MARKET TIMING AND REIT CAPITAL STRUCTURE CHANGES LI YING NATIONAL UNIVERSITY OF SINGAPORE 2006 MARKET TIMING AND REIT CAPITAL STRUCTURE CHANGES LI YING (HT040939B) (B Mgt and B A., Tianjin University) A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SCIENCE (Estate Management) DEPARTMENT OF REAL ESTATE NATIONAL UNIVERSITY OF SINGAPORE 2006 Acknowledgement First, I would like to say thanks to my advisor, Associate Professor Ong Seow Eng, because this study is carried out under his careful supervision Professor Ong has provided me continuous support during my master studies He is always there to help me with my study, and has given me a lot of insightful suggestions, in both asking the research question and answering the question This study could not be finished without Professor Ong’s help Besides, his rigorous attitude toward academic research sets a good example for me and many other people to follow Special thanks should be given to another advisor of mine, Dr Muhammad Faishal Bin Ibrahim He is both a good teacher and a good friend He has confidence in me even when I doubt myself I also want to say thanks to my family and friends, who always give me courage and support in both my life and my study i Table of Contents Summary List of Tables List of Figures Introduction 1.1 Capital Structure Theories…………………………………………5 1.2 About Real Estate Investment Trust……………………………….7 1.3 Research Objective………………………………………………9 1.4 Organization of the Study………………………………………10 Literature Review 11 2.1 Trade-off Theory and Pecking Order Theory……………………11 2.2 Market Timing Theory……………………………………………13 Research Methods and Data Sources 23 3.1 VAR Model………………………………………………………23 3.2 Probit Model……………………………………………………25 3.3 Data Sources……………………………………………………26 Market Timing of REITs 29 4.1 The Equity and Debt Market Timing of REITs…………………29 ii 4.2 Test the Hypotheses of the Information-based Market Timing…35 4.3 Market Efficiency and Market Timing in REIT Equity Offerings…46 4.4 Market Timing in REIT Debt Issuances……………………………51 Security Choice of REITs Offerings 56 Conclusion 65 Bibliography 70 Appendices 76 iii Summary This paper seeks to determine if REIT equity and debt offerings depend on capital market conditions Specifically, we utilize a vector autoregressive (VAR) model to analyze the relationship between capital issues of REITs and relevant capital market conditions to see whether market timing behavior is supported In addition, we seek to understand the fundamental mechanism behind the market timing behavior where we test two different hypotheses of market timing- the information-based market timing and market inefficiency-based market timing Last but not least, we examine the security choice of REITs to test between different capital structure theories- trade-off theory, pecking-order theory and market timing theory The empirical results from 1980 through 2004 support market timing in REIT equity and debt issues In addition, support is also found for the information-based market timing theory for equity offerings and backward looking market timing in debt issuances Our results have two implications First, although REITs are relatively more transparent than industrial firms, REITs managers still could time the equity market Asymmetric information and adverse selection still exist for REITs, but with less obvious timing patterns Second, the absence of long-run return anomaly after SEOs of REITs means that the market efficiency is not violated This is different from studies about general stocks, in which the market inefficiency-based market timing is preferred compared to the information-based market timing With regard to the debt issuances, two hypotheses are tested- backward-looking and forward-looking, and backward-looking debt market timing is supported In addition, we find that, although market conditions are important in the security choice of REITs, they are not the only factors that determine the capital structure changes of REITs Firm characteristics, such as size, leverage, debt capacity, etc, all have significant effects on the financing activities of REITs The trade-off theory and the pecking-order theory, also find partial support from our analysis We conclude that there is no single theory that fully explains the capital structure of REITs List of Tables Table 1: Equity and Debt Offerings by Year………………….