Another Hunt for the Capital Structure Puzzle: Leverage and Return Relationship in the REIT Market27.06.2009Ralf Hohenstatt, dipl. econ.,Ph.D. student at the Chair of Real Estate Management

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Schedule:

1. Motivation for the investigation

2. Related literature

3. Empirical Analysis

4. Empirical Results

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Motivation for the investigation

1. Mentoring of a diploma thesis about Capital Structure of REITs

2. Search for a proper research area for my dissertation

No relationship between Sharpe-Ratio (dependent variable)

and leverage in a panel regression

No consideration of MB, Size, ROA

No consideration of joint determination or interactions of leverage and other variables

Challenging Econometric Analysis and data availability (SNL)

According to previous studies (next slide) expectation of consistent results

was promising

3. Financial Crisis raises again questions concerning debt

Why REITs?

Good data availability of US-REITs

Homogeneity due to legislation and focus on one industry

REITs have better possibility to collateralize debt than any other industry

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Related Literature

1. Barclay, Marx and Smith (2003): The Joint Determination of Leverage and Maturity

Focus on identification of endogenous variables Development of firm value as a function of maturity, leverage, investment opportunities

and regulatory environment

3. Giambona, Harding and Sirmans (2007): Explaining the Variation in Reit Capital Structure: The Role of Asset Liquidation Value

System of two equations: Leverage and Debt Maturity Focus on leverage and liquidation value

2. Ooi and Liow (2004): Risk-Adjusted Performance of Real Estate Stocks – Evidence from Developing Markets

Important paper for the explanation of the performance of real estate companies Combination of balance sheet data and market environment as explanatory variables

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Empirical Analysis: the variables

1. Sample: 306 US REITs, 1993-2008, quarterly frequency, 2.873 observations (missing data)

2. Dependent Variables:

Total Excess Return:

Leverage (market based):

3. Independent Variables:

* US-Treasury Bond with 6 months to maturity

Time Dummies for booms and busts, Property Focus Dummies, S&P500 Composite, FTSE/NAREIT All

REITs, Size, Size², Profitability/ROA, MB/Growth Opportunities, Income Growth, portion of senior hedged

debt, Asset Maturity, Asset Tangibility

Debt Maturity:

Credit Access: equals 1 if a REITs has a credit rating von S&P´s, Moody´s or Fitch, 0 otherwise

for t = {12, 24, 36, 48, 60, 72}

𝐓𝐄𝐑𝐭 = 𝐒𝐭𝐨𝐜𝐤𝐩𝐫𝐢𝐜𝐞𝐭− 𝐒𝐭𝐨𝐜𝐤𝐩𝐫𝐢𝐜𝐞𝐭−𝟏 + 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐒𝐡𝐚𝐫𝐞𝐭𝐒𝐡𝐚𝐫𝐞𝐩𝐫𝐢𝐜𝐞𝐭−𝟏 − 𝐈𝐑𝐭∗

𝐋𝐞𝐯𝐌𝐁(𝐭) = 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭𝐭𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐬𝐚𝐭𝐢𝐨𝐧𝐭

𝐃𝐌𝐭 = σሺ𝐃𝐞𝐛𝐭 𝐦𝐚𝐭𝐮𝐫𝐢𝐧𝐠 𝐢𝐧 𝐭 𝐦𝐨𝐧𝐭𝐡𝐬∗𝐭ሻ𝐭 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭𝐭

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Endogeneity or Joint Determination of regressors

TERTER LevLev

MBMB

SIZESIZE

ProfitabilityProfitability

DebtMaturity

DebtMaturity

FTSE/NAREIT, S&P500, Property Focus, Time Dummies

Asset Tangibility, Asset Maturity, Rating, Earnings Growth

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Solution: system of simultaneous equations

𝐓𝐄𝐑𝐢𝐭 = 𝛃𝟎 +𝛃𝟏𝐌𝐁𝐢𝐭+ 𝛃𝟐𝐒𝐢𝐳𝐞𝐢𝐭+ 𝛃𝟑𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲𝐢𝐭+ 𝛃𝟒𝐋𝐞𝐯𝐢𝐭+ 𝛃𝟓𝐋𝐞𝐯𝟐𝐢𝐭+ 𝛃𝟔𝐋𝐞𝐯𝐢𝐭∗𝐃𝐞𝐛𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭+

