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Agency Cost, Dividend Policy and Growth: The Special Case of REITs

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Abstract

Dividend distribution enhances information transmission, and mitigates agency conflicts by restricting managers’ access to free cash flow, and exposing firms to the scrutiny and monitoring by market participants when raising external capital. The reduction in agency costs and improvement in information dissemination reduce the cost of funds, and investment at more competitive cost of capital enhances firm value. For REITs, because of the mandated high dividend distribution, growth depends on the availability of external capital at competitive rates, such that mitigation of agency costs is critical to sustain growth. We examine the relation between dividends and growth with a sample of U.S. equity REITs. Our data reveal a significantly positive relation between externally financed growth and dividend payments. The relation is stronger among REITs with more growth opportunities, and REITs that issue new equity and debt. We interpret this evidence as consistent with the notion that by reducing agency costs and facilitating capital raising, dividends enhance growth.

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Notes

  1. This sample largely coincides with those of recently studies Hardin and Hill (2008) and Chou et al. (2013).

  2. 75 % of REIT assets must be held in cash, government securities, and real estate assets.

  3. A REIT must have more than 100 shareholders, and the five largest may not own more than 50 % of the total shares outstanding.

  4. The inability of REIT managers to invest outside the real estate sector is often cited as a reason why there are no hostile takeovers among REITs.

  5. Hardin and Hill (2011) report strong association between REITs’ line of credit availability and dividend payment, investment and capital market access. The authors find an inverse relation between equity offerings and line of credit, which implies that REITs use lines of credit as a precautionary measure, and use equity to rebalance capital structure. Hill, Kelly and Hardin (2012) test the substitutability between cash and line of credit. They find that unused credit lines are significantly less valued than cash, and vice versa.

  6. Ooi et al. (2010) find evidence that bank credit lines can protect REITs when credit quality deteriorates and provide financial slack to support investment opportunities. Ooi et al. (2010) show that in their financing choices, REITs are driven by both market timing and target capital structure. When REITs deviate from target debt ratios to adjust to market conditions, lines of credit can provide the necessary liquidity.

  7. With data from Form 1099-DIV, we have 95 firm-year observations and 43 REITs. Our regression analysis with this small sample produces correct coefficient sign for excess dividend but no statistical significance.

  8. Demirgüç-Kunt and Maksimovic’s (1998) externally financed growth measures are appropriate for our study for two reasons. First, these measures derived from general financial planning models (e.g., Higgins (1977)), which are not industry specific. Khurana et al. (2006) apply this set of measures to the cross-section of all firms without excluding regulated industries. Second, we compare these growth measures among a sample of U.S. incorporated equity REITs. The homogeneous business model of our sample makes these growth measures comparable between firms.

  9. In unreported results, we use untransformed excess growth measures to perform our analysis, and find coefficients of excess dividends are still significantly related to EXCESS_IG and EXCESS_SFG, but not significant with EXCESS_SG. This is likely due to the issues we just discussed.

  10. Florackis and Ozkan (2009) empirically investigate the relationship between managerial entrenchment and agency costs with a large UK sample, and they find agency costs are persistent over time.

  11. The explanatory variables in Boudry’s (2011) study also include a few that are not in Hardin and Hill (2008), such as S&P credit rating availability, location Herfindahl, type Herfindahl, and Baker and Wurgler’s (2004) market dividend premium. However, none of these additional variables are significantly related to excess dividends, therefore we do not include them in our version of excess dividend model.

  12. We exclude ROA from our dividend equation because the Spearman rank correlation coefficient between ROA and mandatory dividend rate is close to 1 with our sample (The Pearson coefficient is slightly lower). This is because mandatory dividend is a fraction of pretax income, and earnings is highly correlated with pretax income given the rather insignificant role of tax REITs pay. In Bondry’s study, the correlation between these two variables is 0.70. The lower coefficient is the result of using two difference data sources to calculate earnings and pretax income.

  13. Hardin and Hill (2008) reduce the number of property focus categories by grouping mall, retail or shopping as RETAIL, diversified, manufactured homes or other as OTHER. The resulting seven categories are: MULTIFAMILY, RETAIL, OFFICE, INDUSTRIAL, SELF-STORAGE, HOTEL, and OTHER.

