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 of how REITs choose among different financing options when they raise external capital is largely unexplored. In this paper, we examine the capital structure of REITs to answer two questions: is there a relationship between market-to-book and leverage ratios? and, does market-to-book have a temporary or a long-term impact on leverage ratios? Our results suggest that REITs with high market-to-book ratios have high leverage ratios, and historical market-to-book has long-term persistent impact on current leverage ratio. We interpret these findings as supportive of pecking order 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 of Connecticut, Storrs, CT, USA. All correspondence may be addressed to Zhilan Feng at fengz@union.edu.

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 firms

because regulation is often designed to address the very same market imperfections that theory

focuses on. The first motivation of our paper primarily draws from the unique regulatory

environment REITs operate in. REITs were primarily created as an investment vehicle for

institutions that tended to avoid investing in real estate assets because of lack of transparency and

liquidity. In essence, the regulation on REITs are geared more to induce investment than to

prevent neglect of fiduciary responsibility.

There are mainly three good reasons to issue debt. One, it raises cash. Two, interest

payments are tax deductible so that the tax shield adds value to the firm. Three, the mandatory

interest payment on debt mitigates the agency cost of managerial proclivity to waste cash on poor

investments. On the negative side, borrowing exposes the firm to bankruptcy costs; and, leverage

may prompt managers to avoid profitable investments to minimize transfer of wealth to

bondholders. Like debt, equity raises cash, but issue costs can be significant if investors discount

the value of shares out of concern that managers issue shares only when they are overvalued. On

balance, debt appears to be the less costly alternative. Over the years, the search for an optimal

capital structure has been largely empirical, albeit elusive.

A second, and potentially more interesting, motivation of our research is the recent

controversy 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 the

trade off between benefits and costs of borrowing. Among the benefits, the most significant is the

tax deductibility of interest payments, but costs of financial distress can be substantial. While

firms deviate from the optimum capital structure in the short term, the long term capital structure

is invariant. The theory implies that adjustments in capital structure in response to fluctuations in

valuation of the firm, and capital needs are temporary; capital structure regresses to the optimal

level in the long run. The evidence on actual capital structure choices lends only scant support to

the trade off theory.

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The pecking order theory developed by Myers and Majluf (1984) is more potent simply

because it provides a better description of actual managerial behavior. The model, based on

information asymmetry between shareholder and managers, says that if managers are more

informed than shareholders about the firm’s prospects, they would be tempted to sell new shares

only when they are overvalued. Wary shareholders will anticipate this and revalue shares

downwards. 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 those

with insufficient free cash flow will have high debt ratios. A more dynamic version of the theory

states that high growth firms may reduce leverage and use retained earnings for current

investment to avoid issuing equity if and when need for additional funds arises in the future. An

important implication of the theory is that no optimal capital structure exists, rather capital

structure 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 more

behavioral in nature and scope and simply states that long-term capital structure is merely a

manifestation 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 market

values and tend to issue equity more often, resulting in low leverage ratios. The idea is that if

market associates high market values with low adverse selection costs, that presents high growth

firms with the opportunity to issue equity at an advantage. It is noteworthy that the market timing

theory and the simple pecking order theory have opposite implications for the relation between

market values and debt ratios. Neither theory identifies an optimal capital structure, however.

A final question that has attracted considerable attention is whether changes in capital

structure are permanent. Trade off theory implies that any change in capital structure is

temporary and firms regress to the long term optimum over time. There is no such implication

under the pecking order or the market timing theories. An evidence of a permanent relation

between the need (investment opportunities) and sources (financing choices) of capital is

sufficient to unequivocally reject the trade off theory.

While the theoretical underpinnings of the theories are well developed, the empirical

evidence is mixed, at best. It is only recently that the empirical enquiries have focused on the

dynamics of the evolution of capital structure over time. Shyam-Sunder and Myers (1999) claim

support 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

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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 the

other two. It is worth noting all studies of capital structure decisions over time reject trade off

theory unequivocally.

Because of their unique regulatory environment, we contend, REITs are an ideal

laboratory setting to provide additional evidence on these competing theories. First, REITs do

not pay any taxes if 95% of taxable earnings are paid out as dividends. Second, high payout

implies that REITs have low free cash flow, such that managers have little opportunity to waste

cash 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 anecdotal

evidence is clearly inconsistent with this notion.1

The requirement that 95% of the taxable earnings be paid out as dividends forces REITs

to 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 of

adverse selection which must be borne by the existing shareholders. We argue that these costs

are particularly severe for REITs. For example, monitoring REIT managers calls for special

skills and knowledge about general and local economic trends, conditions of comparable

properties, complex financing arrangements, other specialized skills, and even inside information

[Han (2004)]. In addition, since REITs are involved in real property transactions that include a

wide range of heterogeneous, illiquid assets, it is difficult for shareholders to determine the fair

market values of these transactions. This results in lack of transparency which makes monitoring

of 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 the

standard governance mechanisms. To elaborate, to qualify as a REIT, the firm must maintain a

diversified ownership with at least 100 shareholders, the five biggest of which may not own more

than 50 percent of the total shares outstanding. Campbell et al. (2001) contribute the lack of

hostile takeovers among REITs to this regulation. This unique ownership structure diminishes

the effectiveness of monitoring by the market for corporate control, and exacerbates the lack of

transparency. In essence, issuing equity is a particularly costly proposition for REITs. Under

this scenario, pecking order theory predicts financing first with retained earnings, then debt, and

1 Brown and Riddiough (2003) reports that over the period September 1993 to March 1998, REITs made a 120 debt offerings of $133m each, on average.

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equity last. Since retained earnings are very low for REITs, pecking order leans heavily towards

debt financing.

Finally, market timing theory suggests that managers look for opportunities to time

equity issues when adverse selection costs are low. It may be argued that these opportunities are

relatively scarce for REITs because of lack of transparency and incomplete monitoring. In

summary, the trade off prediction of all equity contradicts anecdotal evidence, pecking order calls

for 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 exceeds

the cost of financial distress, and equity otherwise. The choice of financing is essentially an

empirical issue. The clear advantage with REITs is that because of low retained earnings, the

financing decision may come down to a simple choice between debt and equity.

