Capital Structure in the REIT Sector - Green Street Advisors

Capital Structure in the REIT Sector — July 1, 200915Appendix C: If Leverage Doesn’t Turbocharge Returns During a Bubble, When Will It?As discussed in Section V, REITs with higher leverage have substantially underperformed their less leveredbrethren over the last 15 years. A potential criticism of this finding is that REIT pricing suffered anunprecedented decline near the end of the time period studied, thus raising the prospect that results bylevered companies would look a lot better during a “normal” time period. While this gripe is not entirelywithout merit, concerns should be minimized by the fact that cap rates today are very close to where theywere 15 years ago. Against a flat-cap-rate backdrop, leverage should have boosted returns, but it appearsto have impaired them.At least as surprising is the fact that leverage did not significantly enhance returns in the ten years precedingJanuary ‘07, the peak of the asset valuation bubble. Considering that cap rates went from roughly9% to 6% over this time frame, causing asset values to skyrocket, leverage should have served as a returnturbocharger. As shown below, there is some weak evidence that more levered REITs outperformed duringthis period, but the findings are not statistically significant. That leverage failed to clearly boostREIT returns during a period when it should have provided a huge boost provides yet one more reason tothink that the costs associated with debt (at the leverage ratios typical for REITs) must be sizable.Leverage and Returns Before the BustTotal Return '97-'06 (ann.)25%20%15%10%PSAW RECUZAVBBREVNOKIMSK TFRTR EGCPTEQR PLDLRYDR EW RICLIPPST CODDRCBLM ACSPGUDRELSCL PHIWGGPBest fit line +/- 2 St.DeviationsR 2 = 0.095%30% 35% 40% 45% 50% 55% 60% 65% 70%Avg Leverage RatioWWW.GREENSTREETADVISORS.COM© 2010, Green Street Advisors, Inc. - Use of this report is subject to the Terms of Use listed at the end of the report.This report contains copyrighted subject matter and is covered under the Green Street Advisors' Terms of Use.Green Street Advisors reserves all rights not expressly granted.