+ 𝛃𝟕𝐌𝐄𝐑ሺ𝐍𝐀𝐑𝐓𝐄𝐈𝐓ሻ+𝛃𝟖𝐌𝐄𝐑ሺ𝐒𝐏𝟓𝟎𝟎ሻ𝐢𝐭+ 𝛃𝐢𝐏𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐅𝐨𝐮𝐜𝐬𝐢 + 𝛃𝐣𝐃𝐓𝐢𝐦𝐞 + 𝐮𝐓𝐄𝐑,𝐢𝐭𝟐𝟎

𝐣=𝟏𝟓𝟏𝟒𝐢=𝟗

𝐋𝐞𝐯𝐢𝐭 = 𝛅𝟎 + 𝛅𝟏𝐌𝐁𝐢𝐭+ 𝛅𝟐𝐒𝐢𝐳𝐞𝐢𝐭+𝛅𝟑𝐈𝐧𝐜𝐨𝐦𝐞 𝐆𝐫𝐨𝐰𝐭𝐡𝐢𝐭+ 𝛅𝟑𝐃𝐑𝐚𝐭𝐢𝐧𝐠,𝐢𝐭+ 𝛅𝟒𝐓𝐄𝐑𝐢𝐭+ 𝛅𝟓𝐀𝐬𝐬𝐞𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭 ∗𝐃𝐞𝐛𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭+ 𝛅𝟔𝐃𝐞𝐛𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭+ 𝛅𝟕𝐀𝐬𝐬𝐞𝐭 𝐓𝐚𝐧𝐠𝐢𝐛𝐢𝐥𝐭𝐢𝐲𝐢𝐭+ 𝛅𝐢𝐏𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐅𝐨𝐮𝐜𝐬𝐢𝐭

𝟏𝟑𝐢=𝟖 + 𝐮𝐥𝐞𝐯,𝐢𝐭

Equation 1 (of main interest):

Equation 2:

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Endogenous Variables in Equation 1

TERTER LevLev

MBMB

SIZESIZE

ProfitabilityProfitability

DebtMaturity

DebtMaturity

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Endogenous Variables in Equation 2

TERTER LevLev

MBMB

SIZESIZE

ProfitabilityProfitability

DebtMaturity

DebtMaturity

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Maximizing TER with respect to DM and Lev

2. Partial effect of Leverage on Total Excess Returns:

Ceteris paribus, REITs with higher Excess Returns are less levered (Equation 2)!

Given the „fact“ that leverage and debt maturity are substitutes and jointly determined it follows: Leverage and Debt Maturity have to be set to minimize their sum in order to maximize Excess Returns (Equation 1)!

Positive partial impact of leverage on total excess returns

up to the maximum requires leverage ratios smaller than

48% and average debt maturities smaller than 43,4

months!

1. Partial Effect of Total Excess Returns on Leverage

𝐝𝟐𝐓𝐄𝐑𝐢𝐭𝐝𝟐𝐋𝐞𝐯𝐢𝐭 = −𝟐,𝟒𝟏𝟐 < 𝟎

𝐝𝐋𝐞𝐯𝐢𝐭𝐝𝐓𝐄𝐑𝐢𝐭 = −𝟎.𝟒𝟑𝟑

𝐋𝐞𝐯𝐢𝐭 = 𝟎,𝟒𝟖− 𝟎,𝟎𝟏𝐃𝐌𝐢𝐭 𝐃𝐌𝐢𝐭 = 𝟒𝟑,𝟑𝟕− 𝟖𝟗,𝟑𝟑𝐋𝐞𝐯𝐢𝐭

𝐝𝐓𝐄𝐑𝐢𝐭𝐝𝐋𝐞𝐯𝐢𝐭 = 𝟏,𝟏𝟕𝟏 − 𝟐∗𝟏,𝟐𝟎𝟔∗𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞𝐢𝐭− 𝟎,𝟎𝟐𝟕∗𝐃𝐞𝐛𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭 = 𝟎

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Economic reasoning of the results and adjustment to prior research

1. Higher leverage is associated with higher sensitivity to macroeconomic factors namely

unexpected inflation as well as risk and term structure of interest rates. Chan, Hendershot

and Sanders (1990). This problem is even more severe if debt maturities are relatively long

because interest rate and inflation risk increases in debt levels and debt maturity likewise.

2. Market environment and REITs specific characteristics (e.g. property focus) very robustly

influence leverage . Capozza and Seguin (1998)

3. Other endogeneity issues with respect to (balance sheet) leverage like credit rating and

financial flexibility are still not ruled out. Graham and Harvey (1999). Upon that target

(balance sheet) leverage ratios might mainly justified by receiving an investment grade rating.