To determine how capital structure evolves over time, and the persistence of capital

structure change, a time series analysis of the relation between needs and sources of financing

must be conducted. Baker and Wurgler (2002) study the firms’ financing decision from the initial

public offering (IPO). Conceivably, issuing debt is not appealing at the IPO stage because young

firms are considered more risky. As the firm matures, financing decisions reflect both pure

adjustments (if any) in capital structure and need for investment funds. It is generally assumed

that need for funds is a function of the firm’s investment and growth opportunities and the

standard sources of capital include retained earnings and security issuances. The standard proxy

for need for funds is the market value to book value ratio, the assumption being that high market

value 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 using

the same approach as Baker and Wurgler (2002). Over this period, we follow the REITs from the

year they go IPO to the last surviving year. The sample size is therefore driven by the IPO

activity of REITs. The most active years were 1994, 1995 and 1996 when over 50 REIT IPOs

raised capital. The smallest sample size is 4 in 1992, steadily growing to the largest sample size

of 108 in 2003. We use market to book ratio as a proxy for investment opportunities and firm’s

need for capital. The analyses based on contemporaneous data reveal a weakly significant

positive relation between M/B ratio and leverage, strongly negative relation between M/B ratio

and net equity issues, and weak relation between M/B and retained earnings. The long term

weighted average M/B ratio is a strongly significant determinant for leverage ratio which

suggests that the effect on M/B ratio on leverage is not transient and firms do not adjust their

leverage ratios to a target level. The long-term persistence of leverage decisions is inconsistent

with the trade off theory. The long-term as well as the contemporaneous evidence is not

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consistent with the market timing theory. We find weak evidence in favor of the pecking order

theory 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 in

Baker and Wurglar (2002) for a broader data set, and subject to interpretation vis-a-vis the

conclusions in Brown and Riddiough’s (2003) analysis of REIT capital structure. Baker and

Wurglar find evidence in line with the market timing theory. A potential explanation for the

differential findings is that the window of opportunity when adverse selection costs are low is less

frequent and narrower for REITs. The lack of transparency of real estate assets, and the

consequent information asymmetry is a contributing factor. Reinforcing the problem is the

restrictive ownership requirements in REITs which makes it difficult for blockholders to form

ownership stakes, and diminishes their incentive to monitor management. A sheltered

management widens the credibility gap between shareholders and managers.

Brown and Riddiough (2003) analyze public issues by REITs over the years 1993-1998

and document several stylized characteristics of these offers. An important finding is that offer

spreads are positively related to maturity, which suggests that if performance improves and

market value increases over time, market expects REITs to sell more debt so that, ex ante, offer

spreads are higher for longer maturity issues. The authors further report that REITs use public

issue proceeds primarily for investment purposes so that security sales often induce capital

structure changes. These findings are consistent with the existence of a target leverage ratio as

suggested by the trade off theory. However, testing the theories of capital structure requires that a

time series analysis of financing decisions be undertaken. In the short run, trade off and pecking

order (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 capital

structure. 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, and

conclude in section VI.

II. Literature Review

A. Tradeoff Theory

Tradeoff theory posits that the firm has a target debt ratio which is determined by the

tradeoff between the costs and benefits of borrowing, with the firm’s assets and investment plans

held constant. The most significant benefit of debt financing is the tax shield of interest

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payments. Mandatory interest payment reduces free cash flow which mitigates the agency

conflict between securityholders and managers. This implies higher leverage and payout ratios

for profitable firms, and the opposite for firms with more investments. The cost of financial

distress is the major downside of debt financing. Further, from the shareholders’ perspective,

leverage may induce managers of struggling firms to avoid profitable investments because most

of 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 debt

targets are more likely to issue debt. Firm size, cost of financial distress and asset composition

were the significant determinants of firm’s leverage ratio. He also finds some evidence for the

market timing theory. Specifically, the results demonstrate that firms with large share price

increases tend to issue equity, and prevailing market conditions influence firms’ finance

decisions. 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 past

profitability tends to reduce a firm’s debt level. The latter evidence is more in line with the

pecking order theory. Rajan and Zingales (1995) use a sample of corporations from G-7

countries to investigate the capital structure choices across countries. They find some evidence

consistent with tradeoff theory. For example, tangibility is positively correlated with leverage in

all countries. Consistent with market timing, the market-to-book ratio has a significant and

consistently negative relationship with leverage in all countries. Size is positively correlated with

leverage 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 point

out, however, a deeper examination of the evidence suggests that the current capital structure

models fail to fully explain the observed patterns.

Under the tradeoff theory, deviations from target capital structure are only temporary. In

a dynamic setting, firms make financing choices to adjust the debt ratio to the long-term optimum

which implies that no systematic relation between debt ratio and the firm’s investment

opportunities is predicted. However, if costs of financial distress varies across firms, a cross

sectional variation in optimum capital structure is expected. For example, high-growth firms that

are more sensitive to fluctuations in business outlook and are therefore more vulnerable due to the

costs of financial distress, choose to use less debt financing. Highly profitable firms, on the other

hand, can risk higher debt ratios. The findings in Smith and Watts (1992) and Barclay, Morellec,

and Smith (2001) are consistent with this notion.

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B. Pecking Order Theory

Developed by Mayers (1984) and Mayers and Majluf (1984), the pecking order assumes

that 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 poorly

performing firms will have the incentive to issue equity. The avoidance of adverse selection cost

is the main motivation for firms to prefer the safest security available, which means that firms

always choose debt over equity if bankruptcy costs are not an immediate concern. Hence, high

growth firms that need more external capital end up with high leverage ratio. The dynamic

pecking order theory, however, predicts that, holding profitability constant, firms with more

investment opportunities keep payout low to conserve funds, and maintain low leverage to

preserve debt capacity so as not to be forced into high debt in the future. These firms are forced

to have high leverage only if adjustments in dividend payout are difficult, and investment

commitments are persistently large. On the other hand, holding investments fixed, more

profitable firms have higher payout ratios and lower leverage ratios because they have larger cash

reserves, and can withstand adversities better.

