Bank Line of Credit, REIT Investment and Bank Relationship

Bank Line of Credit, REIT Investment and Bank Relationship Zhonghua Wu and Timothy Riddiough School of Business University of Wisconsin-Madison This Draft: April 1, 2005 Abstract This paper examines the empirical relationship between use of bank line of credit (L/C) and investment by equity REITs using a unique panel data set of REITs from 1990 to 2003. We also explore the interaction between use of bank L/Cs and equity and public debt issuance by REITs. The major findings are: (1) REITs use more bank L/Cs than regular C-corporations as a short-term financing vehicle. This suggests that bank L/C serves as a substitute for cash and helps relax liquidity constraint for REITs resulting from the 90% dividend payout rule. (2) The relative use of bank L/C monotonically increases with the asset growth of REITs, which implies that bank L/C plays an important role in funding REITs growth. (3) REIT investment in year t is positively related to the amount of bank L/C drawn in year t. Moreover, this relation is stronger for smaller and higher dividend payout REITs. This shows that financially constrained REITs may rely more on bank L/Cs for investment purposes. (4) There is a positive relation between REIT bank L/C available in year t-1 and net investment of REITs in year t. More importantly, the relation is stronger for REITs with a banking relationship. This is consistent with the notion that REITs use bank L/Cs to store financial capacity for investment, and that banking relationship facilitates REITs to gain better access to bank capital. (5) The dividend rule has a significant impact on REIT financing pattern in that REIT managers tend to use bank L/Cs to bridge finance investment. These findings provide novel understandings on REIT investment and financing, and shed light on the design of optimal financing policy for both REITs and firms in general. We thank François Ortalo-Magné, James Seward, James Shilling, Mike Mihelbergel, and seminar participants at the University of Wisconsin-Madison for helpful comments. We are also grateful to the Puelicher Center for Banking Education at University of Wisconsin-Madison for generous financial support. Direct correspondence to: Zhonghua Wu, 975 University Avenue, Madison, WI 53706, (608) 234-0027, E-mail: zhonghuawu@wisc.edu. 1

1 Introduction The past decade has witnessed dramatic growth in U.S. REIT industry as evidenced by a 26% annual growth rate of aggregate REIT market capitalization (see Capozza and Seguin (2003)). As REITs are capital intensive public firms with a considerable restriction on earning retention, they have to rely heavily on external financing and carefully plan their financing to fund investment and growth. Hence, financing has been a very important factor in determining individual REIT s success during the new REIT era (see Ott, Riddiough and Yi (2004)). Previous literature on REIT financial structure mainly focuses on analysis of REIT public debt and equity issuances (see, e.g., Brown and Riddiough (2003)), little research has been done on use of bank debt, especially on its impact on REIT investment and growth. 1 Given REITs inability to retain earnings, however, bank debt or bank line of credit (L/C) 2 plays a critical role in REITs financing activities. In particular, bank L/Cs provide REITs with short-term liquidity and financial flexibility, which are extremely important for REITs to make acquisitions and meet their cash needs for operation. According to Rich Horn, the President of Duke Realty Group, bank L/Cs allow REITs to more quickly process substantial transactions needed to buy and develop properties. Because of its pivotal role in REIT financing, bank L/C is considered blood line by REIT managers for daily operation and investment. This paper first provides evidence in REITs use of bank L/C, including its significance in REIT financial structure, bank L/C loan characteristics, and difference in using bank L/Cs between REITs and regular C-corporations. We then investigate the empirical relationship between REIT investment and use of bank L/Cs. Finally, the interaction between use of bank L/Cs and equity and public debt is also explored. We approach these issues by asking the following questions: (i) 1 One of the reasons is lack of REIT bank loan data. Compared to REITs public capital offerings, bank loan data are not that accessible and clean. 2 According to Loan Pricing Corporation s DealScan database, bank lines of credit account for approximately 80% of REIT bank debt issuance. 1

Do REITs issue more bank L/C than C-corporations? What are the differences between bank L/Cs issued by REITs and C-corporations? (ii) How is REIT investment related to use of bank L/C? Does this relation vary across different groups of REITs sorted by different firm characteristics (e.g. small and large firms) and by strength of banking relationship a REIT has? (iii) How does use of bank L/C by REITs interact with seasoned equity and public long-term debt issuance? Investigating these questions helps us better understand REIT financial policy and the impact of financing frictions on firm investment. Our study relates to three strands of literature in finance. The first is investment-cash flow sensitivity analysis used to investigate the impact of financing frictions on real investment decisions. In an influential paper, Fazzari, Hubbard and Petersen (1988)(FHP) examine the relation between firm investment and internal cash flow. They argue that firms prefer to use internal funds if they face external financing constraints resulting from capital market frictions. As such, firm investment not only varies with the investment opportunities but also with the availability of internal funds. Hence, investment-cash flow sensitivities across samples of different firms based on several financial constraint criteria can be used to evaluate the effect of financing frictions on firm investment. Since then, examining investment-cash flow sensitivity has become the standard approach in the literature. 3 In this paper, we study the relation between REIT investment and use of bank L/C, using a similar methodology in the investment-cash flow sensitivity literature. Our goal is to demonstrate the impact of bank L/C usage on REIT investment. We argue that due to the dividend payout rule, REITs are cash (or liquidity) constrained. As bank L/C is a close substitute to internal cash flow for REITs, by examining investment-bank L/C sensitivity of REITs across different groups 3 See Hubbard (1998) for an excellent review. However, several recent papers have challenged the validity of this approach on examining the impact of firms financial constraint (see Kaplan and Zingalas (1997), Erickson and Whited (2001), and Alti (2003)). 2

