t(c) D t(d) e t(e) R-sqr Panel A: Change in book leverage %IPO+1 68 -2.65 -0.58 -0.23 -1.46 -0.07 -0.15 -1.60 -1.46 31.02IPO+2 68 0.61 0.11 -0.18 -1.60 -0.34 -0.48 0.63 0.62 17.61IPO+3 80 -2.81 -0.78 -0.13 -1.31 0.03 0.07 -0.59 -0.94 25.65IPO+4 88 14.06 2.40** -0.34 -2.61** -0.71 -1.40 0.72 0.68 21.71IPO+5 89 8.05 2.61** 0.06 0.68 -0.13 -0.36 -0.48 -0.68 13.20IPO+6 82 6.57 2.56** -0.13 -1.99** -0.46 -2.80*** 0.00 0.01 18.67IPO+7 71 2.62 0.85 -0.33 -2.77*** -0.75 -3.16*** -0.57 -1.13 30.88IPO+8 63 -3.63 -0.93 0.17 1.00 0.58 2.48** 2.43 4.05*** 50.70IPO+9 57 0.68 0.20 -0.15 -0.95 -0.08 -0.25 1.06 1.69* 0.00IPO+10 29 -1.34 -0.18 0.60 1.73* -0.19 -0.26 -0.45 -0.27 6.48All firms 715 2.41 1.85 * -0.11 -3.07*** -0.13 -1.21 0.07 0.28 14.97 Panel B: Change in Book Leverage Due to Net Equity Issues %IPO+1 68 -10.97 -1.73* -0.25 -1.17 0.34 0.50 0.58 0.38 1.13IPO+2 68 -11.15 -1.67* -0.26 -1.99* 0.21 0.36 2.03 1.67* 12.49IPO+3 80 -17.30 -3.40*** -0.14 -1.01 1.93 3.60*** -0.26 -0.29 13.43IPO+4 88 4.42 0.57 -0.29 -1.65 0.28 0.41 0.88 0.62 1.73IPO+5 89 -1.48 -0.41 -0.23 -2.33** 0.94 2.27** 1.75 2.11** 11.33IPO+6 82 1.70 0.55 -0.26 -3.42*** -0.16 -0.79 2.19 3.84*** 30.97IPO+7 71 -23.73 -4.23*** -0.45 -2.09** 0.05 0.11 2.04 2.22** 40.21IPO+8 63 -15.19 -3.19*** -0.01 -0.07 1.45 5.05*** 2.97 4.06*** 61.88IPO+9 57 -8.23 -2.28** -0.26 -1.58 0.11 0.33 0.71 1.05 9.94IPO+10 29 -3.71 -0.54 -0.05 -0.15 -0.46 -0.70 0.85 0.54 0.00All firms 715 -8.66 -5.15*** -0.23 -4.80*** 0.54 3.84*** 1.88 5.78*** 12.77 Panel C: Change in Book Leverage Due to Newly Retained Earnings %IPO+1 68 -1.64 -1.89* 0.06 1.90* -0.05 -0.55 -0.47 -2.30** 29.70IPO+2 68 -3.71 -2.43** -0.03 -0.86 -0.18 -1.34 -0.73 -2.63** 24.67IPO+3 80 1.51 1.39 0.05 1.58 -0.61 -5.30*** -0.24 -1.26 33.90IPO+4 88 -0.34 -0.26 -0.07 -2.29** -0.28 -2.47** -0.34 -1.46 10.61IPO+5 89 -2.49 -1.84* 0.08 2.25** -0.55 -3.52*** -0.98 -3.14*** 32.88IPO+6 82 -1.87 -1.99* 0.10 4.11*** -0.39 -6.49*** -0.37 -2.16** 68.50IPO+7 71 0.65 0.45 -0.04 -0.66 -0.29 -2.62** -0.38 -1.63 21.24IPO+8 63 2.01 1.59 -0.05 -0.91 -0.25 3.29*** -0.19 -0.96 34.84IPO+9 57 0.39 0.31 0.11 1.81* -0.19 -1.61 -0.23 -0.96 6.11IPO+10 29 -0.36 -0.09 -0.12 -0.65 -0.39 -1.05 -0.59 -0.68 0.00All firms 715 -1.82 -4.64*** 0.03 2.80*** -0.25 -7.79*** -0.39 -5.14*** 22.90 Panel D: Change in Book Leverage Due to Growth in Assets %IPO+1 68 9.96 2.07** -0.03 -0.21 -0.36 -0.70 -1.71 -1.50 42.83IPO+2 68 15.48 2.74*** 0.11 1.00 -0.38 -0.76 -0.67 -0.65 31.87IPO+3 80 12.99 2.89*** -0.03 -0.28 -1.30 -2.73*** -0.09 -0.12 26.84IPO+4 88 9.97 2.62** 0.01 0.12 -0.72 -2.17** 0.18 0.26 13.39IPO+5 89 12.02 3.94*** 0.21 2.44** -0.52 -1.49 -1.25 -1.78* 28.76IPO+6 82 6.74 2.11** 0.04 0.49 0.09 0.43 -1.81 -3.07*** 23.19IPO+7 71 25.70 4.86*** 0.16 0.79 -0.51 -1.24 -2.23 -2.57** 42.70IPO+8 63 9.55 3.35*** 0.23 1.89* -0.62 -3.58*** -0.35 -0.79 28.15IPO+9 57 8.51 3.24*** 0.01 0.07 0.00 0.01 0.58 1.18 18.73IPO+10 29 2.82 0.57 0.77 3.36*** 0.67 1.43 -0.70 -0.64 33.58All firms 715 12.88 10.01*** 0.08 2.32** -0.41 -3.86*** -1.42 -5.70*** 35.46 27