Shyam-Sunder and Myers (1999) study a sample of mature corporations with continuous

data on flow of funds between 1971 and 1989. They find that pecking order theory has much

greater time-series explanatory power than a static tradeoff model. They conclude that pecking

order is an excellent first-order descriptor of corporate financing behavior. Clearly, if companies

have well-defined optimal debt ratios, managers are not much interested in getting there. One

criticism of the Shyam-Sunder and Myers (1999) study is that the inferences are based on a rather

small sample.

Fama and French (2002) present a comprehensive analysis of the complementary and

contrasting implications of the tradeoff and pecking order theories for both dividend payout and

leverage ratios. They identify profitability and investments and the interaction thereof as the key

determinants of financing and dividend decisions. Consistent with both trade off and dynamic

pecking order theories, they find firms with more investments are less levered. Next, their

finding that more profitable firms have less leverage supports the pecking order, and contradicts

the trade off story. Further support for the pecking order theory draws from the evidence that for

dividend paying firms, short-term variation in investment and earnings is mostly absorbed by

debt. Finally, the authors report that the least-levered and non-dividend paying firms (typically

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small, growth firms) make the largest net new issues of equity which is contrary to the pecking

order theory. Among other authors to report evidence inconsistent with pecking order theory are

Helwege and Liang (1996) and Frank and Goyal (2002). Using a panel of IPO firms, Helwege

and Liang (1996) find no relationship between the decision to raise external funds and the

shortfall of internally generated funds. Studying the financial activities of US firms from 1971 to

1988, Frank and Goyal (2002) conclude that new equity issues track the financing deficit more

closely 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 condition

is 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- or

over-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, the

market timing theory [Baker and Wurgler (2002)] asserts a negative relation between market

value to book value ratio and the firm’s leverage ratio. This is contradictory to the simple form of

the 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 negative

impact on firm’s leverage ratio. Their data further reveal that most of the financing is done by

issuing equity, not through retained earnings. The authors reject the trade off and pecking order

models and interpret the result as supportive of the notion that current leverage ratio is a

cumulative outcome of firm’s previous attempts to time the market.

In summary, while the three theories have several overlapping implications, they also

make some predictions that can be useful to infer which one best fits observed capital structure

choices. We highlight the aspects of each theory that is unique. The trade off theory predicts a

target capital structure that firms regress to in the long run, implying that any relation between

capital structure and profitability or investments is transient. Neither the pecking order theory nor

the market timing theory identifies an optimum capital structure. For dividend-paying (non

dividend-paying) firms, the pecking order theory predicts a long run positive (negative) relation

between market to book value ratio and leverage ratio. The market timing theory leads to a long

run positive relation between market to book value ratio and leverage ratio for all classes of firms;

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the difference between the two is that under pecking order, funds are drawn from retained

earnings 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 structure

from 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 as

dividends. This nullifies two significant benefits of debt financing. One, the tax deductibility of

interest payments and the tax shield is non-existent. Second, since most of the earnings is

distributed, 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 financial

distress further reinforce the preference for equity. The only effect that induces less than all

equity capital is that asymmetric information between shareholders and managers causes

valuation discounts. In the aggregate, if REITs have an optimum capital structure, it includes

relatively low level of debt.

The main motivation to prefer debt over equity issues is that managers may use

privileged information to sell overvalued equity and shareholders are aware of it. So, an equity

issue is always discounted by the market. Greater the information asymmetry, higher is the

discount. Information asymmetry is particularly severe in REITs because the transparency of the

underlying assets is less than perfect. For example, analysis of REIT assets may require special

skills and knowledge about general and local economic trends, conditions of comparable

properties, and complex financing arrangements. In addition, shareholders may find it difficult to

determine the fair market values of real estate transactions because they often include

heterogeneous, and illiquid assets.

Restrictions on REIT’s income sources and investment options may further exacerbate

the information asymmetry. The restrictions that REITs derive their income largely from real

estate 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 less

employable, and induces them to avoid hostile takeovers [Campbell, Ghosh, and Sirmans]. The

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requirement that no single investor owns more than 10 percent of REIT shares deters blockholder

formation. In conjunction, these regulations make managers less vulnerable to the discipline of

the takeover market, and render the board weak. Weak monitoring allows opportunistic

managers to reveal less information. Under this scenario, REITs would be expected to avoid

equity issues and prefer funding investment from retained earnings first, then sell debt if more

capital is needed. A more complex form of pecking order, Myers (1984) notes, states that firms

with generous reserves of cash may avoid issuing debt to preserve debt capacity for future capital

needs, 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 because

of 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 market

to 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 and

across 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 share

prices to abnormally high levels. Because of the reasons narrated above, the opportunities of low

adverse selection costs may be relatively infrequent for REITs. Under this premise, the market

timing theory prediction of a long-term negative (positive) relation between market to book value

ratio and leverage (equity issues) is questionable for REITs.

The theories and hypotheses are summarized in table 1. Trade off theory predicts a low

long term target debt ratio. The simple pecking order theory implies a positive relation between

debt ratio and market value to book value ratio. The complex pecking order theory which

implies a negative relation between market to book ratio and leverage for cash rich firms may not

hold for REITs. The market timing theory predicts a negative relation between market value to

book value ratio and leverage and requires opportunities when adverse selection costs are low, a

less likely event for REITs.

B. Empirical Evidence

The first attempt to analyze capital structure of REITs from the perspective of valuation

was 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 a

negative reaction to debt issues is predicted. A negative reaction is consistent also with the

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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 unexpected

security offerings suggest that operating cash flows are lower than expected. A positive reaction

to debt sales follows only from Ross’s (1977) assertion that debt issues convey the favorable

information that future earnings will be sufficiently large to support the mandatory interest

payments. Extant literature [Mikkelson and Partch (1986), and Eckbo (1986)] documents non-

positive to significantly negative reaction to debt offerings. Contrary to these studies, Howe and

Shilling (1988) find a significant positive reaction, which they interpret as weak support for

Ross’s signaling hypothesis.

