We examine the relation between firm value and liquidity among REITs. Results show shareholders benefit from both cash and unused credit line capacity. The market values an additional dollar of cash at a premium and, as theory predicts, unused credit lines are significantly less valued than cash. Evidence suggests an increase in the market value of liquidity during the recent financial crisis. We also find that financial characteristics quantifying financial constraint influence the value of REIT financial flexibility. Most notably, the value of cash decreases with remaining credit line capacity. Although prior studies argue that cash and credit lines are substitutes, this is one of the first tests of whether the market prices this substitutability.
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We ignore commercial paper because REITs are not frequent users of the commercial paper market (Riddiough and Wu 2009).
A REIT must meet three other provisions, in addition to the dividend payout restriction, to maintain their tax-exempt status. First, five-or-fewer shareholders may not hold more than 50% of the REIT’s stock. Second, at least 75% of the total assets of the REIT must consist of real estate, mortgages, cash, or federal government securities, and a minimum of 75% of the REIT’s gross annual income must be derived from the ownership of real estate properties. Last, REITs must derive their income from passive sources such as rents and mortgage interest and not from the short-term trading or sale of property assets.
Wang et al. (1993) note that the minimum dividend is not binding due to depreciation expense, which, coupled with capital gains on property sales, allows REITs to pay dividends in excess of taxable income, and many do just that (Bradley et al. 1998; Ghosh and Sirmans 2006; Feng et al. 2007a, b; Hardin and Hill 2008). Although, REITs have some discretion when choosing their degree of financial constraint, the mandatory dividend precludes these firms from pursuing meaningful growth given the capital intensity of the industry.
A contemporaneous working paper by Flannery and Lockhart (2010) conditions the value of cash on credit line access for non-REITs and reports results qualitatively similar to ours.
Similarly, Hardin III and Hill (2010) examine the determinants of REIT credit line use but ignore the firm value implications of credit line use.
Pinkowitz et al. (2006) use the model to value cash held by international non-REITs. Pinkowitz and Williamson (2007) and Drobetz et al. (2010) use the model to value cash holdings for U.S. firms. Dittmar and Mahrt-Smith (2007) and Fresard and Silva (2010) use the framework to value excess cash holdings for US firms and US cross-listings, respectively. The model is a variant of the Fama and French (1998) valuation model.
This understatement is due to the capital intensity of REIT investment and existing growth strategies that imply large depreciation expenses. Furthermore, depreciation expense does not have the same economic meaning for REITs as real estate properties are less prone to obsolescence like non-REIT assets.
As discussed in greater detail in Section Data and Summary Statistics, we use quarterly data for the analysis.
The SNL keyfields (in parentheses) used in the analysis include: Assets (220), Market Value of Equity (6,111), Cash (3,727), Total Preferred Equity (3,798), FFO (6,116), Property Sector (6,270), Interest Expense (7,271), Common Dividends Paid (14,126), Preferred Dividends Paid (14,129), Total Liabilities (18,083), Amounts Available from Credit Lines (6,164), Amount Drawn from Credit Lines (6,165) Debt Maturing-Current FY (7,597), Debt Maturing-Next FY (7,598), Debt Maturing-FY2 (7,599), Debt Maturing-FY3 (7,600).
Property categories are established after combining those listed in SNL with relatively similar leasing structures. REITs classified as Retail have SNL property focus types of Mall, Retail, or Shopping. Multi-family and Manufactured home REITs are classified as Residential. REITs with SNL property focus types of Diversified, Healthcare, or Specialty are grouped into one category named Other. The seven property focus categories are: Hotel, Industrial, Office, Other, Residential, Retail, and Self-storage, and Retail is used as the base case. Retail is the reference case as this the property focus classification with the largest number of observations.
Pinkowitz et al. (2006) discuss that it maybe problematic to nest both the level and changes (lead and lagged) in cash as current period cash may change expectations regarding future growth (page 2,739). Another problem, brought to our attention by a discussant, is that including both the level and prior period change causes difficulty in interpreting the market value of a change in cash. For these reasons, Dittmar and Mahrt-Smith (2007), Fresard and Silva (2010), and Drobetz et al. (2010) include only the level of cash in their regressions. Subsequently, we follow the literature; however, as discussed in the robustness section, our results are qualitatively and quantitatively similar if we include the changes (prior and future) and the level of the liquidity variables.
Long-term leases imply reduced cash flow uncertainty.
The marginal effect of cash on firm value is calculated by taking the partial derivative of the regression equation with respect to cash. Since market value and cash are scaled by net assets, β 1 represents the change in market value for an additional $1 held in cash.
