Abstract
The rapid growth of REITs over the last two decades raises an old debate on the existence of scale economies. Out of the 874 growth incidents recorded by individual REITs between 1992 and 2012, we observe that 44.5% of them are sub-optimal, that is they resulted in the acquiring REITs operating at decreasing returns to scale. Large REITs with more free cash flows have a higher propensity to engage in bad growth activities. We find evidence that institutional investors play an effective role in discouraging managerial opportunism and empire building. Independent directors and external creditors, however, do not appear to be effective in discouraging REIT managers from making bad growth decisions.
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Notes
The rapid growth could be attributed a host of external factors. The credit crunch in the early 1990s forced heavily leveraged real estate firms to turn to the equity market for survival and to reconstruct their impaired balance sheet. Aided by the 1993 Revenue Reconciliation Act, which removed the 5/50 rule that had prevented institutional investors from actively participating in real estate, the IPO boom in 1993 and 1994 saw REITs gaining popularity among large investors (Vogel 1997). On the supply side, the UPREIT structure introduced in 1992 provided another impetus for REITs rapid expansion by offering the benefits of deferred capital gain tax for real estate owners who were previously reluctant to sell-off their assets. Innovations in the debt securitization market provided further fuel through the financing channel to feed the insatiable appetite of REITs to grow through mergers and acquisitions. Finally, the inclusion of Equity Residential REIT into the S&P 500 index in 2001 provided the formal recognition of REIT as an established investment vehicle.
Berger and Ofek (1995) find a positive association between disclosure level and benefits from diversification and conclude that greater disclosure reduces management’s proclivity for investing in assets that destroy shareholders value. Hope and Thomas (2008) observe that MNCs which do not disclose their geographic earnings are likely to expand their overseas business at the expense of a decline in profit.
Ling and Ryngaert (1997), for example, argue that the dramatic increased ownership of institutional investors (from below 10% before 1990 to 41.7% in the early 1990s), who are presumably better informed than retail investors, affected the pricing of IPO REIT shares in the post 1990 era.
Before 1993, companies were required to meet two basic ownership rules in order to qualify for REIT designation, namely the 100 Shareholder Rule and the 5/50 Rule. The 100 Shareholder Rule stipulated that a REIT company must be owned by 100 or more shareholders, while the 5/50 Rule maintained that 5 or fewer individuals cannot own more than 50% of the stocks of a REIT. The 5/50 Rule, in particular, made REIT securities unattractive to institutional investors, such as pension funds which were treated as an individual under the old 5/50 rule. With the passage of the 1993 Revenue Reconciliation Act, the 5/50 rule was altered - instead of counting a pension fund as a single investor, beneficiaries of the pension fund are now counted as individual investors (Anoruo and Braha 2010). Below et al. (2000) and Devos et al. (2013) also note that institutional investors prefer to invest in larger REITs.
The fixed effects for property type include retail, health care, residential, industrial/office, diversified, lodging/resorts, and self-storage sectors. Ambrose et al. (2005) argue that each sector is effectively a separate industry with its own operating and competitive dynamics.
Similar to the concept of efficient frontier in portfolio construction, the logic behind the DEA technique is that if one REIT can produce q outputs with i inputs, then other REITs must be able to do the same, or else they are identified as having some degree of inefficiency.
Net property investment is defined as total properties less accumulated depreciation. Loans to customers include loans and finance leases held for investment or held for sale, net of unearned discount and gross of loss reserves. Interestingly, 60% of the equity REITs held a small amount of loan assets in their balance sheet. For example, Kimco Realty declared in its 2012 10-K a sum of $70.7 million (0.7% of total assets) for mortgage and other financial receivables which include loans acquired or originated by the REIT. Other assets refer to asset categories other than net property investment or loans to customers.
Since the total assets and property assets of REITs may be affected by their depreciation policy, we also tried adding back depreciation to total assets and are pleased to report that the results are robust.
Allen and Sirmans (1987) and McIntosh et al. (1989) record significantly positive returns associated with merger announcements. Campbell et al. (2001) however find REIT stocks react adversely to merger announcements due to geographical diversification. Cross-sectional studies have also yielded inconclusive results. While Ambrose et al. (2000) cast doubts on the ability of large REITs to generate economies of scale, Ambrose et al. (2005) find a direct relationship between firm profitability and firm size. Note that the average REIT in their sample (1990–2001) has a market capitalization of more than $1 billion. Since 2001, the size of REITs have rose dramatically (see Figure 1).
In an unreported regression, we included two additional variables, namely whether the REIT is structured as an UPREIT and whether it is registered in the Maryland state (Hartzell et al. 2006). The two variables are also insignificant.
Debt ratio of the individual REITs is represented by the book value of total debt divided by the book value of total assets. The empirical results are robust when a market-value measure of leverage is employed.
We observe that the percentage of bad growth is higher in the following years: 1995 (61.1%), 1997 (59.3%), 1999–2000 (65.0%–70.2%), and 2007–11 (51.0%–72.7%).
The agency theory premises that managers take advantage of their position at the expense of the shareholders. While we do not differentiate poor growth due to managerial opportunism from poor growth attributable to managerial incompetence, the role of monitoring is arguably valid in reducing poor growth decisions. Incompetent managers who consistently perform badly are likely to be replaced.
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Acknowledgements
We thank the Special Issue Editors, Neil Dunse, Robert Edelstein, Dan French, Thies Lindenthal, Colin Lizieri, Nick Mansley, Seow-Eng Ong, S. McKay Price, Woei-Chyuan Wong as well as participants at NUS-Maastricht-MIT symposium in Singapore (2015), the American Real Estate and Urban Economics Association Meeting in Boston (2015), the American Real Estate Society Meeting in San Diego (2014), the Asian Real Estate Society Meeting in Gold Coast, Australia (2014), the University of Cambridge’s real estate finance seminar (2014), and the Heriot-Watt University’s real estate research seminar (2014) for helpful comments and suggestions.
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Xu, R., Ooi, J.T.L. Good Growth, Bad Growth: How Effective are REITs’ Corporate Watchdogs?. J Real Estate Finan Econ 57, 64–86 (2018). https://doi.org/10.1007/s11146-017-9640-1
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DOI: https://doi.org/10.1007/s11146-017-9640-1