In an important and comprehensive piece, Brown and Riddiough (2003) study the public

offerings by equity REITs between September 1993 and March 1998, and identify numerous

patterns in the issuance behavior. While the scope of the research seems limited to identifying

some stylized facts about REIT capital structure, certain results have bearing on our analyses. A

significant finding is that maturity of public REIT debt is positively related to offer spread. The

authors point out that if credit market participants assess that REITs issue debt when they are

aggressively leveraged, and if they anticipate that REIT balance sheets will strengthen in the

future, then credit spreads should decline with maturity. On the other hand, if REITs issue public

debt at long-term target leverage ratios, then credit spreads are predicted to increase with

maturity. 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 also

suggests a target long-run debt ratio, an alternative explanation – consistent with pecking order

theory -- is that as long as REITs can attain minimum investment-grade credit rating, they prefer

to issue debt instead of equity to boost their credit ratings. Further, a significant number of

REITs that issue equity are highly leveraged and remain so subsequently. Apparently, firms issue

equity only when bankruptcy threat looms large, and even at this juncture, they raise just enough

equity capital to mitigate the funding pressure. Finally, REITs with higher total assets and

revenues 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 the

pecking order model, REITs largely fund investment with bank lines of credit and other sources

of private debt. When these sources are exhausted, REITs access the public capital market and

use 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 tax

advantage, the standard deadweight costs of financial distress, and the pecking order and free

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cash flow rationales being muted by the dividend payout requirements2, REITs prefer issuing debt

and choose equity only as a last recourse. Howe and Shilling’s (1988) analysis demonstrates that

the 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 all

accounting and firm specific information required for analyses from 1991 to 2003 are available in

the 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 real

estate, stock price, and the total number of shares outstanding. We also identify the IPO date for

each firm during 1991 to 2003. Table 2 shows the number of REITs in SNL database that went

IPO 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 on

leverage ratio. However, missing values reduce the sample size when we test the long-term

relationship between market-to-book and leverage ratios. This limits the scope and interpretation

of 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 then

stabilizes at 108 in 2003. That most firms survived during the entire period under study is

apparent in the low attrition reported in panel B. By the tenth year after IPO, as many as 30 of

the original 33 REITs remained in the sample. However, as evident in column 2, availability of

data is very limited for young IPO firms during the early years of our study. For example, only

68 of the eligible 107 firms have data in the first year after IPO. The proportion is much higher

as the firms mature.

Leverage is measured as the ratio of book value of debt to book value of assets. As

Myers (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 investment

decisions. As a result, in practice, managers have a good reason to calculate debt ratios using

2 Free cash flow rationale of debt financing states that mandatory interest payment on debt mitigates the agency cost of free cash flow. This is muted for REITs by the regulatory requirement to payout 95% of taxable income as dividends.

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book values. Additionally, we investigate the impact of investment opportunities on leverage

ratios. Titman and Wessels (1988) and Fama and French (2002) suggest that a negative

relationship between market leverage and investment opportunities may simply be a

manifestation of better investment producing higher market values, rather than the workings of

trade-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 total

liabilities and preferred stock plus deferred taxes and convertible debt. Book leverage is

calculated as the ratio of book debt to total assets (D/A). Market leverage is book debt divided by

total assets minus book equity plus market equity. Market equity is the product of number of

shares outstanding and the stock price. Net equity issues (e/A) is defined as the change in book

equity 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 debt

issued (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 financing

by 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 data

base studied by Baker and Wurgler (2002). During 1991 to 2003, REITs maintain a debt ratio of

above 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 over

calendar years reveal the same pattern.

Higher leverage ratio for REITs is consistent with the pecking order theory, but contrary

to tradeoff and market timing models. Tradeoff theory predicts lower book leverage for REITs

due to the tax exempt status and lower free cash flow problem. The business nature of REITs

makes 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 pecking

order model, firms with high asymmetric information tend to resort to debt when they need

external funds, and are more likely to have high leverage ratios. Market timing certainly provides

no rationale for this phenomenon. If REITs behave like other firms in choosing the source of

external capital, and raise equity under favorable market conditions and debt under unfavorable

market conditions, it is hard to reconcile why REITs, on average, have higher leverage ratios

relative to other types of firms.

13

Second, we observe an increasing trend in debt ratio as the maturity of REIT firm

increases. This trend is consistent with table 2 in Baker and Wurgler (2002). The average debt

ratio is 52 percent one year after IPO and steadily grows to 66 percent ten years later. If firms

have a target capital structure in mind, it is difficult to reconcile why debt ratio is growing

continuously over the years. The average debt ratio also increases over the calendar years. This

trend can be explained only as an age effect, not a survival effect. Most REITs in 2003 have a

trading history of at least 4 to 5 years. This pattern contradicts the reversion to target capital

structure over time prescribed by the trade off theory.

Finally, REITs issue more debt than equity in nine out of ten years after IPO (seven out

of ten years based on calendar year). Although the percentage of net debt issued is decreasing

over the years, it is the driving force in the annual change in total assets. Consistent with the

prediction of pecking order theory, this result suggests that REIT managers turn to debt financing

first, before they consider equity financing. On the other hand, both tradeoff theory and market

timing theories predict firms depend on debt financing in some years and on equity financing in

other years depending on leverage ratio and cost of adverse selection cost.

In table 4, we report the correlation between various variables. Most interesting is the

persistently positive relation between book leverage ratio and market-to-book ratio over the past

ten years. The 9-year back market-to-book ratio is still positively associated with the current

book leverage ratio. The univariate analysis thus demonstrates a persistent and positive long-term

impact of market-to-book on leverage ratio, which constitutes strong evidence against trade off

and 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 expressed

in terms of how leverage ratio varies with profitability and investment opportunities. We use

market-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 than

adjustments in capital structure provides some justification for the use of M/B ratio as a

determinant of debt ratio. Under trade off theory, bankruptcy costs are lower, and leverage higher

for more profitable firms. To minimize agency cost of free cash flow, profitable firms use higher

leverage to disgorge more of firm’s excess cash. Conversely, firms with more investment

opportunities have less free cash flow and can have low leverage ratio. Pecking order theory

asserts that to avoid sale of discounted equity, firms fund investment with retained earnings first,

14

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 time

equity issues when equity is overvalued. If investment opportunities are persistent, a long-term

negative 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. Following

Baker and Wurgler (2002) and Rajan and Zingales (1995), we include three variables that are

correlated with leverage.

