Capital Structure in the REIT Sector - Green Street Advisors

Capital Structure in the REIT Sector — July 1, 20092"The pizza deliverer says to Yogi Berra: 'Do you want the pizza cut into quarters or eighths?'Yogi answers: 'Cut it into eight pieces. I'm feeling hungry tonight.' "Merton MillerI. OverviewThe real estate industry has historically relied primarily on debt, rather than equity, to satisfy its financingneeds. Key structural differences that have long separated real estate from broad capital markets explainwhy this has been true, although in the last 15-20 years, most of those differences have been eliminated.Despite that, the industry has been slow to question whether adherence to historical practices isappropriate in light of how much the world has changed. This report explores that question, specificallyas it pertains to REITs, and concludes that the capital structure of most REITs typically contains toomuch debt and too little equity. Three key arguments support this conclusion:1. Well-accepted financial theory suggests that there is no reason why non-taxable entities such asREITs need to have any debt. While there is nothing objectionable about the use of modest leverage,the costs associated with credit crunches have proven to be so high for leveraged operatorsthat optimal leverage ratios for most REITs likely fall in the 0-30% range. Above those levels, theweighted average cost of capital begins to increase (albeit, slowly at first) and firm value declines.2. Despite the fact that most corporations have a powerful incentive to utilize debt (i.e. interest expensehelps minimize the double taxation of corporate profits), they typically employ far less leveragethan REITs. The simple fact that real estate can support relatively high debt levels has nothingto do with whether it should.3. The historic track record from the REIT industry shows that leverage is associated with lower returns.Considering that leverage should enhance returns in order to compensate for the higherrisk, these results are very surprising.• Over the last fifteen years, more leveraged REITs have substantially underperformed REITswith less leverage.• A similar review of total returns in the ten years preceding the early ’07 peak of the asset valuationbubble shows that leverage may have provided a very small boost to total returns, but thisfinding is not statistically significant. Considering that cap rates dropped from 9% to 6% overthat period, leverage should have provided a powerful turbocharger for returns, yet this clearlydid not occur. If it didn’t substantially enhance returns over that time frame, when will it?The deleveraging process that is now underway in the REIT sector is in the very early stages, with a lot ofwork to be done before most capital structures resemble their pre-credit crunch make up. After thatwork is done, well-run REITs will continue the process, as they increasingly acknowledge that their priorleverage targets were too high. Those REITs that articulate thoughtful strategic objectives with regard totheir optimal leverage ratios will be well rewarded in the marketplace, which is why we will ascribehigher warranted share prices to companies that operate at lower leverage levels.WWW.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.