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Leverage and Returns: A Cross-Country Analysis of Public Real Estate Markets

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Abstract

The theoretical literature suggests a positive relation between financial leverage and asset returns, but the empirical evidence on this effect is mixed. We examine leverage effects in public real estate markets across eight countries with active public real estate markets. Cross-country public real estate markets provide an interesting testing ground given the significant use of leverage in real estate markets, the variation in REIT capital structures within and across countries, and the cross-country differences in liquidity, ownership, economic, institutional, and capital market structures. After carefully isolating leverage effects in firm-level returns, we find that leverage has a significant effect on returns both unconditionally and conditionally using standard asset pricing models. In addition, greater use of leverage during the 2007–2008 REIT crisis period is associated with larger share price declines.

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Notes

  1. For more information on index construction, see FTSE EPRA/NAREIT, Ground Rules for the Management of the FTSE EPRA/NAREIT Global Real Estate Index Series, Version 5.5, May 2013, which is available at www.epra.com.

  2. In our Appendix available on request from the authors, we show that our results for the UK with a smaller sample period are consistent with our reported findings in this paper. Germany and Hong Kong also had active public real estate markets over our sample period. However, legislation allowing “REIT-like” structures was not passed in these countries until well after the beginning of our sample period. These countries are therefore excluded from our analysis.

  3. We report year-end firm counts for expositional purposes. In constructing our indices, we form and hold constant the constituents on a quarterly basis.

  4. There are cases in which a company listing is not the same as the country of incorporation, or the actual assets are located somewhere else. To deal with these cases, EPRA has introduced nationality rules, in which it assigns a country classification (Rules 4.8 and 4.9 of the Ground Rules). The nationality of a company will generally be the same as that allocated by FTSE in the construction of the FTSE Global Equity Index Series, except where this would be inconsistent with the allocation of the company to the Developed subseries’ rule. In this case, the nationality of a company in the Developed subseries will be determined by the Developed country and, in the case of an Emerging subseries constituent, the Emerging country that contributed most to the company EBITDA as evidenced by the company’s most recent financial report.

  5. Special care is taken to correct for missing ISIN codes. Among the ISIN codes provided by EPRA, we have 51 missing ISIN codes. Unfortunately, DataStream does not retain data for firms whose ISIN code changes through time. For instance, AMB, a U.S. industrial REIT, merged with Prologis in 2011Q2. The ISIN code for AMB before the merger was US00163T1097. However, this ISIN code is not in the DataStream database, instead it was replaced with the ISIN code US74340W1036 that identifies the merged company.

  6. In Canada, REITs are required to be exchange listed only if they are structured as closed-end funds.

  7. No development restrictions are imposed on REITs in Australia, Canada, the Netherlands, and the U.S.

  8. Alcock et al. (2013) find that real estate company capital structure choices reflect REIT regulations; while a study by Green Street Advisors (July 2009) suggests the existence of market pressures to reduce leverage ratios.

  9. Two U.S. REITs had zero leverage during a sample month (one each in 2004 and 2009). Ten REITs had more than 90 % leverage at the beginning of a month, although most of these observations occurred in 2008.

  10. We would prefer to use the current market value of all debt claims and preferred shares in our unlevering algorithm. However, marking-to-market all such claims on a monthly basis is not feasible.

  11. In March 2008, the Australian Stock Exchange introduced the term “A-REIT” to replace “Listed Property Trust.” Thus, for the Australian firms in the sample before 2006, we designate them as a REIT any time we find a statement in the financial report that recognizes corporate tax exemption. For instance, for AMP SHOPPING CENTRE (2002q1-2003q2), we found the following statement in its 10Q for 2003q2: “Under current tax legislation, the Trust is not liable to pay tax provided its taxable income and taxable realised capital gains are distributed to unit holders.” We interpret this as a clear sign that this firm is indeed a REIT because A-REITs must payout 100 % of annual income and capital gains.

  12. In our sample, one REIT (Hilltop Holdings Inc. ISIN: US0082731045) revoked its election as a REIT for U.S. federal income tax purposes in 2006 (page 4 of the Annual Statement for fiscal year 2007). Therefore, in our sample this firm is included as a non-REIT in 2007–2011.

  13. In Australia, we could not identify the REIT status for the two firms (COLO.1ST.STE.PR.TST.GP and PRINCIPAL OFFICE FUND). Each of them counts for around 3 % of the total assets of all the firms in the sample in 2001 and 2002, respectively. The All-Firms levered index is 11.43 % over the sample period, which is less than both the REIT and Non-REIT returns of 11.97 % and 19 %, respectively. This is because the Non-REIT index has a gap from 2008Q3 to 2009Q1. Indeed, if we look at the sample figure over the same sample periods we have until 2008Q3, the returns are 13.86 % (all-firms), 14.67 % (REIT) and 3.81 % (non-REIT), while levered returns from 2009Q2 are 31.07 %, 30.39 %, and 56.28 %, respectively.

  14. Though untabulated, Treynor ratios using corresponding country-, regional-, and global-level estimated betas yield similar results.

  15. All regional and country-specific excess returns are calculated using the one-month US Treasury yield.

  16. See Ken French’s website: (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html). Mkt-RF is the value-weighted return in excess of the US Treasury. SMB (“small minus big”) is designed to measure the additional return investors earned in a particular month by investing in companies with relatively small market capitalizations. This “size premium” is computed as the average return for the smallest 30 % of stocks minus the average return of the largest 30 % of stocks in that month. HML (high minus low) is designed to measure the “value premium” obtained by investing in companies with high book-to-market values. HML is computed as the average return for the 50 % of stocks with the highest B/M ratio minus the average return of the 50 % of stocks with the lowest B/M ratio each month. MOM is the average return on high prior return portfolios minus the average return on low prior return portfolios.

  17. The market value of total assets is equal to [book value of assets + market value of common equity – common equity – deferred taxes].

  18. The correlation between leverage and measures of financial distress is addressed below.

  19. These global risk factors were obtained from Ken French’s website: (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html).

  20. For the total asset value (the aggregate denominator in the relative weights), we hold the book value of debt and liquidation value of preferred equity constant throughout the year given the annual data frequency of these data.

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Acknowledgments

We would like to thank Xudong An, Dennis Capozza, David Downs, Bob Edelstein, Piet Eichholz, Dan French, Julia Freybote, David Geltner, Fraser Hughs, Seow Ong, Michael Seiler, Tim Riddiough, and the EPRA research committee, as well as seminar participants at the MNM 2013 MIT symposium and Homer Hoyt Institute for helpful comments and suggestions. We also thank EPRA for providing both data and financial support.

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  1. Department of Finance & Real Estate, Hough Graduate School of Business, University of Florida, Gainesville, FL, 32611-7168, USA

    Emanuela Giacomini, David C. Ling & Andy Naranjo

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  1. Emanuela Giacomini
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Correspondence to Andy Naranjo.

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Giacomini, E., Ling, D.C. & Naranjo, A. Leverage and Returns: A Cross-Country Analysis of Public Real Estate Markets. J Real Estate Finan Econ 51, 125–159 (2015). https://doi.org/10.1007/s11146-014-9489-5

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