1111 −−−−

⎟⎠⎞

⎜⎝⎛+⎟

⎠⎞

⎜⎝⎛+⎟

⎠⎞

⎜⎝⎛+=⎟

⎠⎞

⎜⎝⎛−⎟

⎠⎞

⎜⎝⎛

ttttt AEBITDAd

AntREinvestmec

BMba

AD

AD

tt

t uADfSe +⎟⎠⎞

⎜⎝⎛++

−−

11)log( (1)

The sign of coefficient b is the main focus of this equation. Both tradeoff and market timing

theory predict a negative sign, while pecking order suggests the opposite. A more complicated

version of pecking order asserts that firms with larger expected dividends may keep current

leverage low to preserve debt capacity so as to avoid funding future investments with new risky

securities [Myers (1984)]. For REITs, however, such a strategy may not be feasible because of

the 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 much

variability is not expected in the data. Hence, we do not expect a relationship between tangible

assets 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 required

to pay out 95 percent of the earnings as dividends. Hence, there is limited free cash flow and a

significant relationship between profitability and leverage may not emerge. The natural

logarithm of total revenue is used as a proxy for firm size. As large firms are less likely to suffer

financial distress, they might be associated with high leverage if the financial distress costs are

considered to be of first-order importance to the firms (as tradeoff theory suggests). Fama and

15

French (2002) argue that larger firms may have less volatile earnings which will also induce a

higher leverage ratio. Therefore, in accordance with trade off theory, we expect the coefficient of

firm size to have a positive sign. Finally, we add the lagged leverage in our model, as Baker and

Wurgler (2002) suggest, to control for the fact that debt ratio is bounded from 0 to 1. It is

expected to have a negative sign3.

Panel A of table 5 reports the regression results from equation (1). We run this model for

each year after IPO (IPO regressions). This allows us to study the changes (if any) in capital

structure as the firm matures. We also construct the full 1991 to 2003 SNL sample for

comparison. The regression estimates for the sample with all firms contains multiple

observations on the same firm from different calendar year. First, the negative and significant

coefficient of real estate investment and non-significance of the coefficient of firm size do not

support 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 regression

which is contrary to market timing and the trade off theory, but consistent with the pecking order

story. It is also interesting to note that the non-negative coefficient for M/B is not consistent with

the Myers (1984) dynamic form of pecking order model which states that in anticipation of

funding requirements for higher investments in the future, firms may preserve debt capacity by

using retained earnings for current needs. While regular dividend paying firms with stable cash

flow are most capable of following this strategy, REITs are at a disadvantage because of high

payout requirements. In essence, the positive sign for M/B ratio allows us to unequivocally reject

the 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 order

theory. 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 into

equity issues, retained earnings, and the residual change in leverage, which depends on the total

growth 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 never significant in any level.

16

⎥⎦

⎤⎢⎣

⎡⎟⎟⎠

⎞⎜⎜⎝

⎛−−⎟⎟

⎠

⎞⎜⎜⎝

⎛ ∆−⎟⎟

⎠

⎞⎜⎜⎝

⎛−=⎟

⎠⎞

⎜⎝⎛−⎟

⎠⎞

⎜⎝⎛

−−

− 11

1

11

ttt

t

t

t

t

tt AAE

ARE

Ae

AD

AD (2)

This decomposition allows us to identify more specifically the driving force behind the leverage

change. We use each component as our dependent variable and run the same regressions for each

IPO year, as well as for all firms from 1991 to 2003. The results are presented in panels B, C and

D of table 5. As Braker and Wurgler (2002) point out, the coefficients in panel A should equal

the 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 equity

issues -- on changes in leverage as predicted by market timing. In five out of ten IPO regressions

as well as in the regression for all firms, we find net equity issues help to reduce the leverage ratio

when the market valuations of the firms are high. However, these effects are not significant in

the other half of the IPO regressions. Also, consistent with our expectation, panel C shows only

weakly significant impact of internally generated funds on REITs’ leverage ratio. In contrast, we

find 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 absolute

value compared to those in panel B. In the all firms regression, the coefficient for market-to-book

is 12.88 in panel D compared to 8.66 in panel B. Hence, the dominant factor for change in

leverage ratio is the growth of total assets. To put it in perspective simply, the growth in total

assets is mainly funded by net debt issues. Comparing panels B and D, we conclude that debt

funding 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. Firms

with higher growth opportunities are more likely to fund their investment through external debt

issuance. This statistically and economically significant impact is predicted by pecking order

theory, 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 persistent

over time as predicted by pecking order and market timing or just temporary as suggested by

tradeoff theory. We use the three variables that were reported to be correlated with leverage ratio

by Rajan and Zingales (1995) as control variables.

17

111, −−−

⎟⎠⎞

⎜⎝⎛+⎟

⎠⎞

⎜⎝⎛+⎟

⎠⎞

⎜⎝⎛+=⎟

⎠⎞

⎜⎝⎛

tttefwat AntREinvestmed

BMc

BMba

AD

ttt

uSfA

EBITDAe ++⎟⎠⎞

⎜⎝⎛+ −

−1

1

)log( (3)

where s

t

st

rrr

ss

tefwa BM

de

deBM

⎟⎠⎞

⎜⎝⎛

+

+=⎟

⎠⎞

⎜⎝⎛ ∑

∑

−

=−

=

−

.1

01

0

1,

(4)

The 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 term

effects of market-to-book on the leverage ratio. This variable takes high values for firms that raise

external finance when the market-to-book ratio is high and vice-versa. If firms tend to raise

equity when the market-to-book is high reflecting greater investment opportunities, as predicted

by the market timing story, then we expect a negative relationship between this variable and the

leverage ratio. If firms tend to raise debt when the market-to-book is high, as predicted by

pecking 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 should

not 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 in

the total amount of external finance raised in each period. The lagged value of market-to-book is

included to control for the current cross-sectional variation in the level of market-to-book. What

is left for the weighted market-to-book ratio is the residual influence of past, within-firm variation

in market-to-book.

