The effect of financial structure on net operating income: evidence from the European REITs market

The availability and use of credit have increased significantly over time due to economic growth and development, stronger institutional structures, increased financial innovation and integration, as well as firm-level considerations. Although many firms and households have delevered their balance sheets in response to the recent financial crisis, many governments and financial firms, and especially public real estate firms, continue to maintain significant levels of debt. This raised a lot of interest among academic on the determinants of public real estate firms’ capital structure choice. In fact, some recent research has provided evidence on the consistency of U.S. REIT capital structure choices against existing theories of optimal capital structure (e.g., Harrison et al., 2011). However, empirical evidence on the effect of financial structure on net operating income is still inconclusive, especially with respect to the European market. REITs and REIF are quite unique as their performance can be disentangled in two main components (current and capital gains component). However, what determines the dynamic of those two components and how it affects REITs/REIFs capital structure is still an open question. This paper aims to fill this gap. Precisely, we will first investigate the dynamic of profitability to analyze which component has been the most variable in the years before and after the crisis, which REITs/REIFs institutional features affect this dynamic (e.g. portfolio characteristics), and whether an increase of current income volatility leads capital gains volatility or vice versa. More importantly, we will test empirically the effect of financial leverage and debt composition on the two performance components.The results of this research will also have important implications for lenders of public real estate entities because we will shed light on the winning policy of banks (i.e. those who bet on the asset or income flows).