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...from firm-level investment opposed to new entry. Firm-level investment was largely financed by equity and long-term debt, with little reliance on retained earnings. Financing policy stabilized in the new-REIT era, and capital structures became more complex. We find that REITs provided returns over and above their cost of capital, where most of the value-added investment occurred in the new-REIT era by newer firms. Finally, we present novel evidence on IPO activity and new firm investment-investment performance relations that is consistent with Tobin's q theory of investment.
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Do real estate investment trusts (REITs) destroy or generate value for the shareholders? What is the relation between investment and investment performance? How do REITs finance their investments? Do financial policies of REITs mimic or depart substantially from those adopted by most firms in the U.S. stock market? How do performance relations change depending on the time period? The answers to these questions are still largely unknown, more than four decades after Congress first introduced REITs to American investors.
To address these questions, we measure investment, investment performance and the financing of investment in the equity REIT sector over a sample period from 1981 through 1999. We are particularly interested in identifying differences between the relatively sleepy, slow-growth "old-REIT" era of the 1980s and early 1990s and the dynamic, high-growth "new-REIT" era that began around 1992-1993.
In the late 1980s and early 1990s, publicly traded commercial real estate firms had access to liquidity while private firms (which were often financially distressed) did not. The net result of this disequilibrium was a REIT investment and IPO boom, as the sector increased in size by more than 11 times from 1992 to 1999. Interestingly, most of the new-era growth was caused by investment from established firms rather than new entry into the sector.
We document that investment was financed primarily by equity and long-term debt, representing 84% of aggregate investment over the entire sample period. Retained capital earnings financed only 7% of investment, and short-term debt and preferred stock made up the rest. This compares to 70% of industrial firm investment being funded through retained earnings, as documented by Fama and French (1999). These contrasting results are largely explained by REIT tax rules, which require a large proportion of earnings to be paid as dividends.
Financial policies were much more stable in the new-REIT era than in the old-REIT era. We conjecture that this outcome occurred in response to concerns of outside investors and rating agencies, who were looking for consistent and disciplined financing policy to sustain the high investment growth rates of the new-REIT era. REIT capital structures also became increasingly complex over time, as firms issued unsecured debt and hybrid financial claims to finance investment and reconfigure their liability structures.
We examine whether REITs added value over and above their cost of capital. This analysis is interesting for several reasons. First, there is some disagreement as to whether publicly held real estate firms really add value for their investors or are something more like a closed-end fund. Second, there is a viable private market for holding commercial real estate--and a long-running dialogue about whether it is more efficient to hold assets publicly or privately--so cost of capital and investment performance metrics enhance comparison of the markets. Third, analysis of the REIT sector on either side of its growth phase provides insight into the development of the market. Fourth, because of its high variability in growth over time, the REIT sector provides a nice setting to analyze investment-investment performance relationships as they relate to Tobin's q investment theory.
To measure investment performance we apply the internal rate of return (IRR) method developed by Fama and French (1999). This method distinguishes whether firms are acquired by the sector at cost or market value. When firms are acquired at cost, the internal rate of return measures the average product of capital. When they are acquired at their market value, the internal rate of return measures the weighted average cost of capital. The difference between the IRR-on-cost and the IRR-on-value provides a measure of investment performance, where a positive differential indicates value creation over and above the cost of capital.
We document an average nominal cost of capital to the sector of between 8.2% and 10.8% over the entire sample period, depending on whether firm assets are valued at market or net asset value (NAV) at termination. Real capital costs are in the range of 5.5% to 7.8%. The average return to the sector over and above its cost of capital is between 1.6% and 2.9% per year, depending on how firms are valued when they enter the sample and how they are valued at termination. This finding indicates that the REIT sector did indeed create real value for investors over the 1981-1999 sample period.
Further analysis indicates that all or most of this value was added during the new-REIT era. Moreover, firms that entered the sector during the new-REIT era were more successful than established firms at identifying and harvesting investment opportunities. These results make sense in the context of Tobin's (1969) q theory of investment, where publicly traded firms had access to liquidity during a time when financially distressed private firms did not. One would expect new firms could enter the sector only if they had a comparative advantage over established firms--otherwise, capital would be better allocated to the established firms.