In panel A of table 6, we use only the traditional control variables from Rajan and

Zingales (1995). We find that current cross sectional market-to-book value has a positive impact

on the leverage ratio in three of IPO regressions and the all firms regression. This result is

consistent with those reported in previous tables. We also find that other control variables do not

have a significant relationship with leverage ratios in most of our IPO regressions as well as the

regression including all firms. As discussed previously, this finding is consistent with the unique

regulatory characteristics of the REITs.

In panel B, we add the weighted average market-to-book ratio in our models to test the

long-term relationship between market-to-book and the leverage ratio. We do not include this

18

weighted average for IPO+1 and IPO+2 regressions due to the high correlation between this

variable and the lag market-to-book ratios. We find that weighted average market-to-book is the

most 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 IPO

regressions 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 is

not temporary and capital structure is not mean reverting as suggested by tradeoff theory. REIT

managers 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 Theory

does 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 provisions

of REITs influence their capital structure decisions. Trade off theory predicts that capital

structure represents a trade off between costs and benefits of debt financing; pecking order theory

states that under asymmetric information, managers choose to fund investment with retained

19

earnings first, then debt, and lastly equity; market timing theory asserts that managers issue equity

whenever conditions are favorable. In the long run, trade off theory predicts no relationship

between leverage ratio and market to book ratio, pecking order suggests a persistent positive

relation, 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 mitigates

the agency cost of free cash flow. With no special benefit to debt financing, bankruptcy costs

imply one hundred percent equity financing under trade off theory. High payout has an

additional effect -- it forces REITs to raise investment capital externally where valuation is

uncertain due to information asymmetry between securityholders and managers. REIT

shareholders are especially vulnerable because real estate assets tend to be illiquid and less

transparent. Regulatory restrictions on sources of income and choices of assets that REITs are

allowed to invest in further exacerbate the information asymmetry. To elaborate, regulation

limiting managers’ investment options narrows their experience to sector specific assets. To

prevent job loss, these entrenched managers may collude to forestall hostile takeover threats, and

create an environment where discipline and monitoring by the market corporate control is

weakened. Finally, regulatory restriction on ownership size makes takeovers difficult and acts as

a disincentive to institutional investors and blockholders. Thus protected, REIT managers are

under little pressure to reveal full information. If shareholders recognize this agency problem to

be persistent, new share issues would be deeply discounted, and opportunities to sell equity

scarce. Under this scenario, debt financing is the preferred choice so that the pecking order

theory rather than the market timing theory provides a more apt description of expected

managerial behavior in REITs.

We analyze REITs’ financing choice over a number of years following their IPO. The

objective is to explore how REIT capital structure evolves in response to needs for investment

capital. The data reveal no indication of regression to a long term optimum capital structure, as

trade off theory would suggest. Rather, REITs with historically high market-to-book ratio tend to

have high leverage ratio. In essence, REITs with high growth opportunity and high market

valuation raise most of their needed funds through debt issuance. This finding is contrary to the

financing decisions of non-regulated firms. We attribute it to the special regulatory environment

of REITs where, despite no apparent benefits to debt financing, management prefers issuing debt

to equity to raise funds because the adverse selection costs due to information asymmetry exceeds

the potential costs of financial distress. This analysis has significant implications for the

literature on corporate capital structure decisions.

20

21

References

Baker, 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

Table 1: Theories of capital structure and REIT regulatory environment

Theory Impact Variables Debt and M/B ratio Real Estate Regulation Trade-off: A long-term optimum capital structure exists where benefits of debt financing are traded off against the costs

Tax-deductibility of interest payments encourages high debt levels. Bankruptcy costs force low debt levels. Mandatory interest payments on debt reduce free cash flow, and mitigate agency costs; but, high debt levels induce shareholder value-maximizing managers to reject profitable investments to prevent transfer of wealth to debtholders.

Firms with high M/B ratio (high growth and investment) have low free cash flow and tend to be risky. To avoid financial crisis in a downturn, high M/B firms choose low debt ratios. To maintain capital structure at the long-term optimum level, firms adjust capital structure to changes in M/B ratio. So, no long-term relationship exists between M/B and capital structure.

REITs are exempt from corporate taxes if 95% of current earnings are paid out as dividends. High payout reduces free cash flow. Loss of tax-deductibility and low free cash flow imply low debt ratios. Implication: Trade-off theory predicts low debt ratio for all REITs, regardless of M/B ratios. The long term adjustment to optimum capital structure holds.

Pecking Order: Managers always prefer issuing debt to avoid the potential valuation discount associated with equity issues. This theory predicts a positive relation between M/B ratio and debt ratio, but, no long-term optimum capital structure.

Information asymmetry between shareholders and managers implies preference for debt over equity.

High M/B firms require investment capital. To avoid issuing discounted equity, they issue debt. This results in high debt ratios. Alternatively, high M/B firms choose low debt ratios to create slack such that they can avoid issuing equity if and when they need funds in the future. This strategy requires access to high free cash flow and retained earnings.

Real estate assets are difficult to value which implies REITs would prefer to finance investment through debt issues, or retained earnings. The 95% payout requirement results in low free cash flow in REITs. In conjunction with discount on equity issues due to information asymmetry and adverse selection, low free cash flow implies REITs must sell debt to raise funds, pushing debt ratios higher. 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 issue equity when cost of equity capital is low. Under this theory, a negative relation between M/B and debt ratio is predicted, but no optimum capital structure exists.

Information symmetry between shareholders and managers induces adverse selection costs in equity issues. These costs vary across time and across firms. Extremely high expectations by irrational investors periodically cause equity to be mispriced rendering cost of equity abnormally low.

If high M/B ratio implies low adverse selection cost, then managers can take advantage of high M/B ratio to time equity issues. Extreme values of M/B indicate extreme investor expectations. Managers exploit extreme valuations by issuing equity when M/B ratios are high.

