REIT Leverage Puzzle

Abstract

Real Estate Investment Trusts (REITs) utilize significant financial leverage, with a typical REIT employing around 40 percent of debt financing. For non-taxable entities like REITs, the absence of tax benefits raises questions about the optimal level of financial leverage. This study explores the effects of leverage on shareholder returns in REITs and provides empirical evidence supporting the trade-off theory of capital structure. Our findings indicate that some REITs may have reached their optimal level of financial leverage, beyond which the marginal benefit diminishes. Additionally, the study reveals that high leverage can create agency conflicts between managers and shareholders, leading to a market penalty on REITs with excessive financial leverage. Importantly, we also find that the impact of financial leverage on REIT performance varies depending on the economic context, showing divergent trends pre- and post-financial crisis and during the COVID-19 pandemic recovery phase. The implications of these findings are critical for understanding REITs’ governance and financial management.