of firms, we provide understandings on how external-source liquidity 4 helps relax the liquidity constraint and influences REIT investment. The second related literature pertains to REIT capital structure and financial policy. Two big questions raised by Brown and Riddiough (2003) in REIT corporate finance are why debt is used at all to finance REIT investment and which types of debt are most advantageous. They argue that, as REITs do not pay tax at corporate level, there is no tax saving advantages for REITs to use debt. Also, free cash-flow rationale for debt is muted by REITs mandatory dividend payout rule. They conclude that more research needs to be done in this area. Furthermore, an interesting financing pattern of REITs is that REITs often adopt a bridge financing strategy to fund investment (see Elayan et al. (2003)). That is, REITs prefer to use cash or short-term debt to pay for transactions, and then issue either public long-term debt or seasoned equity to retire short-term debt. In this paper, we address these issues by investigating the significance of bank L/C in REIT financing, and how use of bank L/C and public capital offerings interplay with each other using a multivariate regression framework. In particular, we explicitly test the bridge financing pattern in REIT financing. The third relevant literature is related to value of banking relationship. Previous research in banking relationship has highlighted the role of banks as relationship lenders (See Boot (2000) for a comprehensive review). Banks, through repeated interaction with firms, have comparative advantages over other capital sources in information production. Banking relationship allows firms and banks to negotiate more efficient contracts, facilitates firms to obtain financial flexibility from banks, and provides monitoring benefits that are useful to outside shareholders. More importantly, banking relationship is viewed as an effective way to partly overcome capital market imperfections 4 I consider internal cash flow as internal-source liquidity, while bank L/C being as external-source liquidity. 3

(see Houston and James (2001)), since it helps smooth informational frictions that might otherwise restrict the flow of external funds to firms. In this paper, we document the benefits arising from banking relationship for REITs, which add new empirical evidence to banking relationship literature. REITs provide a natural laboratory to study these issues. First, the 95% dividend payout rule distinguishes REITs from other public firms in that REITs have little internal cash flow available after dividend payout, 5 and thus have to rely heavily on bank L/Cs to meet their short-term liquidity needs. This produces a natural setting resulting from the exogenous dividend payout regulation which help us study the relation between firm investment and liquidity constraint. 6 Second, the rapid growth of REITs leads to a soaring demand for external financing. As most of the REITs are small, young firms, use of bank debt is important for REITs in that they need gain reputations through bank borrowing in order to better access the public capital markets (see Diamond (1991)). This creates a rich environment to study the role of bank L/C in REIT financing in the context of industry growth. Finally, the tangible nature of REIT assets provides a more accurate measure of Tobin s Q, which mitigates the measurement error problem in the investment-cash flow sensitivity literature (see Erickson and Whited (2001)). To conduct this study, we construct a unique data set consisting of REIT bank L/C issuance and usage information. Specifically, the detailed information on bank L/C usage and REIT firm financial information are from the SNL REIT database. The bank L/C usage data include information on total bank L/C available at the end of each year, amount drawn of bank L/C, and average bank L/C drawn ratio. In addition, to study the interaction between REIT equity, long-term debt issuance and use of bank L/C, we obtain detailed information on REIT capital offerings from the 5 Wang et al. (1993) show that most of the REITs pay more than 100% of their taxable income. 6 Observations from the real world support the notion that REITs often use bank L/Cs to substitute internal cash flow to meet their short-term liquidity needs. The authors discussions with some REIT managers, such as CFO of General Growth Properties, confirms this view. 4

NAREIT database, which is then hand-matched into the SNL REIT sample. The individual loan information of REIT bank L/Cs is from Loan Pricing Corporation s DealScan loan database, which is used to classify different level of banking relationship. This unique data set allows us to examine the relation between use of bank L/C and REIT investment using a fixed effect model. The major findings are: (1) REITs use more bank L/Cs than regular C-corporations as a shortterm financing vehicle. This suggests that bank L/C serves as a substitute for cash and helps relax liquidity constraint for REITs resulting from the 90% dividend payout rule. (2) The relative use of bank L/C monotonically increases with the asset growth of REITs, which implies that bank L/C plays an important role in funding REITs growth. (3) REIT investment in year t is positively related to the amount of bank L/C drawn in year t. Moreover, this relation is stronger for smaller and higher dividend payout REITs. This shows that financially constrained REITs may rely more on bank L/Cs for investment purposes. (4) There is a positive relation between REIT bank L/C available in year t-1 and net investment of REITs in year t. More importantly, the relation is stronger for REITs with a banking relationship. This is consistent with the notion that REITs use bank L/Cs to store financial capacity for investment, and that banking relationship facilitates REITs to gain better access to bank capital. (5) The dividend rule has a significant impact on REIT financing pattern in that REIT managers tend to use bank L/Cs to bridge finance investment. These findings provide novel understandings on REIT investment and financing, and shed light on the design of optimal financing policy for both REITs and firms in general. This paper is organized as follows. After the introduction, Section II describes the institutional background and develops three hypotheses for empirical study. In Section III, we analyze the data and discuss the methodology used in this paper. Next Section presents empirical results on the relation between use of bank L/Cs and REIT investment. Section V concludes. 5

