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«‘Liquidity and Liquidation: Evidence From Real Estate Investment Trusts’ Article in The Journal of Finance · January 2000 ...»

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See discussions, stats, and author profiles for this publication at: https://www.researchgate.net/publication/227504808

‘Liquidity and Liquidation: Evidence From Real

Estate Investment Trusts’

Article in The Journal of Finance · January 2000

Impact Factor: 4.22 · DOI: 10.1111/0022-1082.00213 · Source: CiteSeer


1 author:

David Brown

University of Florida

17 PUBLICATIONS 544 CITATIONS SEE PROFILE Available from: David Brown Retrieved on: 08 July 2016 Liquidity and Liquidation: Evidence from Real Estate Investment Trusts David T. Brown* July 1998 * Department of Finance, Warrington College of Business, University of Florida. Mark Flannery, Charles Hadlock, Chris James, Jay Ritter, Mike Ryngaert, an anonymous referee, and seminar participants at Georgetown University and the Atlanta Finance Forum provided useful comments on earlier versions of this paper.


This study provides evidence that highly leveraged owner-managed properties liquidated assets during the commercial real estate decline of the late 1980s, and that this provided buying opportunities for better capitalized buyers. The analysis documents significant financial distress costs for highly leveraged firms during an industry-wide downturn and shows that these costs are particularly large for owner-managed firms.

This paper examines the effects of the large decline in commercial real estate values that occurred in the late 1980s and early 1990s because of (1) declines in occupancy rates in commercial properties as a result of overbuilding during the 1980s, and (2) credit problems that limited the financing available for borrowers (see Fergus and Goodman (1994) and Peek and Rosengren (1994)). The analysis compares the effects of the decline in commercial real estate values on highly leveraged owner-managed properties and on less leveraged properties held by real estate management companies with access to public equity markets. The data on ownermanaged properties come from mortgage Real Estate Investment Trusts (REITs): publicly traded entities that made commercial real estate loans largely to owner-managed property managers or developers, and the loan-to-value ratio on these loans was typically 80 percent or more. In contrast, equity REITs held equity positions with much less financial leverage and the properties were managed by corporate property managers.

This paper provides a systematic analysis of the mortgage and equity REITs during the real estate downturn and yields three important findings. First, the book value of mortgage loans held by mortgage REITs declined significantly from the end of 1988 to the end of 1991, while the book value of real estate equity positions held by equity REITs increased. Mortgage REITs were net sellers of highly leveraged assets while equity REITs were net purchasers. Second, in spite of the indications that the market for commercial real estate was very depressed, mortgage REITs seldom reorganized their nonperforming loans. The vast majority of nonperforming loans were foreclosed. Third, during the 1989-1990 period, the total mortgage REIT stock returns were more negative than the total equity REIT stock returns. A decline in the value of real estate, absent any costs of financial distress, should result in a smaller decline in the value of mortgage REIT stock given that mortgage REITs hold a more senior claim on real estate assets than equity REITs. The larger share price declines observed for mortgage REITs during the downturn period are consistent with financial distress costs borne by mortgage REITs, including fire sale liquidations being capitalized into mortgage REIT share prices. They are also consistent with buying opportunities being capitalized into equity REIT prices.

The data presented in this paper suggest that the decline in real estate values beginning in 1989 forced a systematic sale of real estate at distressed prices by lenders that obtained the properties in foreclosure, and that less leveraged firms purchased these assets. These findings are consistent with the Shleifer and Vishny (1992) model of asset liquidity and evidence provided by Pulvino (1996) that financially distressed airlines receive lower prices than their solvent rivals when selling used narrow-body aircraft. The finding that mortgage REITs foreclosed rather than reorganized their loans to financially distressed owner-managers supports the models of Brown (1997) and Diamond (1993) that show that owner-managed firms suffer from managerial moral hazard problems in financial distress that cannot be eliminated by a financial reorganization that benefits the borrower and lender. Thus, these models predict that lenders will prefer to foreclose on loans to owner-managers and sell the asset even if asset prices are depressed.

The remainder of this paper is organized as follows. Section I discusses the anticipated effects of a decline in commercial real estate values. Section II describes the sample of REITs examined in this study and (1) compares the investments made by equity and mortgage REITs from the beginning of 1989 to the end of 1991, and (2) examines the extent to which mortgage REITs foreclosed their loans versus reorganized their debt. Section III analyzes the total returns to equity and mortgage REITs during the real estate downturn. Section IV provides a summary and conclusion.

I. Predicted Effects of a Decline in Collateral Values.

This section provides (1) a discussion of the important differences between mortgage and equity REITs and the properties they finance and (2) the anticipated effects of a decline in collateral values on the different types of properties examined. In addition, testable implications are provided.

A. Equity and Mortgage REITs.

For a firm to qualify as a REIT (1) it must distribute, in the form of dividends, at least 95 percent of its taxable income to shareholders, (2) at least 75 percent of the it’s gross income must come from rents, mortgages or gains from the sale of real property, (3) the it must have at least 100 shareholders, and (4) no five shareholders can own more than 50 percent of the shares.

Trusts that qualify as REITs avoid double taxation. That is, profits paid out as dividends are not taxed at the corporate level. Further, during the period examined in this study there were significant tax penalties for REITs that were net sellers of over 30 percent of their assets in a given year.

