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.
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...