…………………… 27 Table 2: Statistic Summary…………………………………………… …………33 Table 3: Correlation Matrix…………………………………………………………33 Table 4: VAR Result…………………………………………………………………34 Table 5: Event Day Return on Announcement of Equity Offerings…………………36 Table 6: Event Day Return on Announcement of Debt Issues………… .37 Table 7: Distribution of Time Lags… ……………………………………………44 Table 8: Event Day Return Regression……………………………………………45 Table 9: Long-run Performance Calculation………………………………………49 Table 10: Effect of Interest Rate and Interest Rank on REIT Debt Offering… 54 Table 11: Interest Rates Subsequent to Debt Issues…………………………………55 Table 12: Probit Regression……………………………………………… .60 Table 13: Summary of the Predictions of Different Capital Structure Theories… 64 Table 14: Logit Regression ………………….………………………………………76 Table 15: Equity Market Capitalization Outstanding of REITs……………………77 List of Figures Figure 1: Cumulative Normal Distribution ……….……….………………………25 Figure 2: Distribution of Time Lags…………………………… .40 Figure 3: Distribution of Time Lags in Different Decades………… ……………41 Figure 4: NAREIT Equity REITs Price Index……………………….…… 78 Figure 5: S & P 500 Price Index…………………………………….………………79 Figure 6: 10-Year Government Bond Yield……………………….…………………79 Chapter Introduction Recent evidence in capital structure research has supported the market timing explanation for capital structure where capital financing decisions depend on capital market conditions (Graham and Harvey, 2001; Baker and Wurgler, 2002) Real Estate Investment Trusts (REITs) are typically excluded in studies for general stocks as they are special investment vehicles This study links market timing with REITs to understand the capital financing and capital structure changes of REITs An introduction to different capital structure theories, including the market timing theory, and a description of REITs is given in this chapter Then the research objective and the organization of this study are introduced 1 Capital Structure Theories The development of capital structure theories starts with the capital structure irrelevance theory, which was developed by Modigliani and Miller in 1958 This theory is based on a number of assumptions, which include: (1) capital markets are frictionless, (2) individuals can borrow and lend at the risk free rate, (3) there are no bankruptcy costs, (4) firms only issue risk-free debt and risky equity, (5) all firms are Chapter Conclusion REITs have always been considered as special investment vehicles because of their different institutional structure, and are usually excluded from general stocks in empirical studies However, the REIT industry has a heavy dependence on capital due to special requirements on dividend payout Because REITs are required to pay out at least 90% of the distributable dividends to their investors, there would less retained earnings available for asset acquisitions At the same time, equity REITs have higher predictability in their future cash flow as the main source of revenue is rent, thus information is expected to be less asymmetric in REITs Also, the holding assets of REITs are mostly tangible assets Given these characteristics, would the phenomenon of market timing found in general stocks apply for REITs as well? In this paper, we evaluate both equity and debt market timing of REITs from 1980 through 2004 In addition, hypotheses from both the information-based and market inefficiency-based equity market timing are tested to see which theory could be used to explain the equity market timing of REITs Both short-term and long-term performances 65 of REITs around capital issues are analyzed Last but not least, to understand the capital structure changes of REITs more clearly, we include three capital structure theories (trade-off theory, pecking order and market timing) in our probit model to test the financing pattern and security choice of REITs First, we find that market timing exists for REIT equity and debt issues using the VAR approach REITs seasoned equity offerings (SEOs) usually occur when stock prices are high, supporting market timing behavior Debt market timing is also supported in that increasing interest rates reduces debt offerings We also find support for the market timing theory under the asymmetric information framework from examining the shortterm performance of REITs around capital issues The stock price decreases on equity offering, but the timing of the equity issues is less obvious compared to general stocks There is no relationship between the issue day price drop and the timing of the issues Interestingly, we not