...increasing prospects while succeeding at lowering costs, leading to 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.

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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.

Background

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.g., Linneman 1997, 2002). (1)

Since 1994 industry watchers have routinely predicted a wave of consolidation in the industry. (2) The period of 1997-1999 was a particularly noticeable consolidation period in almost every property sector. (3) Then, while the dotcom bubble was bursting in early 2000 and investors finally abandoned overvalued companies with little-to-no tangible assets, real estate stood out as a relatively strong and stable investment. In fact, REITs averaged a 26% return for the year, and 2000 was the first year for REITs to outperform both the Nasdaq and DJIA. Thus, with the increase in funds and popularity, REITs again consolidated. While the rate over the past 3 years has not been as substantial as the 1997-1999 period, consolidation has continued. (4) In fact, 2001 was the third-busiest year for REIT and REOC merger and acquisitions activity, falling behind 1997 and 1998, respectively. Interestingly, while mergers and property acquisitions continue on a monthly basis, research on these topics has been mixed.

In an early study, Allen and Sirmans (1987) examined acquirer returns from REIT mergers during the period of 1977 to 1983, and they found significantly positive REIT abnormal returns in reaction to merger announcements. McIntosh, Officer and Born (1989) followed up with an examination of returns for REIT merger targets during the period of 1969 to 1986. Again, they found significantly positive returns. Overall, evidence from early research is consistent with the notion that market participants believe that these mergers would allow larger REITs to achieve economies of scale through better asset utilization. However, as noted by Ling and Ryngaert (1997), REITs changed significantly in the late 1980s and early 1990s. Thus, to see if the regime has changed, Campbell, Ghosh and Sirmans (2001) examined REIT mergers during the period of 1994 to 1998. In general, they found that acquirer returns are slightly negative while target returns are significantly positive. While the positive return for target firms is consistent with the scale economies argument, the negative return to acquirer firms is not driven by diseconomies of scale. Instead, because REITs often obtain significant geographical diversification through mergers, these diversifying mergers can limit opportunities for economies of scale. Thus, the authors explain that while diversification of all kinds was beneficial to REITs in the 1970s and 1980s, geographical diversification is not beneficial to the modern fully integrated REIT because it may limit economies-of-scale opportunities.

Interestingly, McIntosh, Liang and Thompkins (1991) find evidence of a "small-firm effect," that is, small REITs earn higher average rates of return than large firms after accounting for risk. Using REIT returns from 1974 to 1988, they find that although small REITs earn higher returns than large REITs, they are no more risky than large REITs. While the "small-firm effect" contradicts the scale economies argument that efficiency gains should be reflected in higher returns, other studies that examined the impact of announcements concerning property acquisitions on REIT share prices found insignificant wealth effects for either sale or purchase transactions. For example, McIntosh, Ott and Liang (1995) conclude that REITs do not experience significant wealth effects from the announcement of either acquisition or divestment of properties. Unlike McIntosh, Liang and Thompkins (1991), who find evidence against economies of scale, the results of McIntosh, Ott and Liang (1995) find evidence neither dismissing nor supporting scale economies. As a result, the early evidence appeared to suggest that significant consolidation of property assets had not clearly created significant gains in shareholder wealth, but research had also not eliminated the hope for such gains.

A Brief History of REIT Economies of Scale Research

Unfortunately, as was the case for banking and other industries in the early phases of their consolidation, it is extremely difficult to identify the presence of economies of scale in the real estate industry. This problem arises for two main reasons. First, given the relatively similar size of most REITs and their recent integration, the statistical technology available to accurately measure economies of scale is not sufficiently precise to fully capture cross-sectional variations. For example, Mester (1996) notes that an implicit assumption in the studies of economies of scale is that all firms in the study have access to the same cost frontier and should be using the same technology. Second, the effort required by growing firms to capture scale economies is difficult and time consuming, with the pain of integration generally occurring prior to the realization of the benefits. Thus, exploring cross-sectional variations in the presence of significant merger and acquisition activity understates the benefits of scale. Moreover, the market is not static as the consolidation activities described above have been almost continuous in the real estate industry. As leading firms merge and achieve competitive advantages, their competitors respond, making it difficult to capture the effect of scale economies cross-sectionally.

Research from the 1980s and early 1990s focused on the set of very small REITs that existed from the early 1970s and 1980s, which bear little resemblance to today's fully integrated REITs. Not surprisingly, limited statistical evidence of scale economies exists based on data from the 1970s and 1980s, a period when debt was plentiful and the largest players were small by today's standards. For example, in the late 1970s and early 1980s the average equity REIT had a market capitalization of only $28 million, but in 1990 the average equity REIT had an inflation-adjusted market capitalization of $95 million. Furthermore, regulations during this earlier period (such as shareholder concentration rules) severely restricted the ability of REITs to raise sufficient capital to expand and capture any meaningful economies of scale. Thus, it is not surprising that researchers using REIT data from the same period find positive stock price reaction to announcements of asset sales and attribute this to the belief that scale economies do not exist for REITs, as these companies had no scale.

Research from the late 1990s and early 2000s utilized data from the 1980s and early 1990s. The research in this period suggests that scale economies exist, at least for larger REITs. (5) These more recent studies attempt to isolate the effect of economies of scale in REIT expenses, revenue growth and capital costs and build on the hypothesis that larger REITs have higher earnings growth potential. (6) For example, evidence indicates that the nondiscretionary component of general and administrative (G & A) expense increases at a decreasing rate as REIT size increases, and other evidence indicates that scale economies exist in REIT management costs. (7) However, the studies that examine various REIT expense items (G & A, interest expense, management fees, operating expenses) find that economies of scale are most present in smaller expense items, suggesting that while economies of scale exist, the gains from realizing these economies may be insufficient to lead to massive consolidation in the REIT industry. (8)

Ambrose et al. (2000) compared REIT income growth and profitability relative to changes for the market to explore economies of scale using data from the 1990s. The results indicate that small REIT net operating income (NOI) growth rates exceed average growth rates in the markets in which they held properties, and thus small REITs appear to be generating revenue and operating economies. However, this does not seem to be the case for the largest REITs. Their findings indicate that NOI gains, relative to the market, were large prior to 1996, but are no longer so, with REITs at the end of the 1990s outperforming the market primarily via revenue enhancement, not cost reduction. Thus, the results from the Ambrose et al. (2000) study call into question the ability of large REITs to generate sufficient economies of scale based on income growth. However, this conclusion must be interpreted with caution because the study was based on...

NOTE: All illustrations and photos have been removed from this article.



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