Does Debt Management Matter for REIT Returns?

Abstract

Asset and debt management are two essential managerial tasks in any firm. The traditional view holds that asset management is the primary driver of real estate investment trust (REIT) returns for the following reasons: (1) interest tax shields are not a source of incremental value for REITs and (2) the plain tangibility of real estate assets helps to diminish the financial distress costs of REITs. This paper examines empirically whether debt management also matters for the operating returns (i.e., ROA, ROE, ΔROA or ΔROE) of a portfolio of REITs. Both applying a novel dynamic decomposition method to ΔROA or ΔROE and also defining ROA and ROE under the net income and the funds from operations metrics guide the empirical approach of this paper. Our findings show that the effects of debt management on REITs’ operating profitability cannot be ruled out. However, the direction of these effects appears to be opposite to that of asset management. These results call for renewed and further investigations into the optimal capital structure questions for REITs.

Appendix

Alternative Dynamic Decompositions¹⁴

At time t, the ROE (R_t) equals net income (NI_t) divided by total equity (E_t). That is,

$${R}_t=\frac{NI_t}{E_t}$$

(7)

where ${NI}_t={\sum}_{i=1}^{n_t}{NI}_{i,t},{E}_t={\sum}_{i=1}^{n_t}{E}_{i,t},$ and n_t is the number of REITs. After substitution and rearrangement, we get

$${R}_t={\sum}_{i=1}^{n_t}{r}_{i,t}{\theta}_{i,t},$$

(8)

where r_i,t equals the ratio of net income to equity for REIT i in period t and θ_i,t equals the i-th REIT’s share of portfolio/industry equity. We want to decompose the change in portfolio/industry ROE into “within,” “between,” “entry,” and “exit” effects. The change in portfolio/industry ROE equals the following:

$$\Delta {R}_t={R}_t-{R}_{t-1}={\sum}_{i=1}^{n_t}{r}_{i,t}{\theta}_{i,t}-{\sum}_{i=1}^{n_{t-1}}{r}_{i,t-1}{\theta}_{i,t-1}.$$

(9)

The number of REITs in period (t) equals the number of REITs in period (t-1) plus the number of REIT entrants minus the number of REIT exits.¹⁵ That is,

$${n}_t={n}_{t-1}+{n}_t^{enter}-{n}_{t-1}^{exit}.$$

(10)

Rearranging terms in Eq. (10) yields

$${n}_t-{n}_t^{enter}={n}_{t-1}-{n}_{t-1}^{exit}={n}_{t/t-1}^{stay};\ or$$

(11)

$${n}_t={n}_{t/t-1}^{stay}+{n}_t^{enter}, and\ {n}_{t-1}={n}_{t/t-1}^{stay}+{n}_{t-1}^{exit}$$

(12)

Thus, Eq. (9) adjusts as follows:

$$\Delta {R}_t={\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,t}{\theta}_{i,t}+{\sum}_{i=1}^{n_t^{enter}}{r}_{i,t}{\theta}_{i,t}-{\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,t-1}{\theta}_{i,t-1}-{\sum}_{i=1}^{n_{t-1}^{exit}}{r}_{i,t-1}{\theta}_{i,t-1}.$$

(13)

Case 1: Existing Dynamic Decomposition - Laspeyres Difference Index.

While we already separate the “stay” terms from the “entry” and “exit” terms, we now need to decompose the “stay” terms into the “within” and “between” effects. Bailey et al. (1992) and Haltiwanger (1997) weight the “within” effect with the individual firm’s portfolio/industry share of equity in the initial year.¹⁶ That is, we need to add and subtract ${\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,t}{\theta}_{i,t-1}$ from the right-hand side of Eq. (13). After some manipulation, we get

$$\Delta {R}_t={\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,t}{\theta}_{i,\Delta t}+{\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,\Delta t}{\theta}_{i,t-1}+{\sum}_{i=1}^{n_t^{enter}}{r}_{i,t}{\theta}_{i,t}-{\sum}_{i=1}^{n_{t-1}^{exit}}{r}_{i,t-1}{\theta}_{i,t-1},$$

(14)

where θ_{i, ∆t} = θ_{i, t} − θ_{i, t − 1} and r_{i, ∆t} = r_{i, t} − r_{i, t − 1}.

