USC Student Jonathan Shum sends me to a Green Street Report on Capital Structure in the REIT Sector

Its summary:

A Cultural Affinity for Leverage: Until about twenty years ago, the structural make-up of the real estate industry (i.e. small players, fragmented ownership, no outside equity sources, etc.) dictated that debt, not equity, serve as the primary source of external capital. As a result, market participants grew accustomed to operating with far more leverage than is found in virtually any other industry. Now that financing options for major real estate companies are very similar to what
is available to other large corporations, there are several reasons to believe that less debt and more equity should be the norm going forward.

Financial Theory: There is no reason why a non-taxable entity (e.g. a REIT) should have any debt, yet the costs associated with credit crunches (both in the form of distress and missed opportunities) provide ample reason to limit leverage to relatively low levels. These costs have proven to be so high that optimal leverage targets for most REITs likely fall in the 0-30% (debt/
asset value) range.

Best Practices in Corporate America: Most corporations have a strong incentive to utilize debt –interest expense helps minimize their corporate tax bill – yet it represents less than one-quarter of the typical corporation’s capital structure. REITs, by contrast, have no reason to use debt, yet it typically comprises about half the capital structure. There is no justifiable reason why financing
practices should differ as much as they do.

The Real World Lab Experiment: Higher leverage should be accompanied by higher returns in order to compensate for its added risk. This has not been the case, however, in the REIT sector, as more levered REITs failed to provide meaningfully better returns even in the ten-year period preceding the peak of the asset valuation bubble. Lower levered REITs have substantially outperformed over the last fifteen years.

De-leveraging & Value Creation Ahead: The REIT sector has commenced what is likely to be a multi-year de-leveraging process. It should unfold in three stages: 1) de-lever to ensure survival; 2) de-lever to return to prior leverage targets; and 3) acknowledge that prior leverage targets were too high and de-lever to achieve new, lower targets. Much progress has been made on the first phase, yet most companies are not yet entirely out of the woods. The subsequent stages will entail
massive amounts of equity issuance, as leverage ratios need to decline by more than 1500 bps to return to prior norms, and a substantial reduction beyond prior targets is appropriate. At a time when other real estate market participants lack access to capital, REITs that aggressively de-lever as they articulate thoughtful strategic objectives with regard to their long-term capital structures will be well-rewarded.