REITs must earn 75% of their earnings from real estate activities. Investment options for REITs are also restricted mainly to sector specific assets. Finally, no single entity can own more than 50% stake. Restricting operations and acquisitions to the same sector denies managers the opportunity to acquire inter industry experience which shrinks their job market. This induces managers to collude against hostile takeovers. Ownership restriction deters formation of 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

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 of

our 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.

Year Number of firms in SNL

database that went IPO during 1991-2003

Number of firms with accounting information available at (t-1)

Number of firms with information available to calculate the weighted

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

Table 3: Summary Statistics of Capital structure

In this table, we report the summary statistics on current leverage ratio and the changes in current leverage ratio. Book leverage is calculated as book debt to total assets. Market leverage is book debt divided by the result of total assets minus book equity plus market equity. Market equity is the product of number of share outstanding and the stock price. Net equity issues (e/At) is defined as the change in book equity minus the change in retaining earnings divided by assets. Newly retained earnings (∆RE/At) is the ratio of the result of net income minus dividend amount and total assets. We calculate the new debt issues (d/At) as the residual 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 Year

IPO+1 68 51.63 18.66 46.54 18.60 16.15 17.24 11.45 16.53 -1.08 2.68 IPO+2 68 55.18 18.51 50.39 19.57 14.39 14.46 8.87 13.73 -1.12 3.38 IPO+3 80 56.28 17.00 50.10 18.29 13.60 12.35 8.56 11.25 -0.72 2.75 IPO+4 88 59.22 18.80 52.79 17.55 12.69 16.57 5.93 16.86 -0.88 2.91 IPO+5 89 62.37 17.42 56.54 16.53 9.14 14.79 4.45 10.39 -0.60 4.48 IPO+6 82 65.34 17.13 59.91 16.81 5.28 15.13 0.87 7.62 0.17 3.43 IPO+7 71 65.72 18.90 60.15 17.40 3.30 9.97 1.45 12.26 -0.90 2.74 IPO+8 63 66.09 16.94 59.86 16.57 0.86 17.56 2.36 11.03 -0.71 2.24 IPO+9 57 66.11 16.80 56.81 16.30 3.00 9.13 1.57 5.19 -0.86 1.79 IPO+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 Year 1994 19 52.01 26.50 43.60 22.40 13.79 14.43 11.91 18.66 -2.03 1.74 1995 38 50.19 21.14 42.10 18.53 10.06 12.21 10.35 16.11 -1.98 1.68 1996 41 51.50 18.17 40.86 17.80 12.12 11.06 14.16 14.14 -1.22 1.88 1997 54 55.12 17.41 44.49 16.07 18.65 12.85 15.10 13.35 -0.90 1.62 1998 79 59.76 15.90 56.23 14.90 24.43 16.24 9.39 18.36 -0.31 2.15 1999 91 61.87 15.01 61.63 14.23 8.27 11.15 1.58 5.90 0.03 2.94 2000 95 62.49 16.76 60.82 16.63 3.00 11.25 -0.25 5.11 -0.23 4.52 2001 96 64.21 17.25 58.38 16.96 3.50 11.42 0.69 8.06 -0.64 2.66 2002 95 65.44 18.91 58.98 16.86 3.78 10.71 1.08 7.29 -0.85 3.61 2003 98 64.65 18.90 52.27 16.88 2.19 17.70 4.21 12.50 -1.05 3.66

25

Table 4: Correlation between Leverage and Past Market to Book Ratio

In this table, we present correlations between leverage ratio and past market-to-book ratios. Book leverage is calculated as book debt to total assets. Market leverage is book debt divided by the result of total assets minus book equity plus market equity. Market equity is the product of number of share outstanding and the stock price. Market-to-book is defined as total assets minus book equity plus market equity then divided by total assets. We include all firms. The numbers in parentheses contain multiple observations on the same firm from different calendar years for which past values of market-to-book ratio are available in SNL database. Book

Leverage Market Leverage

MTB t-1

MTB t-2

MTB t-3

MTB t-4

MTB t-5

MTB t-6

MTB t-7

MTB t-8

MTB t-9

MTB t-10

Book Leverage

1.00 (715)

0.73*** (713)

0.23*** (715)

0.25*** (641)

0.23*** (567)

0.26*** (485)

0.23*** (396)

0.21*** (308)

0.18*** (225)

0.20** (154)

0.24** (93)

0.26 (39)

Market Leverage

1.00 (713)

-0.35*** (713)

-0.25*** (639)

-0.18 *** (565)

-0.15*** (483)

-0.17*** (394)

-0.18*** (306)

-0.07 (223)

-0.03 (152)

0.09 (92)

0.04 (39)

MTB t-1 1.00 (715)

0.84*** (641)

0.66*** (567)

0.59*** (485)

0.64*** (396)

0.58*** (308)

0.33*** (225)

0.31*** (154)

0.33*** (93)

0.35** (39)

MTB t-2 1.00 (641)

0.81*** (566)

0.65*** (484)

0.56*** (395)

0.60*** (308)

0.40*** (225)

0.33*** (154)

0.33*** (93)

0.42*** (39)

MTB t-3 1.00 (567)

0.83*** (484)

0.61*** (395)

0.45*** (307)

0.44*** (225)

0.40*** (154)

0.32*** (93)

0.44*** (39)

MTB t-4 1.00 (485)

0.81*** (395)

0.53*** (307)

0.39*** (224)

0.52*** (154)

0.42*** (93)

0.31* (39)

MTB t-5 1.00 (396)

0.74*** (307)

0.48*** (224)

0.55*** (153)

0.59*** (93)

0.31* (39)

MTB t-6 1.00 (308)

0.81*** (225)

0.68*** (154)

0.64*** (93)

0.56*** (39)

MTB t-7 1.00 (225)

0.79*** (154)

0.64*** (93)

0.66*** (39)

MTB t-8 1.00 (154)

0.82*** (93)

0.75*** (39)

MTB t-9 1.00 (93)

0.84*** (39)

MTB t-10

1.00 (39)

