Another Hunt for the Capital Structure Puzzle: Leverage and Return Relationship in the REIT Market

1. Another Hunt for the Capital Structure Puzzle: Leverage and Return Relationship in the REIT Market 27.06.2009 Ralf Hohenstatt, dipl. econ.,Ph.D. student at the Chair of Real Estate Management

2. Schedule: • Motivation for the investigation • Related literature • Empirical Analysis • Empirical Results

3. Motivation for the investigation 1. Mentoring of a diploma thesis about Capital Structure of REITs • 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 2. Search for a proper research area for my dissertation • 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

4. 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 • 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 • 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

5. 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: • 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} • 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 * US-Treasury Bond with 6 months to maturity

6. Endogeneity or Joint Determination of regressors FTSE/NAREIT, S&P500, Property Focus, Time Dummies Debt Maturity SIZE TER Lev Profitability MB Asset Tangibility, Asset Maturity, Rating, Earnings Growth

7. Solution: system of simultaneous equations Equation 1 (of main interest): Equation 2:

8. Endogenous Variables in Equation 1 Debt Maturity SIZE TER Lev Profitability MB

9. Endogenous Variables in Equation 2 Debt Maturity SIZE TER Lev Profitability MB

10. Maximizing TER with respect to DM and Lev 2. Partial effect of Leverage on Total Excess Returns: 1. Partial Effect of Total Excess Returns on Leverage 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! • 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)!

11. Economic reasoning of the results and adjustment to prior research • 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. • Market environment and REITs specific characteristics (e.g. property focus) very robustly influence leverage . Capozza and Seguin (1998) • 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) • 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)

12. Shortcomings • No consideration of any variance measures: Sharpe Ratio, Variance of Earnings • No deep exploration of the leverage return relationship for different property types and no time series dimension of the property focus dummies. • No exploration of the L-R-Relation during boom and bust periods • No further equations in the system, i.e. for debt maturity. • Omitted variable: Liquidation value Shleifer and Vishny (1992) and Benmelech (2005) and Giambona, Harding and Sirmans (2007) • Astonishing: Balance sheet leverage was not identified to be endogenous but market leverage was?!

13. Coments and Suggestions Thank you very much for your attention!!!

14. SEM 3SLS Regression Results:

15. Hausman Test for Endogeneity

16. Boom and Bust Cycles

17. Descriptive Leverage Return Relationship

18. Descriptive Leverage Return Relationship

19. Distribution of Property Focus