find evidence of long-run underperformance after REIT SEOs This is different from what is found in general stocks and an earlier study by Howton, et al (2000) We find that the REIT market is efficient in that market efficiency is not violated by the long-run return anomaly after SEOs, as in the case for general stocks All these evidences suggest that although REITs also exhibit market timing behavior, the timing of such equity issues is different from general stocks both in the long-run and short-run The different institutional structure and requirements of REITs may be one of the reasons for these differences 66 Two debt market timing hypotheses – backward-looking and forward-looking – are tested What we find is that the historical rankings of interest rates are important determinants of the debt issuing activities of REITs, supporting backward-looking debt market timing But the data does not support the forward-looking debt market timing hypothesis in that interest rates not rise after debt issuances by REITs Validation of such differences in market timing abilities for general stocks would be an interesting extension Our findings imply that the capital structure changes of REITs are indeed influenced by the market timing behavior, but in a different manner from that for general stocks REITs managers time the equity market to reduce the adverse selection between investors and managers This result is in contrast with that for general stocks, where the long-run underperformance implies that the market inefficiency-based market timing is more likely to be true The debt offering decisions of REITs are also influenced by market conditions In addition, traditional capital structure theories also play a role in explaining this The analysis of the security choice between equity and debt issues shows that the market conditions are important factors In particular, increasing stock prices and higher long-run interest rates increases the probability of equity issues This is consistent with the market timing theory The pecking-order theory is supported by the effect of debt capacity on the debt-equity choice of REITs The trade-off theory is supported by the effects of size, and leverage ratio The body of evidence indicates that the security choice 67 and capital structure changes of REITs could not be explained by only one theory It is reasonable to believe that REITs try to time the capital market when making financing decisions while keeping the leverage ratio away from excessively high levels at the same time Normally, larger REITs and REITs with less stock return variance use more debt Although the pecking-order theory could not be fully rejected by our study, it seems that there is no pecking order that prefers debt to equity in the security choice of REITs We conclude that there is no single theory that fully explains the capital structure of REITs Among our findings, there seem to be some conflicting facts One seemingly conflicting result is that we find the evidence of the market timing behavior of REITs managers, in other words, managers would issue equity when stock prices are high, but we not find the clustering of equity issues shortly after earnings releases As we have mentioned, one explanation is the special characteristics of REITs, in other words, less asymmetric information is expected between managers and investors Thus the earnings announcement does not convey as much information as general stocks However, another possible explanation would be the debt constraints of REITs As we find in the probit model for the security choice of REITs, REITs managers tend to issue equity more when debt capacity is already reached If debt constraints are reached and the stock prices are high, managers would time the market When the earnings announcements are released when the debt capacity is not reached, there would be no clustering of equity issues shortly after that 68 Another potential conflict in our findings is that we not find evidence of long-run underperformance after REITs SEOs From the perspective of the market efficiency, we claim that the market efficiency could not be challenged by REITs equity offerings and the market could make adjustment to prices quickly So there is no long-run underperformance The debt constraint explanation could also explain the different market reactions to equity and debt issues of REITs The market reacts negatively to equity issues of REITs, but not to debt issues This seems