Rob Bauer Piet Eichholtz‡ Nils Kok
Keywords: REITs, corporate governance, firm value, performance JEL: G12, G34, G38
Bauer is with Maastricht University and Netspar, Eichholtz is with Maastricht University and Netspar and Kok is with Maastricht University, all in the Netherlands. The authors acknowledge the helpful comments of DavidDowns, Peter Englund, Erasmo Giambona, Martin Hoesli, Seow Eng Ong, Tim Riddiough and an anonymous referee, as well as seminar and conference participants at the University of Amsterdam, National University of Singapore, the INQUIRE Europe 2007 Autumn Seminar, and the 2007 International AREUEA Meeting. We thank RiskMetrics for providing the governance data. All remaining errors are ours.‡Correspondence to: Piet Eichholtz, Maastricht University, Faculty of Economics and Business Administration, Department of Finance, PO Box 616 6200MD Maastricht, the Netherlands. Phone: +31(0)43 3883838. Fax: +31(0)43 3884875. Mail: P.Eichholtz@finance.unimaas.nl.
Corporate Governance and Performance: The REIT Effect
Abstract REITs offer a natural experiment in corporate governance due to the fact thatthey leave little free cash flow for management, which reduces agency problems. We exploit a unique and leading corporate governance database to test whether corporate governance matters for the performance of U.S. REITs. We document for a sample including governance ratings of more than 220 REITs that firm value is significantly related to firm-level governance for REITs with low payout ratiosonly. Repeating the analysis with the complete database that includes more than 5,000 companies, and a control sample of firms with high corporate real estate ratios, we find a strong and significantly positive relation between our governance index and several performance variables, indicating that the partial lack of a relation between governance and performance in the real estate sector might beexplained by a REIT effect.
The legal setting and organizational structure under which U.S. Real Estate Investment Trusts (REITs) operate, changes the traditional principal-agent setting. Dividend payout maximization – in effect the reduction of the free cash flow problem as described by Jensen (1986) – is less of a concern for REITs, as US law requires a 90% mandatory payoutof net earnings. This legal obligation limits the opportunities for managerial expropriation and is often introduced in countries with a weak legal system, for example Brazil, Chile and Ecuador, as a legal substitute for the weakness of other mechanisms that protect shareholders (La Porta et al. 1998). In the case of U.S. REITs, which are embedded in one of the world’ strongest legal environments,the mandatory payout of s net earnings was never implemented for reasons of shareholder protection. Therefore, the reduction of the agency problem is merely a favorable side-effect. Under the substitution hypothesis (La Porta et al. 2000), the legal restrictions regarding REITs might mitigate the need for strong internal corporate governance mechanisms, i.e. corporate governance is less likely tobe important for REITs than for regular corporations (Hartzell, Kallberg and Liu 2004).
On the other hand, it has been argued that the legal restrictions on REITs do not solve the agency problem. REIT managers face an obligatory 90% payout distribution over net earnings, which is after a substantial depreciation expense. The difference between net earnings and free cash flow createsdiscretionary cash, and REIT managers can freely decide on the actual payout ratio of this free cash flow. 1 Moreover, legal restrictions regarding ownership structure, the so-called 5-50 rule, deters the formation of large block holders, and might protect REIT managers from the scrutiny of the market for corporate control (Eichholtz and Kok 2008). Therefore, a competing hypothesis states that...