Real Risk-Adjusted Performance and Capital Structure: Theory and Evidence from Real Estate Investment Trusts

Firms can choose a capital structure that maximises real risk-adjusted performance by matching nominal liabilities with nominal assets. In doing so, firms minimise the sensitivity of real risk-adjusted returns to unexpected inflationary shocks. We develop a model of real risk-adjusted performance as a function of nominal and real assets and liabilities and demonstrate the solution to the maximisation problem. We explore the empirical support for our theoretical prediction using a sample of US Real Estate Investment Trusts (REITs), as their regulated business model allows for a straight-forward distinction between real and nominal assets and liabilities. We find evidence that firms observe the predicted linear relationship between nominal assets and liabilities, and that real risk-adjusted returns to firm equity are inversely relate to deviations from the optimal nominal liability holdings, as are inflation hedging qualities of investments into the firms' equity. Lastly, firms' holdings of nominal debt appear to increase in times of higher inflation uncertainty, supporting the notion of nominal liabilities as a buffer against unexpected inflationary shocks.