to be consistent with the pecking-order theory, but not the market timing theory However, when debt constraint is a concern, timing behavior 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Binary Logit (Quadratic hill climbing) Sample: 544 Included observations: 544 Convergence achieved after iterations Covariance matrix computed using second derivatives Variable Coefficient Std Error z-Statistic Prob C A DC D I LEV MB NAREIT SP STK_AP SVAR TS DIVERSIFIED HEALTH_CARE INDUSTRIAL_OFFICE LODGING_RESORTS RESIDENTIAL SELF_STORAGE SPECIALTY -4.637672 0.711227 -1.606534 -4.95E-05 -1.366165 -1.981662 0.639985 -1.460663 -0.078159 -3.943112 -10.76740 0.072244 -0.467711 0.945748 -0.194388 -0.615040 0.917706 -0.702490 1.893371 1.817644 0.202062 0.251877 0.000121 0.508330 0.923103 0.436353 2.293518 1.359346 1.389882 19.25494 0.100501 0.468647 0.417148 0.310914 0.567570 0.322182 0.951329 1.006821 -2.551475 3.519839 -6.378250 -0.410687 -2.687553 -2.146740 1.466668 -0.636866 -0.057497 -2.837011 -0.559202 0.718834 -0.998003 2.267179 -0.625213 -1.083637 2.848411 -0.738430 1.880544 0.0107 0.0004 0.0000 0.6813 0.0072 0.0318 0.1425 0.5242 0.9541 0.0046 0.5760 0.4722 0.3183 0.0234 0.5318 0.2785 0.0044 0.4603 0.0600 Mean dependent var S.E of regression Sum squared resid Log likelihood Restr log likelihood LR statistic (18 df) Probability(LR stat) 0.404412 0.409095 87.86335 -265.3206 -367.0694 203.4977 0.000000 Obs with Dep=0 Obs with Dep=1 324 220 S.D dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter Avg log likelihood McFadden R-squared Total obs 0.491230 1.045296 1.195443 1.103999 -0.487722 0.277192 544 76 Table 15: Equity Market Capitalization Outstanding (Millions of dollars at year end) Composite Equity Mortgage Hybrid End # of Market # of Market # of Market # of Market of REITs Capitalization REITs Capitalization REITs Capitalization REITs Capitalization Year 1971 34 1,494.3 12 332.0 12 570.8 10 591.6 1972 46 1,880.9 17 377.3 18 774.7 11 728.9 1973 53 1,393.5 20 336.0 22 517.3 11 540.2 1974 53 712.4 19 241.9 22 238.8 12 231.7 1975 46 899.7 12 275.7 22 312.0 12 312.0 1976 62 1,308.0 27 409.6 22 415.6 13 482.8 1977 69 1,528.1 32 538.1 19 398.3 18 591.6 1978 71 1,412.4 33 575.7 19 340.3 19 496.4 1979 71 1,754.0 32 743.6 19 377.1 20 633.3 1980 75 2,298.6 35 942.2 21 509.5 19 846.8 1981 76 2,438.9 36 977.5 21 541.3 19 920.1 1982 66 3,298.6 30 1,071.4 20 1,133.4 16 1,093.8 1983 59 4,257.2 26 1,468.6 19 1,460.0 14 1,328.7 1984 59 5,085.3 25 1,794.5 20 1,801.3 14 1,489.4 1985 82 7,674.0 37 3,270.3 32 3,162.4 13 1,241.2 1986 96 9,923.6 45 4,336.1 35 3,625.8 16 1,961.7 1987 110 9,702.4 53 4,758.5 38 3,161.4 19 1,782.4 1988 117 11,435.2 56 6,141.7 40 3,620.8 21 1,672.6 1989 120 11,662.2 56 6,769.6 43 3,536.3 21 1,356.3 1990 119 8,737.1 58 5,551.6 43 2,549.2 18 636.3 1991 138 12,968.2 86 8,785.5 28 2,586.3 24 1,596.4 1992 142 15,912.0 89 11,171.1 30 2,772.8 23 1,968.1 1993 189 32,158.7 135 26,081.9 32 3,398.5 22 2,678.2 1994 226 44,306.0 175 38,812.0 29 2,502.7 22 2,991.3 1995 219 57,541.3 178 49,913.0 24 3,395.4 17 4,232.9 1996 199 88,776.3 166 78,302.0 20 4,778.6 13 5,695.8 77 1997 211 140,533.8 176 127,825.3 26 7,370.3 5,338.2 1998 210 138,301.4 173 126,904.5 28 6,480.7 4,916.2 1999 203 124,261.9 167 118,232.7 26 4,441.7 10 1,587.5 2000 189 138,715.4 158 134,431.0 22 1,632.0 2,652.4 2001 182 154,898.6 151 147,092.1 22 3,990.5 3,816.0 2002 176 161,937.3 149 151,271.5 20 7,146.4 3,519.4 2003 171 224,211.9 144 204,800.4 20 14,186.51 5,225.0 2004 193 307,894.73 153 275,291.04 33 25,964.32 6,639.37 Figure 4: NAREIT equity REITs price index NAREIT equity REITs price index 450 400 350 300 250 200 150 100 50 04 20 01 20 98 19 19 95 92 19 89 19 86 19 83 19 19 80 Year 78 2004 2001 1998 1995 1992 1989 1986 1983 1980 % Q 19 80 19 Q 80 19 Q 81 19 Q 82 19 Q 83 19 Q 83 19 Q 84 19 Q 85 19 Q 86 19 Q 86 19 Q 87 19 Q 88 19 Q 89 19 Q 89 19 Q 90 19 Q 91 19 Q 92 19 Q 92 19 Q 93 19 Q 94 19 Q 95 19 Q 95 19 Q 96 19 Q 97 19 Q 98 19 Q 98 19 Q 99 20 Q 00 20 Q 01 20 Q 01 20 Q 02 20 Q 03 20 Q 04 20 04 Q Figure 5: S & P 500 price index S & P 500 Price index 1600 1400 1200 1000 800 600 400 200 Year Figure 6: 10-Year Government Bond Yield 10-Year Government Bond Yield Data 18 16 14 12 10 Year 79 [...]