26

Table 5: Determinants of Annual Changes in Leverage and Components We investigate the impact of market-to-book on temporary change in leverage ratio in table 4. The dependent variable in Panel A is annual change in book leverage. Besides the market-to-book ratio, we also add percentage of real estate investment to total assets as proxy for asset tangibility, EBITDA to total assets as proxy for profitability and logarithm of total revenue as proxy of firm size. These variables are proven to be connected with leverage ratio in Rajan and Zingales (1995). We run this model for each IPO year as well as for all firms in SNL database between 1991 and 2003. We further decompose the change in leverage ratio into equity issues, retained earnings, and the residual change in leverage, which depends on the 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-1 Year 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 31.02 IPO+2 68 0.61 0.11 -0.18 -1.60 -0.34 -0.48 0.63 0.62 17.61 IPO+3 80 -2.81 -0.78 -0.13 -1.31 0.03 0.07 -0.59 -0.94 25.65 IPO+4 88 14.06 2.40** -0.34 -2.61** -0.71 -1.40 0.72 0.68 21.71 IPO+5 89 8.05 2.61** 0.06 0.68 -0.13 -0.36 -0.48 -0.68 13.20 IPO+6 82 6.57 2.56** -0.13 -1.99** -0.46 -2.80*** 0.00 0.01 18.67 IPO+7 71 2.62 0.85 -0.33 -2.77*** -0.75 -3.16*** -0.57 -1.13 30.88 IPO+8 63 -3.63 -0.93 0.17 1.00 0.58 2.48** 2.43 4.05*** 50.70 IPO+9 57 0.68 0.20 -0.15 -0.95 -0.08 -0.25 1.06 1.69* 0.00 IPO+10 29 -1.34 -0.18 0.60 1.73* -0.19 -0.26 -0.45 -0.27 6.48 All 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 1.13 IPO+2 68 -11.15 -1.67* -0.26 -1.99* 0.21 0.36 2.03 1.67* 12.49 IPO+3 80 -17.30 -3.40*** -0.14 -1.01 1.93 3.60*** -0.26 -0.29 13.43 IPO+4 88 4.42 0.57 -0.29 -1.65 0.28 0.41 0.88 0.62 1.73 IPO+5 89 -1.48 -0.41 -0.23 -2.33** 0.94 2.27** 1.75 2.11** 11.33 IPO+6 82 1.70 0.55 -0.26 -3.42*** -0.16 -0.79 2.19 3.84*** 30.97 IPO+7 71 -23.73 -4.23*** -0.45 -2.09** 0.05 0.11 2.04 2.22** 40.21 IPO+8 63 -15.19 -3.19*** -0.01 -0.07 1.45 5.05*** 2.97 4.06*** 61.88 IPO+9 57 -8.23 -2.28** -0.26 -1.58 0.11 0.33 0.71 1.05 9.94 IPO+10 29 -3.71 -0.54 -0.05 -0.15 -0.46 -0.70 0.85 0.54 0.00 All 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** 29.70 IPO+2 68 -3.71 -2.43** -0.03 -0.86 -0.18 -1.34 -0.73 -2.63** 24.67 IPO+3 80 1.51 1.39 0.05 1.58 -0.61 -5.30*** -0.24 -1.26 33.90 IPO+4 88 -0.34 -0.26 -0.07 -2.29** -0.28 -2.47** -0.34 -1.46 10.61 IPO+5 89 -2.49 -1.84* 0.08 2.25** -0.55 -3.52*** -0.98 -3.14*** 32.88 IPO+6 82 -1.87 -1.99* 0.10 4.11*** -0.39 -6.49*** -0.37 -2.16** 68.50 IPO+7 71 0.65 0.45 -0.04 -0.66 -0.29 -2.62** -0.38 -1.63 21.24 IPO+8 63 2.01 1.59 -0.05 -0.91 -0.25 3.29*** -0.19 -0.96 34.84 IPO+9 57 0.39 0.31 0.11 1.81* -0.19 -1.61 -0.23 -0.96 6.11 IPO+10 29 -0.36 -0.09 -0.12 -0.65 -0.39 -1.05 -0.59 -0.68 0.00 All 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 42.83 IPO+2 68 15.48 2.74*** 0.11 1.00 -0.38 -0.76 -0.67 -0.65 31.87 IPO+3 80 12.99 2.89*** -0.03 -0.28 -1.30 -2.73*** -0.09 -0.12 26.84 IPO+4 88 9.97 2.62** 0.01 0.12 -0.72 -2.17** 0.18 0.26 13.39 IPO+5 89 12.02 3.94*** 0.21 2.44** -0.52 -1.49 -1.25 -1.78* 28.76 IPO+6 82 6.74 2.11** 0.04 0.49 0.09 0.43 -1.81 -3.07*** 23.19 IPO+7 71 25.70 4.86*** 0.16 0.79 -0.51 -1.24 -2.23 -2.57** 42.70 IPO+8 63 9.55 3.35*** 0.23 1.89* -0.62 -3.58*** -0.35 -0.79 28.15 IPO+9 57 8.51 3.24*** 0.01 0.07 0.00 0.01 0.58 1.18 18.73 IPO+10 29 2.82 0.57 0.77 3.36*** 0.67 1.43 -0.70 -0.64 33.58 All firms 715 12.88 10.01*** 0.08 2.32** -0.41 -3.86*** -1.42 -5.70*** 35.46

27

Table 6: Determinants of Leverage

We investigate the relationship between market-to-book and leverage ratio in table 5. Penal A, we follow Rajan and Zingales (1995) and use percentage of real estate investment, EBITDA to total assets and logarithm of total revenue as control variables. In panel B, we add the weighted average market-to-book ratio which is proposed by Baker and Wurgler (2002) to capture the long-term effect of market-to-book on leverage ratios. We run this model for each IPO year as well as for all firms in SNL database between 1991 and 2003. In Panel B, we do not include the weighted average market-to-book in IPO+1 and IPO+2 regression 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

Year N b t(b) C t(c) D t(d) E t(e) f t(f) R-sqr %

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 23.18

All 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 37.24

All 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