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Institutional Monitoring and REIT CEO Compensation

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Abstract

Our objective in this paper is to investigate the relationship between institutional ownership and CEO compensation structure of REITs. Based on detailed analyses of data on institutional ownership, performance, CEO and board characteristics over the 10 year period 1998–2007, we find significant evidence that large institutions influence governance through CEO compensation—greater institutional ownership is associated with greater emphasis on incentive-based compensation (higher pay-performance sensitivity of CEO compensation), and higher cash and total compensation for CEOs. Further, we find that institutions are less active when managers are performing in a superior fashion. Two important conclusions emerge from the analysis. First, similar to unregulated firms, institutional owners do act as monitors in REITs. Broadly, this result suggests that governance is necessary for REITs. Second, institutional investors set a high pay-performance sensitivity for CEOs, but are willing to pay higher cash compensation to induce managers to take risk.

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Notes

  1. Gerety et al. (2001) report that over the period of 1987 to 1998, 128 out of 289 firms in their sample have an independent nomination committee (CEO does not serve on the nomination committee). In general, CEO involvement in the selection of directors has reduced over the last twenty years. For instance, between 1988 and 1991, 32 percent of the firms in the sample have a nomination committee that does not include its CEO. This number increases to 49 percent during the 1992–1998 period. The trend is similar for REITs.

  2. For a detailed discussion on how the regulatory structure of REITs can make governance critical to performance, see Campbell et al. (2001), Ghosh and Sirmans (2003), and Feng et al. (2007a, b).

  3. Hartzell et al. (2008) conjecture that because of high mandatory dividend payment and the scrutiny and monitoring associated with capital raising activities, governance through independent board and incentive-based managerial compensation is not as critical for REITs.

  4. CEO compensation is usually set by the Board of Directors. As such, it is not clear that institutional investors have any direct influence on CEO compensation structure or type. However, institutional investors can affect governance and decision making by Boards though their large shareholdings or block ownerships. We are grateful to an anonymous referee for this observation.

  5. Pay performance sensitivity (PPS) is measured as the change in value of executive option grants for $1000 change in the value of equity. Since PPS is a direct function of the number of options granted, it raises the concern of potential CEO entrenchment when the options are exercised. Which effect dominates—the incentive effect of PPS or the entrenchment effect on conversion—is an empirical issue which, to our knowledge, has not been explored in literature. Our data do not allow us to address this issue, but it is an interesting topic for future research. This point was brought to our attention by an anonymous referee.

  6. We recognize this method suffers from the survivorship bias that surviving firms are likely to be those that register better long-term performance and attract greater institutional interest. However, as noted by Boone et al. (2007), it offers some advantages. Our focus is to examine how monitoring by institutional investors influences CEO compensation. Extant evidence suggests that internal governance mechanisms (board structure, ownership composition etc.) evolve gradually over time after the firm goes public and once a stable structure is reached, further changes are infrequent. Following the same set of firms over time allows us to focus on monitoring by institutional owners with other factors at stable levels. In addition, we repeat the tests with the 67 firms that survive through 10 years. The results are similar although the significance levels drop because of smaller sample size.

  7. We only have the names and types of institutional investors from 2000 to 2007 that we can use to classify them into pressure-sensitive and pressure-resistant.

  8. As observed by an anonymous referee, this method ignores the impact of time variation of stock price, stock price volatility, and other factors on the value of previously awarded options. However, lack of detailed information on the history of option awards makes such an analysis difficult.

  9. It is worth noting that CEO option grant PPS is not included in calculating CEO equity ownership. Theoretically, there is no a-priori reason to expect a relation between option grant PPS and CEO stock ownership, although over the long run, CEO ownership in a firm with high option grant will be high through the exercise of stock options.

  10. Hardin and Wu (2008) show that leverage has a strong impact on the interest rate markup over LIBOR paid by REITs. The authors assert that highly leveraged REITs have higher credit risk and thus have to pay a risk premium. These authors also report that REITs losing their primary agent banking relationship due to a bank merger face higher post merger loan pricing and may receive smaller amount of loan commitments from the new lenders.

  11. See Kang and Liu (2005), Khan et al. (2005) and Smith and Swan (2007) for detail.

  12. See Davis and Kim (2005), Rothberg and Lilien (2005) and Levitz (2006) for detail.

  13. Using our data, we repeated the analyses following Hartzell and Starks definition of market capitalization (without log transformation) and institutional ownership concentration (top-five institutional ownership as a proportion to total institutional ownership). We find similar results as reported by Hartzell and Starks in their Tables 2 and 5. Institutional ownership concentration has a positive coefficient in option-grant PPS model and negative coefficients in cash and total compensation models. However, if we only transformed the market capitalization as suggested by Smith and Swan (2007), the significance of institutional ownership concentration went away in both cash and total compensation models. This confirms Smith and Swan (2007)’s observation that significant results in Hartzell and Starks (2003) are potentially driven by “size effect”—smaller firms have higher institutional ownership concentration, not the “monitoring effect” as they claimed by the authors. Hence, in our main body of the analysis, we use log transformation for market capitalization in all our models and measure the concentration of institutional ownership as proportion of top-five institution investors to total shares outstanding as suggested by Smith and Swan (2007).

  14. We are grateful to an anonymous referee for suggesting these robustness checks. These results are not reported in the tables in the interest of space. They are available from the authors on request.

  15. VIF measures how much the variance of a coefficient is increased due to collinearity. The higher the index, the higher the variance is inflated compared to if the independent variable was uncorrelated with the other independent variables.

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Authors and Affiliations

  1. School of Management, Union Graduate College, Schenectady, NY, 12308, USA

    Zhilan Feng

  2. Center for Real Estate and Urban Economic Studies, School of Business, University of Connecticut, Storrs, CT, 06268, USA

    Chinmoy Ghosh & Fan He

  3. The J. Harold and Barbara M. Chastain Eminent Scholar in Real Estate, Department of Risk Management./Insurance, Real Estate & Business Law, Florida State University, 821 Academic Way, P.O. Box 3261110, Tallahassee, FL, 32306-1110, USA

    C. F. Sirmans

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  1. Zhilan Feng
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  2. Chinmoy Ghosh
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  3. Fan He
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  4. C. F. Sirmans
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Correspondence to Zhilan Feng.

Appendix

Appendix

Table 10 Number of observations for each variable by year
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Feng, Z., Ghosh, C., He, F. et al. Institutional Monitoring and REIT CEO Compensation. J Real Estate Finan Econ 40, 446–479 (2010). https://doi.org/10.1007/s11146-009-9216-9

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