Current Issues and Controversies in Real Estate Finance

This special issue of Abacus is devoted to an emerging but very important issue in the literature, real estate finance. Despite its growing importance and relevance to global equity and debt markets, real estate finance has attracted relatively little attention in the accounting and finance literatures. This special issue presents five papers dealing with current issues and controversies in real estate finance.

Guest and Rohde examine the controversial issue of foreign real estate investment and its impact on housing price growth in Australian capital cities. This has proven to be a contentious issue in the media and has dominated much of the political discourse in Australia on housing affordability in recent years. Guest and Rohde observe that over the 2004–2014 period, housing prices increased across Sydney and Melbourne by an average of 64%. At the same time proposed foreign investment in developed residential real estate increased almost tenfold. As noted by the authors, deteriorating housing affordability in Sydney and Melbourne and the apparent surge in foreign residential real estate investment led to a Parliamentary Inquiry into this subject. The Inquiry found a paucity of accurate data on foreign investment in Australian residential real estate. As noted by Guest and Rohde, the Report recommended, inter alia, better audit, compliance, and enforcement processes at the Foreign Investment Review Board (FIRB), along with stiffer penalties for transgressions relating to the value of the property purchased. Despite the apparent correlation between housing price growth and foreign real estate investment in Sydney and Melbourne in recent years, Guest and Rohde argue that the relationship is complicated by several other factors that can influence prices, including the effects of financial deregulation, the ability of housing supply to respond to demand, and population growth driven by immigration. To test their propositions, the authors assemble a unique dataset on real estate prices and foreign investment by combining Australian Bureau of Statistics (ABS) data with information from the FIRB. The authors measure housing prices using the Residential Property Price Index (RPPI) generated by the ABS for Australia's eight capital cities. In addition to their principle variables of interest, Guest and Rohde also collect annual data on population growth, labour earnings, consumer prices, and unemployment. The longest time span for which Guest and Rohde are able to assemble a complete dataset is from 2004–2014. Using both fixed effects and random effects models, their results provide evidence of a strong linear relationship between foreign investment and Australian housing prices. Their econometric models suggest that about one quarter of the growth in these two cities can be attributed to foreign investment. In other words, if foreign investment was held steady over the period, Sydney and Melbourne housing prices would have grown by about 50% relative to the actual growth of 67%. Guest and Rohde conclude that foreign investment had a minimal association with housing prices in smaller capital cities, such as Brisbane, Perth, and Adelaide.

Apart from calling for more reliable data on foreign ownership of residential housing, Guest and Rohde do not support ‘knee-jerk’ regulatory interventions in response to foreign investment in Australian real estate. They see the rapid rise in housing prices in Sydney and Melbourne from 2010 to 2015 as a more complex story that cannot be explained away by foreign investment alone. They also conclude that foreign investment in any Australian asset class, including housing, does not represent a wealth transfer to foreigners. Finally, Guest and Rohde conclude that if public policy concern is more about housing affordability, then government policies that aim to boost housing supply and that address tax and retirement income policies favouring housing investment would ultimately be more effective than a clamp-down on foreign real estate investment.

Tan explores the issue of whether over-confident CEOs of real estate investment trusts (REITs) issue more debt. Tan defines over-confidence according to whether CEOs hold more than a 67% cut-off in-the-money option at least twice during the sample period. Tan's rationale for using the 67% cut-off is that ‘CEO human capital is closely tied to the firm; thus, the CEO should sell his or her in-the-money options when they reach the 67% in-the-money threshold’ (p. 325). The study is explored in the context of demand and supply side scenarios. According to Tan, the demand story assumes that over-confident CEOs demand more debt because they over-estimate the likely future success of their firms. In other words, over-confident CEOs will perceive they have positive private information of which the market is not fully aware. This idea also has some support in the accounting literature. For example, Hribar and Yang (2016) find that over-confident CEOs are more likely to provide voluntary earnings forecasts, which tend to be overly optimistic and with a narrower forecast range. Tan argues that mispricing is more severe for equity than for debt, which may be especially pertinent to REITs. According to Tan, the market capitalization of REITs typically trades at a discount relative to the net asset value (NAV) of the underlying assets. Hence, Tan argues over-confident REIT CEOs might issue debt in an attempt to minimize the impact on perceived mispricing. In other words, over-confident CEOs would prefer debt to equity because they believe they can refinance their investments at a lower cost by using debt when positive news transpires in the future. However, because the market is necessarily at odds with the over-confident CEOs’ perception of less under-pricing in debt value, Tan argues that the demand-side story predicts that the market will react negatively to over-confident CEOs’ debt choices, as higher leverage will typically be associated with high default risk. By contrast, the supply-side proposition implies that while an over-confident CEO may prefer to issue equity, the CEO is effectively screened out of the equity ‘supply’ market, as it is more difficult for equity holders to agree with the over-confident CEO on the new equity value. Hence, Tan states that the supply-side proposition predicts a negative market reaction to equity offering announcements by over-confident CEOs.

