Financing Choice and Liability Structure of Real Estate Investment Trusts

By Brown, David T.; Riddiough, Timothy J. | Real Estate Economics, Fall 2003 | Go to article overview

Financing Choice and Liability Structure of Real Estate Investment Trusts


Brown, David T., Riddiough, Timothy J., Real Estate Economics


We conduct an analysis of public financial offerings of equity Real Estate Investment Trusts (REITs), with a focus on liability structure effects and whether or not firms target longer-run debt ratios. Our major findings are that (1) proceeds from equity offers are more likely to fund investment, whereas public debt offer proceeds are typically used to reconfigure the liability structure of the firm; (2) public debt issuers are often capital constrained and target total leverage ratios to retain an investment grade credit rating; and (3) the preoffer liability structure affects the issuance choice decision, in that firms with higher preoffer levels of secured (unsecured) debt tend to issue equity (public debt). Other notable findings are that the market for public REIT debt is integrated with the broader debt markets and that higher credit quality firms issue longer-maturing bonds.

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Capital structure of the firm is one of the most researched topics in all of economics. Yet little work has been done on Real Estate Investment Trusts (REITs) or commercial real estate operating companies. (1)

The previous literature has generally defined capital structure in terms of total debt and equity. A contribution of this paper is that we conduct a detailed examination of the REIT's liability structure, by emphasizing the various types of financial claims that exist and that are issued by firms, rather than focusing exclusively on total debt and equity that exist at a particular point in time. For example, we distinguish between secured debt, public unsecured debt and common stock, all of which differ in their seniority as a claim on firm assets. These finer distinctions provide insight into complex liability structures and the trade offs involved with REIT financial management.

We are also interested in whether firms actively target debt ratios in their search for an optimal capital structure. Debt ratio targeting, once an accepted part of the corporate finance canon, has lately become a controversial topic. Standard trade-off theories in corporate finance suggest that optimal capital structures exist, and therefore that debt ratio targeting is a productive activity for financial managers. (2) In contrast, recent literature suggests that debt ratio targeting is nonexistent or at best a low-priority activity. For example, Shyam-Sunder and Myers (1999) test the trade-off theory against the pecking-order theory of Myers and Majluf (1984), which suggests that "changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure" (Shyam-Sunder and Myers, p. 221). Shyam-Sunder and Myers present evidence favoring the pecking-order theory over the trade-off theory. Baker and Wurgler (2002) argue that capital structure is the cumulative outcome of previous attempts to opportunistically time financial markets, and therefore that debt ratio targeting is of little importance to financial managers. An extreme case is Welch (2002), who presents evidence that observed capital structures cannot be explained by any of the existing theories of value maximization.

To address questions of liability structure and debt ratio targeting, this paper provides a systematic empirical analysis of financial policy of equity Real Estate Investment Trusts. We focus on public debt and equity issuances by REITs and relate these issuances to their pre- and postoffer liability structures. (3)

We structure our empirical analysis around public debt and equity issuances. We do this for three reasons. First, public offerings are major financing events. They occur infrequently and are large in the sense that offering proceeds typically exceed $50 million. Because of their size, public offerings provide important information regarding the firm's postoffer liability structure. Public offerings also depend importantly on the preoffer liability structure of the issuing firm. …

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