Academic journal article Real Estate Economics

The Value in Targeting Institutional Investors: Evidence from the Five-or-Fewer Rule Change

Academic journal article Real Estate Economics

The Value in Targeting Institutional Investors: Evidence from the Five-or-Fewer Rule Change

Article excerpt

During the 102nd Congress a targeting strategy was proposed to encourage the flow of institutional investment capital, specifically from pension funds, into the (ailing) real estate sector of the economy. The strategy was eventually enacted during the 103rd Congress under the provisions of the Omnibus Budget Reconciliation Act of 1993 (OBRA '93). The targeting strategy entailed a change in the ownership restrictions faced by real estate investment trusts (REITs) in qualifying for favorable tax status. The proposed change effectively relaxed the constraint on REIT ownership concentration for all institutional investors, not just pension funds.(1) The events leading up to the change and following the effective date of the change provide a unique opportunity to examine the value of targeting institutional investors.

This study examines the relaxation of the ownership structure for REITs and its relation to an industry-wide targeting of institutional investors as a value-based strategy. This examination of the REIT ownership change in the context of the broad study of institutional investing raises several questions. First, why did Congress target pension funds for investment in the real estate sector, particularly, given the recent performance of real estate assets? Second, what intra-industry effects might result across REITs from targeting this particular class of investors? Third, is there evidence to suggest that the targeting strategy influenced the investment behavior of the targeted investors? The brief background that follows addresses the first question. The second and third questions provide the basis for the empirical analysis.

Economic Policy and Investor Relations: Not-So-Strange Bedfellows

The depressed real estate market in 1990 and 1991 gained attention as a drain on the economy. At the time, it was estimated that the nation's total real estate wealth had declined by more than $500 billion from 1990 through mid-1993.(2) This decline was credited with eroding the primary collateral of many financial institutions and threatening fiscal crisis with the tax base of metropolitan areas nationwide. The domestic responsibilities of the President of the United States and Congress often cast them in an investor relations role for the nation's economy. That is to say, U.S. public policy leaders frequently concern themselves with the development and nurturing of domestic capital providers. Thus the President and Congress set out to address real estate's capital problems.

President Bush in his 1992 State of the Union Address unveiled a seven-point plan to revitalize the national economy. One significant aspect of the plan was intended to encourage pension funds to invest in real estate.(3) This event marks the beginning of the targeting strategy enactment period as depicted in Figure 1.

The rationale for targeting pension funds followed from the popular opinion that the deterioration of real estate values was due to the exodus of traditional forms of financing.(4) Even performing properties were having difficulty attracting capital. Consequently, the Bush administration proposed several changes to the tax code which would effectively remove restrictions faced by pension funds investing in real estate. One restriction dealt with the treatment of pension-fund investment in REITs.(5)

REITs have been characterized as closed-end real estate funds and have recently been credited with contributing to the "permanent migration" of real estate assets to a securitized form.(6) However, in order to qualify for the special tax treatment afforded the REIT vehicle certain qualification tests must be met. These tests concern asset qualification, income qualification and ownership qualification. The legislation proposed in the 102nd Congress, the administration's strategy for targeting pension fund capital for real estate investment, was aimed at the ownership qualification for REITs. …

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