Tan uses an event study design to examine the demand and supply propositions and finds general support for the demand-side proposition. For instance, Tan's findings show that debt (equity) offering announcements by over-confident CEOs are associated with significant negative (insignificant) two-day cumulative abnormal returns (CARs) of –1.2% and +0.05%, respectively. Tan argues that these findings are more consistent with the demand-side story rather than the supply-side story for at least two reasons. First, over-confident CEOs’ debt issuances are not received well by the market, which suggests that the debt issuance is unlikely to be driven by the market demand but rather by over-confident CEOs’ debt choices (i.e., the perception that debt is less under-priced than equity). Second, over-confident CEOs do not suffer from negative market reaction to equity issues. As a result, it is unlikely that over-confident CEOs are screened out of the equity market, which is implied by the supply-side proposition. Overall, Tan's findings suggest that over-confident REIT CEOs destroy firm value through debt financing.

Van der Spek observes that prior to the global financial crisis it was possible for real estate investors to utilize substantial leverage but this resulted in higher default rates and insolvency issues following the global economic downturn. Van der Spek points out that from the beginning of the credit crisis, banks needed to account for the risks inherent in their real estate debt portfolios and reduce their balance sheet exposures accordingly. He notes that Basle III requirements are likely to further reduce banks’ willingness to expand their real estate loan book, as the capital charge for this risky loan class has increased. This led to the emergence of real estate debt funds, a market that was relatively mature in the US, but fairly new in Europe and Asia. In the years following the credit crunch, real estate debt funds have become very popular among institutional investors. The rising importance of these funds and their shift to the mainstream has motivated Van der Spek to consider whether real estate debt should be treated as fixed income, since the largest component of the return is a fixed (or floating) interest rate, or real estate, because these are the underlying assets that are subject to market declines. Another possibility is to view the debt as equity, as real estate debt is secured by equity in the property. According to Van der Spek (p. 350), applying a Merton model would suggest ‘that components higher up the capital stack have a stronger link with the value of the underlying portfolio. On the other hand, there are clear signs that the equity component is dominant in performance and classification.’ To answer this question, Van der Spek simulates senior and mezzanine real estate debt characteristics in order to analyze their risk return profiles and correlations, which are then compared to each other and the underlying real estate investments. His results indicate that senior debt is not heavily correlated to real estate and therefore behaves more like fixed income and should be valued accordingly. However, he finds that mezzanine debt is correlated to real estate, especially on the downside, and should be underwritten as such. Based on his results, Van der Spek recommends separating senior debt and the more junior debt (i.e., mezzanine) into two distinct products when valuing or structuring real estate debt securities.

Alcock and Steiner explore the interdependence of investment and financing choices among US listed REITs over the period 1973–2011. Their findings suggest a potentially rational explanation for why tax-exempt, transparent REITs may hold significant levels of leverage. In so doing the authors empirically contrast two conflicting theoretical propositions. One proposition is the shareholder–debt holder conflict, which implies that leverage distorts the optimal investment policy. The other is the manager–shareholder conflict, which implies that managers choose leverage to keep investment on its optimal path in order to maximize the utility of the rents they extract from the firm. Under this scenario, leverage follows investment. Alcock and Steiner find evidence that investment determines leverage in REITs, whereas leverage is not a determinant of the rate of investment. This finding reflects the agency conflict between shareholders and managers. The authors see the fundamental role of investments for the financial success of the firm in the REIT business model as leading managers to prioritize the investment decision over the leverage decision. Further, the authors argue that the debt-overhang conflict between shareholders and debt holders does not filter through to the actual investment choices of REITs. The authors’ findings also suggest that REIT managers utilize the maturity dimension of capital structure to mitigate potential investment distortions and to ensure that investment remains on its rent-maximizing path. According to Alcock and Steiner, leverage appears to be the residual absorbing the impact of investment choices.

Using a controlled experiment, Baum and Colley compare the risk and return characteristics of real estate investment strategies that employ varying formats of domestic real estate (direct exposure, balanced and specialist unlisted funds, a multi-manager approach, and listed securities) to deliver returns relative to a UK market index. They particularly examine the case for the multi-manager solution to institutional real estate investment. Based on a random stochastic simulation of historic performance data from 2003 to 2012, Baum and Colley draw several conclusions that seem broadly consistent with modern finance theory. For instance, they confirm previous research that tracking error of direct real estate portfolios against a direct benchmark is significant and varies inversely with portfolio size. They also find that the tracking error of listed real estate portfolios against a direct benchmark is very large (over 22%). They interpret this to mean that while investors preferring to buy REITs and other listed real estate securities may not need to employ a lot of capital, they will be forced to accept significant short-term risk relative to a direct market benchmark. Overall, their analysis shows that for smaller sums invested, multi-manager approaches to real estate seem to offer better direct real estate-style returns with less risk (tracking error) against a direct real estate benchmark. According to Baum and Colley (p. 422), listed securities provide the maximum risk relative to a direct market benchmark, which are caused by ‘impossibly uncorrelated short-term returns’. However, Baum and Colley note that the minimum risk provided by the multi-manager approach comes at the price of reduced returns. Consistent with market efficiency, core direct real estate represents a higher risk, high return strategy, while the multi-manager solution is a lower risk, reduced return strategy. It seems evident from the Baum and Colley simulations that multi-manager strategies tended to deliver returns that more effectively replicated a direct benchmark.