Then, we can rewrite Eq. (14) as follows:

$$\Delta {R}_t={\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,\Delta t}{\theta}_{i,t-1}+{\sum}_{i=1}^{n_{t/t-1}^{stay}}\left({r}_{i,t}-{R}_{t-1}\right){\theta}_{i,\Delta 1}+{\sum}_{i=1}^{n_t^{enter}}\left({r}_{i,t}-{R}_{t-1}\right){\theta}_{i,t}-{\sum}_{i=1}^{n_{t-1}^{exit}}\left({r}_{i,t-1}-{R}_{t-1}\right){\theta}_{i,t-1}$$

(15)

where we evaluate the “between,” “entry,” and “exit” effects relative to the lagged portfolio/industry ROE (R_t−1). For example, the “between” effect sums the differences between each REIT’s ROE and the portfolio’s/industry’s ROE, multiplied by that REIT’s change in equity share. In this case, we evaluate the REIT’s ROE in period (t) and the industry's ROE in period (t-1).

Case 2: Alternative Dynamic Decomposition - Paasche Difference Index.

We decompose the change in industry ROE by weighting the “within” effect by period-t individual REIT’s share of portfolio/industry equity.¹⁷ In other words, we need to add and subtract ${\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,t-1}{\theta}_{i,t}$ to Eq. (13). After necessary manipulations, the final form equals:

$$\Delta {R}_t={\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,\Delta t}{\theta}_{i,t}+{\sum}_{i=1}^{n_{t/t-1}^{stay}}\left({r}_{i,t-1}-{R}_t\right){\theta}_{i,\Delta t}+{\sum}_{i=1}^{n_t^{enter}}\left({r}_{i,t}-{R}_t\right){\theta}_{i,t}-{\sum}_{i=1}^{n_{t-1}^{exit}}\left({r}_{i,t-1}-{R}_t\right){\theta}_{i,t-1},$$

(16)

where we evaluate the “between,” “entry,” and “exit” effects relative to the current portfolio/industry ROE (R_t).¹⁸

Case 3: Bennet Dynamic Decomposition. ¹⁹

The Bennet dynamic decomposition computes the arithmetic average of Case 1 and Case 2 as follows:

$$\Delta {R}_t={\sum}_{i=1}^{n_{t/t-1}^{stay}}{r}_{i,\Delta t}{\overline{\theta}}_{i,t}+{\sum}_{i=1}^{n_{t/t-1}^{stay}}\left({\overline{r}}_i-\overline{R}\right){\theta}_{i,\Delta t}+{\sum}_{i=1}^{n_t^{enter}}\left({r}_{i,t}-\overline{R}\right){\theta}_{i,t}-{\sum}_{i=1}^{n_{t-1}^{exit}}\left({r}_{i,t-1}-\overline{R}\right){\theta}_{i,t-1}.$$

(17)

where ${\overline{\theta}}_i=\left({\theta}_{i,t}+{\theta}_{i,t-1}\right)/2,\kern0.5em {\overline{r}}_i=\left({r}_{i,t}+{r}_{i,t-1}\right)/2, and\ {\overline{R}}_i=\left({R}_t+{R}_{t-1}\right)/2.$  

The Bennet dynamic decomposition includes four effects. The “within” effect equals the summation of each REIT’s change in ROE weighted by its average share of portfolio/industry equity between period (t-1) and period (t). The “between (reallocation)” effect equals the summation of the difference between each REIT’s ROE and the portfolio/industry average ROE between period (t-1) and period (t), multiplied by the change in that REIT’s share of portfolio/industry equity. The “entry” effect equals the summation of the difference between each entering REIT’s ROE in period (t) and the portfolio/industry average ROE between period (t-1) and period (t) times the entering REIT’s share of portfolio/industry equity in period (t). Finally, the “exit” effect equals the summation of the difference between each exiting REIT’s ROE in period (t-1) and the portfolio/industry average ROE between period (t-1) and period (t), multiplied by the exiting REIT’s share of portfolio/industry equity in period (t-1).