Dividend Policy and Firm Performance: Hotel Reits vs. Non-Reit Hotel Companies

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Dividend Policy and Firm Performance: Hotel REITs vs. Non-REIT Hotel Companies Executive Summary. This article investigates whether the greater reliance of real estate investment trusts (REITs) relative to non-REIT corporations on external equity financing suggests greater capital market discipline of REIT management, or greater access to capital, overpaying for assets, overbuilding and overinvestment. Our analysis is based on a sample of sixteen hotel REITs and fifty-one non-REIT hotel corporations from 1993 to 1999. We examine differences in performance and whether free cash flow can explain the differences. The findings suggest that hotel REITs retain a significantly smaller amount of free cash flow than non-REIT hotel companies. Market valuation reflected in the market-tobook ratio is clearly negatively related to free cash flow measured at both before and after dividend levels. In addition, relatively small hotel REITs enjoy significantly higher excess market values than their non-REIT counterparts at similar sizes, suggesting greater growth opportunities for REITs.

by Robert M. Mooradian* Shiawee X. Yang**

In the mid-1990s, real estate investment trusts (REITs) experienced rapid growth fueled by readily available external equity and debt financing. There were a number of REIT IPOs1 and a number of large acquisitions by REITs such as the Starwood Lodging’s acquisition of ITT Sheraton in November 1997. Some companies also went through REIT status changes. In the hotel industry, Starwood Lodging dropped its REIT status while Host Marriott became a REIT in early 1999. Given these corporate organizational changes together with the REIT ‘‘bust’’ beginning in 1998, a key question is whether REIT status affects firm performance. In particular, are REITs prone to overinvestment? One school of thought suggests that economies of scale can be achieved by relatively large companies from improved efficiency in asset management and from improved access to capital. These authors argue that economies of scale are the driving force behind recent mergers and acquisitions in the industry.2 In contrast, others find no significant scale effect from REITs and express a concern that REITs may overpay for properties and overbuild in a race to grow.3 It is generally believed that the capital markets serve as a check on management overinvestment. However, Downs (1997) argues that it has been very easy for REITs to raise capital by floating stock issues. With such easy access to capital, Downs argues that REITs may be expanding too fast. Given the history of overbuilding in the 1980s, if REITs are flush with cash from new stock issues, they may overinvest.4 Journal of Real Estate Portfolio Management 79

* Northeastern University, Moorad@neu.edu. ** Northeastern University, Syang@lynx.neu.edu.

Boston, Boston,


02115 02115

or or

Robert M. Mooradian, Shiawee X. Yang

A concern with REITs is that they tend to overinvest and yet REITs must distribute 95% of their taxable income to shareholders in order to maintain their preferential tax status. Given that difference in dividend policy between REIT and nonREIT companies, REITs generate less free cash flow than non-REIT corporations. REITs have less internally generated equity financing and are more likely to seek external financing for acquisitions. Moreover, if the capital market serves as a check on managers of REITs who are tempted to overbuild or overpay for assets, then REITs are less likely to overinvest (i.e., incur the agency costs of managerial discretion). Does the organizational form of REITs, which differs from the organizational form of non-REIT corporations investing in real estate assets, mitigate the agency problem of managerial discretion that Jensen (1986) attributes to free cash flow? Recent research demonstrates a strong relationship between dividend policy and operating performance of over-investing firms. For example, Koch and Shenoy (1999) find that...
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