The REIT Conversion Puzzle

Abstract

Real Estate Investment Trusts (REITs) are a globally recognized form of real estate ownership that offer tax benefits at a corporate level. Despite their clear advantages, however, a significant share of potentially eligible Real Estate Operating Companies (REOCs) do not opt for conversion to a REIT structure. This paper examines 80 REOC-to-REIT conversions across 13 countries. We find REIT conversions are generally driven by the extent of country-specific tax benefits. They are also more likely following prior conversions by other REOCs, and in countries with a larger share of extant REITs. REIT conversions may be motivated by Net Asset Value (NAV) discounts, especially if management’s compensation is highly equity-based. This illustrates the importance of aligning the interests of management and shareholders. On the other hand, relatively restrictive REIT criteria, such as the disclosure and taxation of hidden values during the conversion process, are associated with significantly lower conversion probabilities. Countries that have eased REIT criteria have subsequently seen significantly more conversions.

Keywords:

• REITs
• REOCs
• conversion
• agency conflicts

Acknowledgments

Our work has benefited from discussions with many of our colleagues. We specifically thank Ali Zaidi (EPRA), Emma Xu, participants at the ARES 2018 meeting, ERES 2019 meeting, and seminar participants at the University of Regensburg. We especially acknowledge our anonymous referees and Bill Hardin, the editor, for helpful comments and suggestions. All authors acknowledge the IREBS Foundation for generous support. David Downs acknowledges the support by The Kornblau Institute at Virginia Commonwealth University.

Notes

1 We define “NAV spread” as a ratio with the numerator being the difference or spread between a firm’s equity market capitalization and its NAV, all normalized by NAV. Equation (2), presented in the Research Design and Variable Definitions section of the paper, restates this terminology and defines the corresponding variable. Throughout the manuscript, we use the terms NAV premium and NAV discount for expositional convenience when the NAV spread is greater than or less than zero, respectively. Our use of the term “NAV spread” as an NAV premium centered on zero is consistent with Woltering et al. (2018) and Woltering et al. (2021).

2 The identification strategy aims to achieve a suitable counterfactual group among the representative property firms gathered by EPRA/NAREIT. Nadauld (2009) analyzes property companies participating in the creation of a REIT on a global scale. The author collects a sample from various sources and reports of limited evidence or even counterintuitive results. Therefore, it is a prime goal for this paper to utilize a proper counterfactual by using only selfconverting listed property companies fulfilling the EPRA rules and by requiring 24 months of listing (as in Ooi et al., 2007). In the end, the sample comprises converted and never-converted listed real estate companies. For the Asian Markets, we investigate spin-offs documented by EPRA and found only 3 relevant events in which an established REOC has created a new REIT. Therefore, we decided to keep a clearly defined counterfactual setting and consequently excluded those firms. Moreover, deselecting the REIT structure occurs very infrequently on an international scale and is not the focus of the current study.

3 Asian REOCs are included in our sample as managers had the option to convert after introduction of the REIT structure. We point out that Figure 1 does not reflect activity for those countries as no Asian-based REOCs convert during our sample period. Asian countries are represented in our regression analysis, again, as they had the option to convert. Our regression results are qualitatively similar when excluding Asian countries from the analysis.

4 See SA Commercial Property Investment News’ online article for more details.

(http://www.sacommercialpropnews.co.za/property-companies-news/6220-growthpoint-properties-converts-toreit-capital-structure.html).

5 Appendix Table A1 summarizes the expected empirical implications.

6 REOCs generally track the activities of their market competitors. Consequently, this variable captures the information on recent REOC-to-REIT conversions over the past two years.

7 Brähler and Schmidt (2014) show properties reported under IFRS accounting standards contain 20% hidden reserves on average. We believe the market’s assessment is a good proxy for the difference between the true market value and the reported value.