  14. We use general and administrative expense rather than the operating expense used in Ang et al. (2000) because large depreciation in REITs asset might not directly capture agency costs. However, our results are not sensitive to this change.

  15. Since our final sample has 275 less firm-year observations, and 29 less unique REITs than the sample without 3-year data availability constraint, we need to test if our sample suffers from selection bias. We compare a battery of variables between the final sample with 3-year averages and the one without such restriction, and we find no statistical difference in sample mean. Since our main dependent variable PROP_IG, PROP_SFG, and PROP_SG have to be calculated over several years, we cannot run our main regression with the larger sample. However, our realized sales growth regression with the relaxed sample shows stronger support for the agency theory of dividends than the more constrained sample. This can be attributed to the fact that unsuccessful REITs may suffer more agency problem, and the effect of dividends in reducing agency costs is more pronounced.

  16. Besides taking 3-year averages of the externally financed growth measures, we also consider 2, 4, and 5 years of the externally financed growth variables. Our results do not change materially.

  17. Negative excess dividends reflect the fact that the excess dividends measure is an approximation as discussed in the “Empirical Method”.

  18. The correlation among our regression variables are similar to Boudry (2011) and Khurana’s et al. (2006) study. Judge et al. (1980, page 459) state that a Spearman rank correlation lower than 0.8 should not be concerned.

  19. Note we exclude ROA in models with mandatory dividend due to their high correlation as previously discussed.

  20. Recall that the correlation coefficient between growth and excess dividends in Table 4 is an insignificant −0.02.

  21. We estimate Columns (1) and (2) with our unrestricted sample that does not average across years, and we find positive but insignificant coefficient on excess dividend in Column (1), and positive and significant coefficient on excess dividend in Column (2). This indicate the positive relation between excess dividends and firm sales growth is not the result of sample bias. The inconsistency in significance is most likely due to the noise introduced by internal financed growth.

  22. As we argued earlier, the effect of dividend payment is similar to that of bank lines of credit. Hardin and Wu note that bank loans offer efficient monitoring services and help young companies to build creditworthiness. As a young industry experiencing rapid growth, access to capital market may be constrained for REITs due to potential information asymmetry and agency conflicts. Bank loans provide effective certification and monitoring of REITs’ acquisition strategies. This allows REITs to raise funds at lower cost which boosts investment. Riddiough and Wu (2009) also note the effectiveness of bank credit lines in enhancing investments.

  23. In addition to Q, Korajczyk and Levy (2003) also impose zero dividends in their classification scheme. Since internal funds account for a very small percentage of REITs’ capital needs, we only use Q in our classification.

  24. If we interpret Q as proxy for information asymmetry, our test also explains the positive relation between excess dividends and growth is not driven by reduction in asymmetric information (e.g., Lee et al. 2010). If that is the case, the positive relation should hold for both high and low Q subsamples.

  25. We also include the square of CEO ownership to account for the nonlinear effect of CEO ownership on dividends.

  26. We thank the editor for suggesting this test.

  27. Similar to these tests, in unreported results, we also test the life-cycle theory of DeAngelo et al. (2006) by adding retained earnings in our dividend equation, but find no change to our results.

  28. More specifically, for firm i in year t, we first regression firm i’s monthly returns in years t-5 to t-1 on corresponding Fama and French three factors from Ken French’s website. We require firm i to have at least 24 valid monthly returns for the regression. Then we multiply these coefficients with the monthly factor returns in year t to obtain the monthly cost of equity. The cost of equity in year t is the average of the monthly cost of equity in year t times 12, similar to Fama and French (1997). The return data are from CRSP, and the Fama and French factor data are from Ken French’s website.

  29. It is also common to use market beta as proxies for cost of equity. However, REITs tend to be smaller in size and their valuation method differs from other industrial firms. Therefore, it is necessary to control for these firm characteristics when estimating REITs cost of equity.

  30. This approach makes three assumptions. First, the ratio of productive assets to sales is constant. Second, the profit margin of each unit of sales is constant. Finally, the depreciation amount reported in the firm’s financial statements is equal to the economic depreciation.

  31. This definition differs from that used in Demirgüç-Kunt and Maksimovic (1998) and Khurana et al. (2006), where they assume payout ratio is zero.

