Regulatory And Market Constrainsí Effects On Reits Capital Structure And Share Value

Most (Continental) European public REITS and comparable investment vehicles are subject to prudential and tax regulation aimed, respectively, to protect and favor retail investors. Regulation typically limits leverage ratio of REITS and recognizes them as income tax free entities. At the same time, as in the Italian case, market evidence shows that public REITS typically trade at (deep) discount on NAV figures. Those legal and market constraints: leverage limitations, market discount on NAV, tax controls, have severe implications on the capital structure of REITS by limiting managersí financial options when defining the optimal balance sheetís liability configuration. In turn, financial options limitations might lead to suboptimal financial structures, generating negative effects on REITSí share value consistently with financial valuation approaches. Suboptimal financial structures could contribute to partly explain market prices discount on NAV figures. The paperís objective is an economic analysis of the effects (i) on capital structure and (ii) on REITSí share value of the above mentioned, major legal and market constraints affecting REITSí business from a loan economics perspective. The hypothesis is that regulatory limitations incentivize REITS to maximize the allowed leverage level regardless of the optimal financial structure managers would choose if constrained free. At the same time, debt maximization induced by regulation generates compliance risk. It arises in the case of market turnarounds lowering real estate asset values below leverage limitations forcing REITS to sell properties at critical points in time at detriment to the investors. The analysis focuses on Italian market evidence.