REIT: In your recent award-winning paper, you found REITs that suffered financial distress during the liquidity crisis—meaning that they had significant debt reaching maturity at that time—experienced a permanent loss of enterprise value. What caused that permanent loss?
Titman/Twite: The evidence that we present in our paper suggests that the permanent loss of value for REITs with more debt maturing in 2008 and 2009 was a consequence of these REITs having to raise equity and sell assets at unfavorable terms during this time period. They also did not have the cash flow to take up available investment opportunities, and we suspect that management would have spent a significant part of their time dealing with distress related issues, e.g., talking to banks and lenders.
REIT: In another joint project, you analyzed how the capital structures of firms in 39 countries were affected by characteristics such as legal systems, bankruptcy codes and levels of corruption. We were especially interested in your findings regarding the importance of defined benefit and defined contribution pension systems on the equity-debt balance and debt maturities. Can you explain those results and their implications for investment and growth?
Titman/Twite: In that paper we found that a country’s legal and tax system, the level of corruption and the preferences of capital suppliers explained a significant portion of the variation in both leverage and debt maturity ratios. In particular, we found that the fixed commitment nature of defined benefit plans results in higher leverage and longer debt maturities in firms located in countries with larger defined benefit pension funds, while firms in countries with larger defined contribution pension funds have lower debt ratios.
Other researchers have found that the ability of firms to grow is to a large part dependent upon the availability of long-term external financing, suggesting that as a source of supply of long-term external financing, both equity and debt, pension funds generally are important to firm growth.
REIT: Dr. Titman, in one study you described the relationship between asset values in the private real estate market and stock prices of listed REITs. You found that you could predict private real estate returns using REIT returns along with the return premium of small-cap stocks relative to large-cap stocks, and that under certain conditions public and private returns should be perfectly correlated. Can you summarize that relationship?
Titman: We were not the first to recognize that REIT returns predict price changes in the private market. However, we have refined the prediction model by accounting for the fact that REIT prices are also influenced by stock market factors that do not affect the measurement of returns in the private real estate market. In particular, REIT returns tend to be influenced by capital flows that affect small stock returns, and when we account for this, we can improve private real estate return predictions.
REIT: Dr. Twite, you’ve studied the role of monitoring and governance on the decision of whether to raise capital privately or through a public offering. What do you see as the drivers of the public-private decision?
Twite: We find that a firm’s asset structure and investment opportunities largely determine the private-public choice. In particular, the more idiosyncratic are the investment opportunities, the higher is the information asymmetry between the firm and the market, and the more likely is the firm to undertake private placements.
We extend this to consider the influence of insider versus monitoring shareholders on the public-private choice. We find that, up to a point, firms use private placements to increase monitoring. However, firms with high existing levels of monitoring use private placements to substitute inside for monitoring ownership, preventing the creation of a new external blockholder.
REIT: Dr. Titman, you’ve considered monitoring and governance as a factor influencing whether REITs hold a geographically focused or diversified portfolio of properties. How does monitoring affect that decision?
Titman: There are clearly positive and negative aspects of diversification, and there is a large academic literature that suggests that corporations often lose value because they diversify too much. In my recent paper with Jay Hartzell and Libo Sun, we examine whether or not diversified REITs sell for a discount relative to their more focused counterparts and how this relates to their ownership structure.
We do find evidence of a diversification discount, but it is much smaller for those REITs owned by active institutional investors. This could reflect monitoring by active institutions that keep REITs from making bad diversification choices, or alternatively, the active institutions may be selecting those REITs that make smart diversification choices.