Finally, we consider the relationship between the rate of investment and investment performance, distinguishing between the old- and new-REIT eras as well as between new and seasoned firms. In general, we find positive relations between investment and investment performance. The relations hold for investment by seasoned firms as well as investment at the sector level through the buying and selling of entire firms.
We also document that newly entering firms in the old-REIT era (i) had lower q ratios, (ii) were smaller, (iii) were less levered, (iv) invested less and (v) earned lower returns than newly entering firms in the new-REIT era. Findings with respect to new firms in the new-REIT era are consistent with Tobin's q theory of investment in the sense that these firms (i) had high initial q ratios, (ii) invested more and (iii) realized higher returns than established firms. The cumulative evidence thus suggests that these new firms were different from established firms, which may have been a factor in their ability to enter the sector through an IPO.
This article is organized as follows. In the next section we describe the data and assess its reliability as it relates to measuring cost and value at the time of entry into and exit from the sample. In the third section we consider firm-level investment and how that investment was financed. Using the IRR investment performance methodology, the fourth section considers whether or not the REIT sector added value over and above its cost of capital. In the fifth section we analyze the relationship between investment and investment performance. The article concludes in the final section.
Data
To construct the sample we searched Standard & Poor's Compustat database by SIC code to identify publicly traded REITs. Annual year-end accounting and share value data were examined for firms classified as equity REITs during the 1981-1999 sample period. In the initial year of the sample, a firm is included if we had both market and book value information as of year-end. In all subsequent years, a firm enters the sample at the end of the first fiscal year when there was both market and book value information. A firm is classified as exiting the sample during the last year for which year-end book and market value information exist.
Table 1 displays the year-by-year composition of the sample. The number of firms that continue from the previous year (Begin) are reported. Then we add the number of firms that Enter the sample in that year to obtain the Sample. Forty-one REITs enter in the initial sample year, and a total of 244 different firms are analyzed over the sample period. The sample provides financial and accounting data for the analysis. Finally, we identify firms that Exit the sample in the following year to obtain the sample that is available for the next year (End). The aggregate market value of assets for all firms in the sample at year-end as well as the average firm size are reported. In total, there are 1,837 annual firm-level observations over the entire 19-year sample period.
A REIT IPO boom occurred beginning in 1992 (showing up in the data beginning in 1993) as the result of liquidity problems in the commercial real estate sector. Many private firms were financially distressed as a result of severe overbuilding in the sector, and badly needed to recapitalize. Because traditional financing was unavailable, certain private firms went public in an effort to obtain financing from alternative sources. The process worked because public market capital providers saw growth opportunities in the large but highly distressed private firm sector. The net result was that, from year-end 1992 to year-end 1999, the REIT sector increased by over 60% as measured by the number of firms and realized more than a 10-fold increase in aggregate capitalized asset value. As a result, average firm size increased sevenfold, going from $219.2 million in 1992 to $1,557.1 million in 1999.
Fama and French (1999) discuss a number of data measurement problems in their study of investment and the investment performance of industrial firms. The most important problem concerns replacement cost estimates of firms entering the sample, where depreciated book value of assets is used to proxy for the replacement cost of assets-in-place. There are two major concerns. First, plant and equipment often experience economic rates of depreciation that are very different from accounting-based rates of depreciation. Second, book values are not adjusted to account for the replacement cost of intangible assets such as human capital. These effects generally bias available replacement cost estimates downward, which causes return on investment measures to be too high.
An accurate estimate of replacement cost of entering firms is therefore critical to obtaining a reliable measure of investment performance. Replacement cost estimates of commercial real estate assets are generally more precise than replacement cost estimates available in other sectors. This is because (i) only the built improvements are subject to depreciation, not the land; (ii) depreciation rates are substantially lower than rates applied to most types of plant and equipment, and are thought to reasonably reflect the rate of economic obsolescence and (iii) built commercial real estate has few growth option components that skew return measures (e.g., there is little or no intangible asset value associated with human capital).
That said, there are some concerns about the accuracy of depreciated book values of certain assets held by REITs, particularly for firms entering the sample in the new-REIT era. Tax-based accounting rules during 1981-1986 allowed for relatively high rates of depreciation. Many of the firms that went public during the new era held assets originally acquired under that tax law regime. An additional issue is the Umbrella Partnership REIT (UPREIT) structure, which was introduced in the early 1990s to facilitate the IPO process. This structure allows capital gains associated with transferring ownership of privately held...
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