December 12th, 2013 | by Sheridan Titman
REITs and Financial Leverage
Real Estate Investment Trusts (REITs) are publicly traded companies that own commercial real estate. In many respects, REITs face the same choices and tradeoffs as any company looking to finance operations: maintaining sufficient liquidity, investing profitably in their core business, and managing their cost of capital. However, REITs are different than standard corporations in a couple of respects. First, they are required to pay out most of their profits to their shareholders as dividends. As a result, REITs need continuous access to capital markets to raise cash and maintain liquidity. Second, REITs are treated as investment trusts not subject to corporate taxes, which implies that unlike public corporations, REITs enjoy no tax advantages from debt financing.
Despite the lack of a tax advantage, REITs do tend to use substantial amounts of debt; perhaps because they are overconfident about their future prospects and want to avoid issuing what they perceive as cheap equity. However, our recent research, “REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis” indicates that the use of debt financing by REITs has some clear disadvantages, which may have hurt the REITs with greater financial leverage REITs as they went into and out of the financial crisis. Indeed, commercial real estate in the US has now fully recovered from the crisis, but REITs are still trading substantially below their pre-crisis highs. We think financial leverage is the culprit.
Highly-levered REITs face significant challenges that are particularly important during financial crises. Financial leverage puts a firm in a position where they are often forced to go to the capital markets when doing so is the least advantaged. Indeed, in the financial crisis, highly levered REITs were forced to roll over their debt in a situation with falling rents, a dysfunctional debt market, and a real estate equity market that had tanked 70-80%. They were faced with two unattractive choices, issue equity at unattractive terms or sell properties into a panicking market. Many of the highly levered REITs did both, and as a result, realized lower returns during the crisis period.
A longer term analysis indicates that investors are not in general rewarded for taking the higher risk associated with high levels of financial leverage. As a result, we allocate risks along more productive lines, and in our global REIT strategy, we tend to tilt away from the more highly levered REITs.