... information-based and market inefficiency-based equity market timing are tested to see which theory could be used to explain the equity market timing of REITs Last but not least, to understand the capital structure changes of REITs more clearly, we include three capital structure theories (trade-off theory, pecking order and market timing) in our probit model to test the financing pattern and security choice of REITs... examination the market timing in REITs capital financing activities, testing hypotheses of informationbased market timing, testing hypotheses of market inefficiency-based market timing and then the debt market timing 4.1 The equity and debt market timing of REITs Equity market timing theory implies that managers choose to issue equity when their stock prices are (or believed to be) overvalued and repurchase... Research findings about equity and debt market timing are different Equity market timing gains supports from two different timing theories: information-based market timing and market inefficiency-based market timing Studies of informationbased equity timing theory were carried out by Lucas and McDonald (1990), Korajczyk, Lucas and McDonald (1991) and Korajczyk, Lucas and McDonald (1992) These studies... efficiency As one important capital structure theory, the market timing concept is being studied by more and more researchers However, most of these studies concentrate on the timing behavior of general stocks REITs are always excluded in general corporate research In this study, we choose REITs as the research focus and examine the market timing and capital structure changes of REITs 1.2 About Real Estate... information is expected between REITs managers and investors Under this condition, what kind of influence does the information asymmetry have on the equity issues of REITs? All the above differences between REITs and general stocks make the capital structure changes of REITs more interesting and distinctive Previous studies on REIT capital structure changes include Brown and Riddiough (2003), who analyze... mortgage REITs, are excluded from this study At the same time, equity REITs take the largest market share of the whole US REITs market (Refer to the Appendix) The REITs mentioned in following parts of the study represent equity REITs 1.3 Research Objective The focus of this study is on testing the market timing and capital structure changes of US equity REITs The first research question is: do REITs time... of US REITs: equity REITs, mortgage REITs and hybrid REITs We choose equity REITs because equity REITs own or have an equity interest in rental real estate, and the operation of equity REITs are close to general stocks Mortgage REITs, which make or own loans and other obligations that are secured by real estate collateral, and hybrid REITs, which combine the investment strategies of equity REITs and. .. in REITs capital structure studies This study seeks to make four contributions to the extant literature First we test whether market timing exists for REITs by evaluating if REITs capital issues depend on capital market conditions A vector autoregressive (VAR) model is applied as it allows us to know how capital structure changes Typically, the total leverage ratio is examined to test different capital. .. strong support by finding that market timing has persistent effects on the capital structure, and the capital structure is the cumulative outcome of past attempts to time the equity market The market- to-book ratio is used to measure the market timing opportunities 15 perceived by managers and managers are believed to time the market in equity issues In addition, Baker and Wurgler (2002) find that leverage... these studies concentrate on the timing behavior of general stocks REITs are always excluded in general corporate research In this study, we choose REITs as the research focus and examine the market timing and capital structure changes of REITs REITs are chosen as the focus of study because they are quite different from general stocks in the following aspects First, REITs are highly correlated with ... informationbased market timing, testing hypotheses of market inefficiency-based market timing and then the debt market timing 4.1 The equity and debt market timing of REITs Equity market timing theory... understand the capital financing and capital structure changes of REITs An introduction to different capital structure theories, including the market timing theory, and a description of REITs... Sources……………………………………………………26 Market Timing of REITs 29 4.1 The Equity and Debt Market Timing of REITs…………………29 ii 4.2 Test the Hypotheses of the Information-based Market Timing 35 4.3 Market Efficiency and Market Timing