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Acknowledgment

We appreciate helpful comments from an anonymous reviewer, William Hardin, Igor Osobov, Alfred Yawson, and seminar participants at Eastern Finance Association 2012 Annual Conference, University of Connecticut, and Florida International University. We are also grateful to Erasmos Giambona, John Harding, Fan He, Scott Roark, Yihong Xiao and the Quantitative Equity Research Group of Deutsche Bank for their generous help with data collection. We thank Ken French for providing the Fama and French factors on his website. Manish Shrivastava provided excellent research assistance.

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  1. Department of Finance, School of Business, University of Connecticut, 2100 Hillside Road, Unit 1041, Storrs, CT, 06269, USA

    Chinmoy Ghosh

  2. AllianceBernstein L.P., 1345 Avenue of Americas, New York, NY, 10105, USA

    Le Sun

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  1. Chinmoy Ghosh
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Correspondence to Le Sun.

Appendix

Appendix

Following Demirgüç-Kunt and Maksimovic (1998) and Khurana et al. (2006), we derive externally financed growth by the “percentage of sales” approach to financial planning.Footnote 30 Then the external financing a firm needs at time t can be expressed as:

$$ \mathrm{EFN_t}=\mathrm{g_t}*\mathrm{ASSETSt}-\left( {1+\mathrm{g_t}} \right)*\mathrm{FFO_t}*\mathrm{b_t}, $$
(A.1)

EFN is the external financing needed, g is sustainable growth rate, ASSETS is the size of assets in the current period, FFO is the funds from operations, and b is the proportion of FFO retained for future growth \( \left( {\mathrm{RE_t}=\left( {\mathrm{FFO_t}-\mathrm{DIV_t}} \right)=\mathrm{FFO_t}*\mathrm{b_t}} \right) \). The first term on the right hand side is total funds required, and the second term is the amount of funds generated from retained earnings.

Following Demirgüç-Kunt and Maksimovic (1998), we estimate three benchmark growth rates that are achievable by a firm with constrained access to external financing: the rate of growth sustainable with internally generated funds (IG), the rate of growth that can be attained with internally generated funds augmented with short-term funds (SFG), and the sustainable growth rate (SG). IG is the maximum growth rate that can be supported if the REIT relies only on internal sources. It is obtained by setting the firm’s external financing to zero, i.e., EFN = 0, and setting b to (FFO – DIV)/FFO, where DIV is the amount of dividends paid. Denoting RE as retained earnings after dividends, it follows that,

$$ \mathrm{IG_t}=\mathrm{RE_t}/\left( {\mathrm{ASSETS_t}-\mathrm{RE_t}} \right). $$
(A.2)

The second benchmark growth rate (SFG) is an estimate of the maximum growth rate of a firm that reinvests all its earnings after dividends, and utilizes short-term debt at the current ratio of short-term borrowing to assets.Footnote 31 This estimate assumes that the firm’s short-term debt capacity does not change significantly. While this assumption ensures that the estimated growth is achievable by the firm, it suffers from the limitation of not capturing changes in the firm’s short-term borrowing capacity. To derive SFG, we set b as in IG, and follow Demirgüç-Kunt and Maksimovic (1998) to use the value of assets that is not financed by new short-term debt instead of total assets as in Eq. (4). Hence,

$$ \mathrm{SFG_t}=\mathrm{RE_t}/\left( {\mathrm{ASSETS_t}-\mathrm{STDEBT_t}-\mathrm{RE_t}} \right), $$
(A.3)

where STDEBT is the amount of short-term debt.

The last growth benchmark (SG) is the maximum sustainable growth rate that can be achieved by a firm without issuing new equity or increasing leverage ratio beyond the current level. The firm obtains just enough short-term and long-term debt without changing its total debt to assets ratio. SG is obtained by setting b as above and using the book value of equity portion of total assets in Eq. (4). Therefore,

$$ \mathrm{SG_t}=\mathrm{RE_t}/\left( {\mathrm{EQUITY_t}-\mathrm{RE_t}} \right). $$
(A.4)

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Ghosh, C., Sun, L. Agency Cost, Dividend Policy and Growth: The Special Case of REITs. J Real Estate Finan Econ 48, 660–708 (2014). https://doi.org/10.1007/s11146-013-9414-3

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