The Rat Race of Capital Structure Research for REITs and REOCs: Two Spotlights on Leverage

Since the seminal work of Franco Modigliani and Merton Miller in 1958, no generally accepted capital structure theory has emerged. Consequently this paper does not aim to validate any of the capital structure theories. In fact, in our paper we focus on "financial flexibility" as an important determining factor for the capital structure of firms according to surveys among CFOs (see e.g. Su (2009) and Lins, Servaes, and Tufano (2010)). Gamba and Triantis (2008) directly address this concept and provide the following definition: "Financial flexibility represents the ability of a firm to access and restructure its financing at a low cost. Financially exible firms are able to avoid financial distress in the face of negative shocks, and to readily fund investment when profitable opportunities arise." We hypothesize that financial flexibility - as the interactions of leverage, cash and cash equivalents and lines of credit - is a broader, but more consistent, concept in explaining the dynamics of financing activities than traditional capital structure theory. In our study, leverage - the pivotal point of every capital structure study - is investigated by two spotlights. Spotlight A is defined as financial flexibility, in the sense of anticipating liquidity management. In this context, we analyze the deviation of the most important balance sheet items induced by changes of leverage, cash and cash equivalents and lines of credit. This approach, albeit new in its broad extent, is the classical model organization of capital structure studies. The innovative spotlight B distinguishes between real stochastic and mainly mechanical relationships of the ratio "leverage" and its fractionalized debt and equity component. This approach takes into account that the leverage ratio of an average firm reverts to mean mechanically. Without knowledge of this characteristic, the economic interpretation of the results could be misleading (Chen and Zhao (2007)). Our results are based on observing US Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs) from 1995 to 2010. By focusing on real estate data, we avoid a dilution of different industry sector effects. The results of perspective A emphasize the substitutive relationship between leverage and credit lines, backed by the existing literature. This claries the importance of credit lines for firms' liquidity management. The positive influence of leverage on cash and cash equivalents is new evidence and contrary to previous research. This effect - which appears especially in downturns - can be explained by the firms' strategy to accumulate cash to fund investment when profitable opportunities arise. The results of perspective B confirm our hypothesized effect that leverage as a ratio would neglect the specic influence on its components and cause misleading interpretation of the effects. At this point, we would like to point out the influence of operating cash flow. In economic upturns, a cash flow increase impacts more investments, financed by equity, but leverage remains unchanged. In downturns, investment expenses are funded by debt corresponding with a leverage increase. Besides these highlighted results, our paper presents the influence of eight traditional and new capital structure variables in 22 different subsamples for perspective A as well as for B.

Hohenstatt, Ralf and Bertram Steininger (2011), The Rat Race of Capital Structure Research for REITs and REOCs: Two Spotlights on Leverage, ZEW Discussion Paper No. 11-077, Mannheim.