The Impact of Misvaluation in the REIT Sector

Misvaluation is defined as the act of misspecifying the current value of an asset or a company. Graham & Harvey (2001) report that misvaluation is one of the most important factors impacting on the decision of when and how to issue common stocks.Within the REIT, investors as outsiders have difficulty to accurately determine the market value of REITs because information asymmetries in the real estate market are high (Garmaise & Moskowitz, 2004). Moreover, REITs rely mainly on external financings for their activities and always issue securities to cover a shortage of internal sources of capital (Boudry et al., 2010). Hence, misvaluation is more likely to be a significant problem for REITs. However, up to now, the effect of misvaluation on the REIT capital structure decisions has not been analyzed.By using the decomposing market-to-book model of Rhodes-Kropf et al. (2005) and the residual income model of Ohlson (1995) to estimate misvaluation, weconduct a comprehensive investigation of misvaluation's impact in the REIT sector. First, we examine the impact of misvaluation on REITs’ financing decisions because the capital structure of REITs is entirely different from non-REIT firms due to their tax-exempt status. Second, we analyze how misvaluation can influence cash holdings and the use of bank credit lines. These things could be severe problems in the REIT sector because the mandatory payout is high and the ratio of cash to total assets of REITs is 12 times lower than that of non-REIT firms (Damodaran, 2005). Altogether our paper makes several contributions to the literature about the effect of misvaluation on the financing decisions and liquidity management policies of REITs.The main results can be summarized as follows: First, REITs experiencing a high appreciation of stock price would have a greater propensity to increase the likelihood of an equity issue, whose purpose could be to exploit the low cost of equity capital relative to other forms of capital. Second, REITs are more likely to increase debt issuances and have greater credit line availability when their stock is overvalued. The reason for these results is that overvalued REITs generally have easier access to debt. Third, regarding the liquidity management policies, we find empirical evidence supporting that overvalued REITs use more cash than bank lines of credit for liquidity management because they can accumulate larger amounts of cash relative to other firms.