From the Research Desk

NAREIT Vice President, Research & Industry Information

11/6/2013 | By Calvin Schnure

Published in the November/December 2013 issue of REIT magazine.

SOURCE:  “Agency Cost, Dividend Policy and Growth:  The Special Case of REITs,” Journal of Real Estate Finance and Economics, March 2013

AUTHORS:  Chinmoy Ghosh (University of Connecticut) and Le Sun (AllianceBernstein L.P.)

SYNOPSIS:  Two of the central issues in corporate finance are how to raise money from outside investors when a firm’s owners and corporate insiders have an information advantage about the firm’s future prospects, and how outside investors can discipline corporate management to maximize shareholder value. Financial markets (and, indeed, the economy as a whole) tend to perform poorly when it is not possible to overcome problems of asymmetric information and corporate governance.

A central feature of the REIT business model is the requirement that REITs distribute most of their income to investors in the form of dividends. This facilitates information flow between corporate insiders and outside investors, while at the same time limiting the opportunities for corporate management to spend free cash flow on projects that do not increase shareholder value.  The authors of this paper examine the relationship between externally financed growth and dividends. Finding a strong positive relationship, the authors interpret their results as showing that the REIT dividend payout rule helps reduce the cost of funds and improve market discipline. Together, this helps maximize growth opportunities and firm value.

“Dividend distribution enhances information transmission, and mitigates agency conflicts by restricting managers’ access to free cash flow, and exposing firms to the scrutiny and monitoring by market participants when raising external capital. The reduction in agency costs and improvement in information dissemination reduce the cost of funds, and investment at more competitive cost of capital enhances firm value. For REITs, because of the mandated high dividend distribution, growth depends on the availability of external capital at competitive rates.  … by reducing agency costs and facilitating capital raising, dividends enhance growth.”

SOURCE: “Effects of Real Estate Cycles on Valuation of U.S. Real Estate Investment Trusts (REITs),” Ph.D. Dissertation, University of British Columbia, July 2013

AUTHOR: Jeong Hwan Joo (University of British Columbia)

SYNOPSIS:  Funds From Operations (FFO) is the most commonly accepted and reported measure of REIT operating performance, which is equal to the REIT’s net income, excluding gains or losses from sales of property, and adding back real estate depreciation under GAAP. This study examines REIT returns from 1995 through 2008 to see whether FFO or GAAP net income better explain REIT valuations. Finding FFO to be the more accurate measure, the author demonstrates how variations in property valuations over the course of a real estate boom and bust cycle can cause differences between economic values and the accounting depreciation measure used under GAAP.  Because the bias in the accounting measure of depreciation tends to vary over the course of a real estate market cycle, FFO tends to be a more accurate measure of firm REIT operating performance.

“Using the REIT valuation model, this study empirically examines the impact of real estate cycles on accounting depreciation bias and on the relative ability of FFO and net income to explain the market value of equity. This study finds that FFO explains stock prices better than net income does in a market boom and that there is no significant difference in explanatory power between FFO versus net income in a market bust. … [These results can be explained because] the market value of real property held by a REIT tends to appreciate when the demand for rental space increases, and it tends to depreciate when the demand for rental space decreases. While this implies that economic depreciation is varying across real estate booms and busts, accounting depreciation will not vary over these phases.”

Calvin Schnure is NAREIT vice president, research & industry information.


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