  29. 29. Table 6: Determinants of LeverageWe investigate the relationship between market-to-book and leverage ratio in table 5. Penal A, we followRajan and Zingales (1995) and use percentage of real estate investment, EBITDA to total assets andlogarithm of total revenue as control variables. In panel B, we add the weighted average market-to-bookratio which is proposed by Baker and Wurgler (2002) to capture the long-term effect of market-to-book onleverage ratios. We run this model for each IPO year as well as for all firms in SNL database between 1991and 2003. In Panel B, we do not include the weighted average market-to-book in IPO+1 and IPO+2regression due to the high correlation between the current market-to-book and weighted average market-to-book. (M/B)efwa,t-1 (M/B)t-1 (Reinvestment/A)t-1 (EBITDA/A)t-1 Ln (Revenue ) t-1 R-sqr % Year N b t(b) C t(c) D t(d) E t(e) f t(f) Panel A: Without Weighted Average Market-to-book IPO+1 68 5.54 0.81 -0.38 -1.60 0.06 0.07 0.67 0.42 5.52 IPO+2 68 4.83 0.51 -0.17 -0.90 0.47 0.58 2.47 1.46 4.13 IPO+3 80 -12.00 -1.50 -0.19 -0.86 1.62 1.96* 1.78 1.30 4.53 IPO+4 88 12.77 1.57 -0.39 -2.12 ** 0.85 1.27 2.84 1.97 * 13.40 IPO+5 89 13.09 2.31** -0.18 -1.14 1.21 1.92* 0.90 0.69 21.02 IPO+6 82 28.00 4.19*** -0.03 -0.15 -0.50 -1.08 0.23 0.17 26.33 IPO+7 71 6.82 0.60 -0.24 -0.55 -1.11 -1.27 0.90 0.49 0.00 IPO+8 63 28.24 2.71*** -0.67 -1.43 -0.58 -0.87 1.26 0.73 8.30 IPO+9 57 18.37 1.59 0.05 0.08 0.97 0.91 1.67 0.76 7.39 IPO+10 29 26.36 1.96* 1.06 1.55 -0.19 -0.14 -0.48 -0.15 23.18All firms 715 9.58 3.85*** -0.17 -2.45** 0.48 2.31** 2.30 4.85*** 10.53 Panel B: With Weighted Average Market-to-book IPO+1 68 5.54 0.81 -0.38 -1.60 0.06 0.07 0.67 0.42 5.52 IPO+2 68 4.83 0.51 -0.17 -0.90 0.47 0.58 2.47 1.46 4.13 IPO+3 67 11.47 3.99*** -23.67 -2.76*** 0.07 0.30 2.38 2.78*** 2.37 1.44 23.11 IPO+4 64 4.16 2.62** -3.68 -0.43 -0.58 -1.73* 0.59 0.71 3.87 2.06** 29.84 IPO+5 61 1.29 0.51 3.83 0.36 -0.28 -1.14 1.52 1.76* 1.02 0.64 25.57 IPO+6 52 12.95 4.24*** -12.48 -1.33 -0.10 -0.47 -0.74 -1.06 -2.80 -1.99* 55.65 IPO+7 39 36.81 3.75*** -25.70 -2.10** 0.35 0.57 -1.11 -1.25 -2.72 -1.41 25.30 IPO+8 34 34.28 3.25*** -19.46 -1.27 0.62 0.85 -0.01 -0.01 -0.94 -0.40 17.43 IPO+9 32 38.88 3.45*** -19.75 -1.42 1.00 1.41 0.04 0.03 -0.14 -0.06 21.30 IPO+10 17 38.41 2.83** -9.99 -0.62 1.74 2.56** -0.40 -0.20 2.81 0.72 37.24All firms 410 3.90 1.32*** -6.88 -1.89* -0.20 -2.11** 1.19 4.15*** 2.48 3.87*** 16.92 28