8 Kim and Wiley (2019) and Graff (2001) document that cash remuneration of key executives and firm size are positively correlated. This provides an incentive for executives to maximize their future earnings by increasing firm size. According to Hope and Thomas (2008) and Jensen (1986), a major motivation for empire building are executives striving for cash compensation and status. As a consequence, they may take actions that are at odds with the maximization of shareholder value (Hall, 1999). We focus our attention on this behavior as opposed to lesser, competing theories and address this in a robustness test.

9 Consistent with Ke (2015), we winsorize the NAV spread at 5% and 95% levels to remove outliers. In addition, REIT test variables and management compensation measures are winsorized at the 1% and 99% levels.

10 The econometric attributes, assumptions and advantages of non-linear models are documented in Wooldridge (1999). The translation to estimation techniques can be reviewed in Wooldridge (2019) and Cameron and Miller (2015).

11 We gratefully acknowledge our reviewers for suggesting this alternative estimation approach. Brown et al. (2018) and Ling et al. (2020) estimate Cox hazard rates either as a complement or in lieu of logistic regressions. The survival analysis results, which are remarkably robust with our logit analysis, are available from the authors upon request.

12 At the suggestion of an anonymous referee, we follow Ling et al. (2020) and use dividend yield to explain the REIT conversion decision. We include dividend yield by itself and in combination with our distribution-test variable to re-estimate Table 3, models i and iv. Across all cases, the impact of dividend yield is not statistically significant, while the distribution test variable retains its significance. We conclude that dividend yield and payout ratios may be more meaningful metrics when considering a single country with homogeneous REIT distribution requirements. In our international context, we define a payout variable to address the fact that regulatory distribution requirements may vary considerably across countries. As described in our variable definitions discussion, the “Distribution Test” variable in our analysis accounts for country-specific payout ratios (i.e., dividend distributions relative to taxable income). The respective results are available from the authors upon request.

13 We incorporate initial costs of conversion measured by exit taxes triggered by a necessary taxation upon the realization of hidden reserves. The results remain robust if we extend these costs by the conversion charge of 2% applied in the U.K.

14 As suggested by an anonymous referee, we acknowledge that our herding proxies may also reflect the fact that market conditions change with persistence. Leary and Roberts (2014) state that it is challenging to disentangle peer mimicking behaviors from the country-wide unobserved factors that simultaneously drive firm behaviors within the same industry, i.e., disentangling rational and behavioral motives is beyond the scope of this study.

15 Notwithstanding our lack of macroeconomic expectations data, we extend our main results by including the CBOE Volatility Index (VIX) as a globally recognized proxy for macroeconomic uncertainty. The caveat, of course, is that VIX is not a market-specific proxy for each REOC’s domiciled country. In short, we find some evidence consistent with the thesis that REOC managers consider macroeconomic uncertainty in the decision to convert to a REIT. Specifically, the evidence indicates that the probability of converting decreases in the short-term, suggesting a tactical decision not to adopt a more restrictive operating structure during a period of uncertainty. Alternatively, the probability of converting is either not affected or may, even, increase slightly in the mid- to longer-term as strategic considerations outweigh, potentially, transient macroeconomic consideration. We acknowledge an anonymous reviewer for suggesting this effect on REIT conversion probability.

16 Since cash compensation can be linked to empire-building behavior, we examine in an additional robustness test whether it is negatively correlated with REIT conversions. Our reasoning is that the REIT structure limits the freedom of key executives to retain earnings and grow firm size organically. We include cash compensation explicitly and hereby follow Pennathur and Shelor (2002) and Alshammari (2004) defining cash remuneration as the sum of base salary, bonuses, and other cash payments per fiscal year. We then normalize cash compensation consistently as in the case of equity compensation using a firm’s enterprise value. In unreported results, we find that the coefficient on Cash Compensation_i,t−8 is not statistically different from zero. This result holds for various definitions of cash-based compensation.

17 We calculate the measures for equity-based compensation based on the literature (Pennathur & Shelor, 2002; Price et al., 2015). Similarly, we find the share of equity to total compensation is significant at the 5% level. The regression results for the share of equity-based compensation are available from the authors upon request.