The REIT Debt Puzzle

Although REITs do not have any tax advantage of debt, their leverage ratio is twice as high as that of non-REITs. By scanning capital structure theories and previous studies, then comparing results of the REIT sample with that of the comparison sample, we find reasons encouraging REITs use of debt financing. First, regarding the impact of capital structure determinants on REIT and non-REIT leverage, our analysis suggests that tangibility is the most influencing factor that contributes 17 percentage points of total difference between REITs’ leverage and non-REITs’ leverage. This result indicates that a high availability of desirable collateral increases the REITs’ preference for debt financing. The most second influencing determinant is operating risk which implies that REITs with more volatile cash flows tend to utilize debt financing to avoid the potential problems of new equity, e.g. misvaluation or the adverse reaction of investors to equity issue announcements. In contrast, firm size is the most influencing factor that reduces the magnitude of the total difference. The reason is that firm size has a positive impact on non-REITs’ leverage, but it has an insignificant impact on the leverage ratio of REITs.Second, we find evidence that REITs and non-REITs pursue different goal functions. Specifically, REITs pursue an optimal deviation from the target leverage ratio to maximize the risk-adjusted performance, while non-REITs follow an optimal deviation to maximize the firm value. Our investigation indicates that REITs can maximize their risk-adjusted performance if they maintain their deviation at the level of 40.6%, which corresponds to the leverage of 62.5%. Similarly, the firm value of non-REITs can be maximized if their deviation is 0.9% or their leverage is 24.5%.Finally, our findings reveal that the market response to a debt issue announcement is more positive than it is to an equity issue announcement. For example, on average, the cumulative abnormal return in the event window of 11 days surrounding a debt issue announcement date is 1.9 percentage points higher than that surrounding an equity issue announcement date. This result implies that the leverage ratio of REITs is high because managers desire to avoid the adverse reaction of investors to equity issue announcements.