Real Estate and Economies of Scale: The Case of REITs
Ambrose, Brent W., Highfield, Michael J., Linneman, Peter D., Real Estate Economics
Building on past research in the economies-of-scale debate, we test for scale economies in real estate investment trusts (REITs) by examining growth prospects, revenue and expense measures, profitability ratios, systematic risk and capital costs. Overall, we find that large REITs are increasing growth prospects while succeeding at lowering costs, leading to a direct relationship between firm profitability and firm size. Additionally, we find an inverse relationship between equity betas and firm size, and for all cost of capital measures we find significant scale economies. Further evidence from the stochastic frontier analysis suggests efficiency opportunities appear possible through continued growth and consolidation in REITs.
The phrase "economies of scale" simply implies that efficiency in production and operations increases with size. Historically, firms in various industries often expand and consolidate in an effort to capture these efficiency gains. Assuming that economies of scale are available in the real estate industry, publicly traded real estate investment trusts (REITs) are excellent tools to take advantage of these efficiency opportunities because, unlike private real estate investors, REITs are not equity capital constrained. Market evidence generally supports the idea that scale economies are available to REITs; after all, investment in income-producing real estate has grown tremendously over the past decade and REITs have enjoyed most of the growth in this industry. If economists and market analysts are correct and economies of scale exist in real estate, then REIT costs should increase at a decreasing rate and efficiency gains should be reflected in higher returns.
While the argument for economies of scale in commercial real estate continues to gain momentum, disagreements about the concept of scale economies in real estate continue to exist. Against this backdrop, this article examines the case for scale economies in REITs on a more complete level than ever attempted before. Recognizing that a serious limitation of the earlier studies of REIT economies of scale is the inability to separate size-related advantages versus a period of rapidly expanding, strong markets, we obtain 1,508 REIT year observations using a sample of 187 equity REITs trading in U.S. markets between January 1990 and December 2001. Thus, our analysis covers an 11-year period that includes a full market cycle of significant market expansion followed by contraction. Using this relatively large data set, we test for economies of scale in REITs by examining growth prospects, revenue and expense measures, profitability ratios, systematic risk and cost of capital measures.
In addition to the size and time span of our data set, we also incorporate news-reported information on merger activity into the analysis of economies of scale. This is important as the costs of integrating a merger occur in the first year or so, while efficiencies are realized largely subsequently. In the following section, we examine the background of consolidation and economies-of-scale arguments in real estate while defining our expectations. Next we discuss the data and hypotheses. This is followed by a discussion of our empirical results and conclusion.
A Brief History of REIT Consolidation
Following banking deregulation in the 1980s, real estate investment, which was already heavily debt financed, surged through the use of debt provided by banks and savings and loans. However, the savings and loan crisis in 1989-1990 resulted in a curtailment in debt financing for real estate, forcing many industry leaders to turn to public capital markets. Some observers argued that the real estate industry would have to follow the example of other capital-intensive public firm-dominated industries and enter a period of significant consolidation, with publicly traded companies leading the consolidation effort (e. …