Brown and Riddiough (2003)

4. The portion of senior debt has no impact on excess returns although it is strongly suggested

by capital structure theory. Ambrose, Bond and Ooi (2009)

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Shortcomings

1. No consideration of any variance measures: Sharpe Ratio, Variance of Earnings

2. No deep exploration of the leverage return relationship for different property types

and no time series dimension of the property focus dummies.

3. No exploration of the L-R-Relation during boom and bust periods

4. No further equations in the system, i.e. for debt maturity.

5. Omitted variable: Liquidation value Shleifer and Vishny (1992) and Benmelech

(2005) and Giambona, Harding and Sirmans (2007)

6. Astonishing: Balance sheet leverage was not identified to be endogenous but

market leverage was?!

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Coments and Suggestions

Thank you very much for your attention!!!

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SEM 3SLS Regression Results:

SME 3SLS

Estimator T-Stat Estimator T-Stat

Total Excess Return - - -0.433 -1.75*LeverageMB 1.171 2.05** - -

Constant -0.058 -1.56 1.117 27.06***MB-Ratio 0.038 9.03*** -0.066 -22.72***

Log(Size) -0.019 -1.72* -0.027 -7.42***

Log(Size)² 0.021 1.23 0.009 -1.48

Profitability 0.292 2.35*** - -

Income Growth - - -0.751 -1.45

Rating - - 0.027 4.85***

Debtmaturity - - -0.023 -3.57***

Asset Maturity * Debt Maturity - - 0.000 -0.79

Asset Tangibility - - 0.082 1.65*

LeverageSD 0.121 1.42 - -(LeverageMB)² -1.206 -2.41** - -

Interaction LeverageMB*Debtmaturity -0.027 -1.94* - -

Market Excess Return S&P500 0.113 1.75* -0.036 -1.56Market Excess Return FTSE/NAREIT 0.377 9.04*** - -

Time Dummie 1992-1994 0.005 0.033 - -Time Dummie 1995-1997 0.175 1.65* - -Time Dummie 1997-1999 0.028 0.33 - -

Time Dummie 1999-2002 0.059 0.89 - -Time Dummie 2002-2004 0.049 1.10 - -Time Dummie 2004-2007 0.061 2.74*** - -

Apartment/Multifamily -0.008 -2.86*** -0.125 -3.60***Hotel 0.007 -1.71* -0.341 -4.39***Office -0.004 -1.09 -0.272 -0.70

Retail/Shopping -0.005 -0.09 -0.171 -4.13***

Diversified 0.012 0.20 -0.170 -3.37***Health Care/Specialty -0.011 -3.20*** -0.110 -2.99**

Probability (F-Statistic)Standard Error of Regression

Equation 1 Equation 2

0.065 0.084

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Hausman Test for Endogeneity

Hausman Test for Equation 1Regressor Estimator T-Stat of ResidualsMB 0.002 0.24Size -0.181 -3.79***Profit -0.192 -2.83***

LeverageMB-0.565 -4.27***

LeverageBS-0.036 -1.18

LeverageSD -0.100 -0.91

***:=p-value<1%, **:=p-value<5%, *:=p-value<10%

Hausman Test for Equation 2Regressor Estimator T-Stat of ResidualsMB 0.214 19.86***Size -0.066 -4.59***Profit -0.590 -3.45***Debt Maturity 0.001 -4.59***TER -0.288 -11.20***

***:=p-value<1%, **:=p-value<5%, *:=p-value<10%

𝐌𝐁𝐢𝐭 = 𝛄𝐨 + 𝛄𝟏𝐌𝐄𝐑(𝐍𝐀𝐑𝐓𝐄𝐈𝐓)𝐢𝐭+ 𝛄𝟐𝐌𝐄𝐑(𝐒𝐏𝟓𝟎𝟎)𝐢𝐭+ 𝛄𝐢𝐏𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐅𝐨𝐮𝐜𝐬𝐢 + 𝛄𝐣𝐃𝐓𝐢𝐦𝐞 + 𝛄𝟑𝐀𝐬𝐬𝐞𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲𝐢𝐭+ ⋯+ 𝐮𝐌𝐁𝐭𝟔

𝐣=𝟏𝟔

𝐢=𝟏

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Boom and Bust Cycles

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Descriptive Leverage Return Relationship

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Descriptive Leverage Return Relationship

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Distribution of Property Focus