A mortgage REIT is a portfolio of real estate loans, and an equity REIT is a portfolio of real estate equity positions. The mortgage and equity REITs examined here financed incomeproducing commercial real estate properties: apartments, office buildings, warehouses, and shopping centers. Mortgage REITs that held only residential mortgages are not included in this analysis.

Mortgage REITs typically financed properties managed by property managers that provided the equity financing for the project. Four of the twenty-four commercial mortgage REITs examined made loans to partnerships affiliated with a single property management company. In these cases, the property manager provided equity capital. There was significant outside equity provided as well. Very few mortgage REITs had significant full-time employees.

Instead, an external advisory company provided investment advice and was compensated based on the amount of assets held by the REIT and the cash flow performance of the loans above a benchmark.

Equity REITs either hired out or performed in house both investment decisions and property management. Equity REITs managed the property directly, or in most cases, hired an advisory company to manage the property. In either case, the cash flows generated from the properties went to the equity REIT shareholders net of a property management fee based on both the amount of assets under management and a percentage of cash flows above a benchmark.

The loan-to-value ratio of the loans in a mortgage REIT portfolio were often 80 percent or more. The charters of all mortgage REITs in this sample restricted the maximum loan-to-value ratio to between 70 percent and 100 percent of assessed value. From discussions in annual reports and data actually reported, it appears that very few loans were made with lower loan-tovalue ratios. The debt obligations of the average equity REIT examined in this study were approximately 35 percent of the book value of total assets immediately prior to the decline in real estate values. Since the equity REIT owned the properties, the leverage of the equity REIT was also the leverage of the property. Thus, mortgage REITs held claims against more leveraged properties than equity REITs.

B. Effects of a Decline in Real Estate Values.

Given the different financial and ownership structures of properties financed by mortgage and equity REITs, one would expect very different responses across the two types of properties resulting from a decline in property values and the resulting reduction in the owner’s equity. The decline in owner’s equity (1) reduces the owner’s incentives to make cash investments in existing properties or purchase other properties and (2) reduces the owner’s incentives to provide effort to enhance the property’s cash flows. Since mortgage REITs financed significantly more leveraged properties, it is expected that both of these debt overhang problems were much larger for mortgage REIT-financed properties during the downturn in asset values.

Mortgage REITs had strong incentives to foreclose rather than reorganize and improve the property manager’s incentives to provide effort or invest in the property. The lender could not exchange her debt claim for an equity claim and improve the owner-manager’s effort incentives because such an exchange would still leave the original owner-manager without a meaningful stake in the property. In order to overcome the distortions associated with debt overhang, the lender must forgive the debt in order to recreate the owner-manager’s equity position (see Brown (1997), Venkataraman (1996), and Diamond (1993)). Thus, it is very difficult for the lender to capture any of the gains associated with avoiding a foreclosure (i.e. retaining the existing property manager). Finally, the foreclosed properties were likely to be sold at depressed prices since the downturn in asset values results in a scarcity of well-capitalized owner-managers.

This logic suggests that since mortgage REITs financed highly leveraged, ownermanaged properties, it is expected that they experienced significant financial distress costs.

Specifically, it is expected that (1) mortgage REITs would have significant loan defaults and the associated declines in owner incentives, (2) mortgage REITs would foreclose on, rather than reorganize, a large proportion of their distressed loans, and (3) these foreclosed properties would be sold at depressed prices. In contrast, equity REITs were less leveraged, did not rely on ownerproperty management arrangements, and thus were less likely to be forced to sell assets by their lenders. In addition, since mortgage REITs financed affiliated partnerships with significant outside equity, it is expected that mortgage REITs with affiliated partnerships were likely to be reorganized because the property manager’s stake is not as critical.

Mortgage REITs would have liquidated properties at a discount given the limited gains from reorganizing the debt claim only if the mortgage REIT could neither manage the foreclosed property in house nor hire an independent property manager to manage the property effectively.

There are two reasons why the mortgage REIT would not hire an external manager. First, the mortgage REIT itself has debt outstanding and the mortgage REIT’s senior lenders may very well prefer and be able to force a liquidation of nonperforming loans. This suggests that more leveraged mortgage REITs would be more likely to sell the property underlying the defaulted loans than to manage the real estate. Second, external management contracts may not work well for property foreclosed upon by mortgage REITs. Prior to the downturn, mortgage REITs financed owner-managed properties while equity REITs provided equity financing for projects that were managed by external contracts. Thus, the benefits of owner-manager financing relative to outside equity financed projects with external management contracts were larger for the kinds of properties financed by mortgage REITs. Therefore, an ownership stake by the property manager is important for the kinds of properties financed by mortgage REITs.

In summary, mortgage REITs financed highly leveraged positions. To the extent that mortgage REITs could not manage foreclosed properties in house at a low cost or were forced by their creditors to liquidate foreclosed real estate, large declines in real estate values would have caused mortgage REITs to liquidate real estate at prices below what the property was worth managed by a well-capitalized property manager. These liquidations would have represented buying opportunities for well-capitalized property managers, namely equity REITs.

The annual reports of mortgage REITs during this period often warned shareholders that the depressed market for real estate presented a problem for the disposition of foreclosed properties while the annual reports of equity REITs often viewed the same situation as a good buying opportunity for well-capitalized equity REITs. The following quote from the 1989 annual report of American Realty Trust, a mortgage REIT, is consistent with statements made in the

annual reports of other mortgage REITs during this period:

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