Yun (2009) provides empirical support for this view as firms rely more heavily on cash, relative to credit lines, to manage liquidity when the threat of takeover weakens. This effect is weaker for better governed firms.
For more details on corporate credit line agreements and the costs involved, please see Sufi (2008).
Specifically, Rev. Proc. 2009–15 states that the IRS will treat the entire value of the declared dividend (including the stock portion) as a dividend, and thereby eligible for the dividends paid deduction so long as the specific calculation formula in Rev. Proc. 2010–12 is met, including that the total amount of cash available for distribution is not less than 10%. Rev. Proc. 2010–12 extended Rev. Proc. 2009–15., which should provide for increased flexibility for REITs throughout 2011. For more information, please see http://www.reit.com/PolicyPolitics/tabid/125/Default.aspx. See the following link for an interesting article on this topic: http://www.nytimes.com/2009/01/25/realestate/commercial/25sqft.html.
The following article provides recent anecdotal evidence of the debt constraints under which certain REITs are currently operating under: http://online.wsj.com/article/SB10001424052748703763904575196492743696902.html?KEYWORDS=hotel+chains.
We presently have data through end of 2009. Because of the two period change in the independent variables, our usable sample ends in the second quarter of 2009.
Slight differences in descriptive statistics, relative to Hardin et al. (2009), are likely attributable to differences in scale factor as we divide by net assets. Since REITs hold so little cash, scaling by total assets or net assets should have little bearing on the descriptive statistics.
Petersen (2009) recommends using robust standard errors that allow for firm level clustering when studying panel datasets.
Property focus dummies are time invariant and are dropped from the fixed effects models. Accordingly, the property focus effect is absorbed by the REIT-specific fixed effect.
See Pinkowitz and Williamson (2007) for comparisons to U.S. firms.
The positive association between firm value and unused credit line capacity maybe due to more than just the liquidity provided by the line. A recent article in the Wall Street Journal (Troianovksi) discusses that the relationships forged between REITs and banks when acquiring lines may also have positive implications when REITs seek investment banking services to issue long-term debt and equity.
Results for differences in estimates tests are available upon request.
Results are available upon request.
As a final robustness test, we examine whether the estimated market value of REIT cash is influenced by simultaneity bias. This is a valid concern as REITs with higher firm value may have a greater propensity to hold more cash. For example, high value firms should have improved investment opportunities, relative to less valuable firms, and holding more cash lowers the probability of underinvestment. To determine whether our results are influenced by simultaneity bias (i.e., testing for the exogeneity of cash), we use Hausman’s (1978) specification test. Accordingly, we regress Cash on the remaining independent variables in the valuation model along with firm size, measured as the natural logarithm of inflation-adjusted revenues; size is an important determinant of REIT cash holdings (Hardin et al. 2009). From this regression we calculate the residuals and then include them in the original firm value regression model. From the estimation of this model, we find that the coefficient estimate for the residuals is statistically insignificant at all conventional levels (p-value = 0.952). Thus, the evidence suggests the initial results do not suffer from simultaneity bias. We thank an anonymous reviewer for suggesting this test.
The insignificance of the level of Cash is due to multicollinearity caused by the inclusion of multiple cash-time interactions.
For the remaining tables, we present only the pertinent results. We estimate the remaining models using the full set of controls Eq. (1), with the addition of the presented interactions. Full results are available upon request.
The standard deviation of UnusedLOC is taken from Table 1. Note that the results can also be interpreted to examine the effect of cash on the market value of unused credit lines. From this perspective, the results suggest a one standard deviation increase in Cash reduce the market value of UnusedLOC by $0.35.
Specifically, once Sufi (2008) controls for credit line access, he finds that several commonly accepted measures of financial constraint lack explanatory power in terms of the cash flow sensitivity of cash.
Proxies for cash flow and dividends paid are FFO and Div, respectively, as defined and included in Eq. (1).
The sample size is reduced because of missing data for the debt maturity variables.
In an earlier version of the paper, we examined the interaction between liquidity and internal advisement. We found strong (mixed) evidence indicating a reduced value of cash (credit lines) for internally-advised REITs. These results are largely consistent with Ambrose and Linneman’s (2001) view that externally-advised REITs are more financially constrained than firms opting for internal advisors. Accordingly, the market imparts a greater valuation for externally-advised REITs’ financial flexibility.
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Hill, M.D., Kelly, G.W. & Hardin, W.G. Market Value of REIT Liquidity. J Real Estate Finan Econ 45, 383–401 (2012). https://doi.org/10.1007/s11146-010-9280-1
- Credit lines
- Financial flexibility
- Firm value