2 Institutional Background 2.1 Background in REIT Growth and Financing REIT industry has experienced dramatic growth and consolidation during the past decade. According to Capozza and Seguin (2003), out of the 26% annual growth rate of aggregate market capitalization from 1992 to 2002, 23% is exclusively from an increase in the size of average REIT. Till December 2004, seven big REITs are included in S&P 500 index. 7 The average size of REITs (by total asset) is about 1.6 billion dollars (see Ott, Riddiough and Yi (2004)). Moreover, there are 68 mergers among REITs from 1994 to 2004. In other words, about 1/3 of the total number of RE- ITs underwent M&As during the period. In such a dynamic and highly competitive marketplace, REITs are under pressure to grow and financing becomes a key factor for REITs to succeed. One critical characteristic of REITs is that they are required to pay 95% of taxable income as dividend to shareholders, which significantly hampers REITs ability to retain earnings. In fact, as Wang, Erickson, and Gau (1993) point out, even the 95% requirement is not a binding constraint. During the 1980-2000 period, the average ratio of cash dividend to net income was about 117%. 8 Consequently, only 7% of total investment of REITs are funded by retained earnings, compared to 70% for other public firms (see Ott, Riddiough, and Yi (2004)). To sum up, most of the REITs are liquidity constrained, and have to rely on external finance to fund daily operation and investment. The unique financial regulation and market setting create incentives for REITs to plan their financing policy with greater care. In practice, REITs grow by acquiring properties using both debt and equity financing. To quickly process their transactions, REITs prefer to use cash and bank L/C 7 They are Simon Property Group, Apartment Investment and Management Co., Equity Office Property Trust, Equity Residential Trust, Prologis Trust, Plum Creek Timber Company, and Archatone-Smith Trust. 8 This is largely because REITs are considered dividend stocks, they have to stabilize their dividend payout in order to attract investors even when they experience a negative income shock. On the other hand, the reason they can do so is that REITs taxable income is often smaller than their net income due to the depreciation effect. Since REITs primarily own properties in their portfolios, they are able to reduce their taxable income substantially because of the depreciation write-off, which is not a cash flow item. 6

to pay for properties. Furthermore, REITs tend to match the term of the debt that finances an investment to the leaseback terms on that property to hedge away interest rate risk. Most of such financing vehicles are long-term, fixed-rate. Thus, REITs often adopt a bridge financing strategy to fund their investment, that is, use cash to pay for purchases of properties, and structure long term financing contracts (public long-term debt or seasoned equity) to retire those short-term debt later. This strategy is consistent with the rationale in Myers (1977) which shows that it is efficient for firms with high growth opportunities to use short-term debt to mitigate the underinvestment problem. 2.2 Bank Line of Credit A bank line of credit is a forward contract issued by a bank to offer debt under pre-specified terms over some future time interval unless the borrower violates certain covenants in the contract (Berger and Udell (1998)). Bank L/Cs are generally revolving credit facilities that allow the firms to borrow as much as needed at any given time over the time interval specified. The actual borrowed amount is called takedown, which is charged by a variable interest rate spread over LIBOR or Prime rate. Besides an interest rate paid for a takedown, there are also multiple fees specified in a bank L/C contract, which typically include an upfront fee and a commitment fee (a fee charged on the unused balance of bank L/C). Those multiple fees, ranging from 50 to 100 basis points, can be a substantial cost for borrowers, which creates a tradeoff for REITs to hold bank L/Cs, i.e, on the one hand, firms obtain financial flexibility and liquidity, on the other hand, this benefit does not come up without a cost (see Shockley and Thakor (1997)). There are several characteristics associated with a bank L/C. First, it is a short-term, revolving credit facility with a typical maturity of one year. Upon expiration, it is often automatically renewed by the bank. If firms desire, bank L/C size can increase over time. Second, bank L/Cs are 7

customized to meet the needs of individual borrowers. However, by imposing restrictive covenants, banks can mitigate moral hazard problems from borrowers. For instance, many L/Cs include Material Adverse Change (MAC) clause, which gives a bank the option to escape its lending commitment when the firm is in serious financial problems. Combined with other covenants, a MAC clause gives a bank wide latitude to limit borrowing under loan commitment if the borrower s conditions deteriorate (see Shockley and Thakor (1997)). These contractual features render banks a powerful tool in mitigating asset substitution and underinvestment moral hazard problems. Finally, empirical evidence shows that bank L/Cs are relatively cheaper than spot loans, and have a lower default probability (see Ham and Melnik (1987)). Bank L/Cs account for a large portion of firms bank debt in U.S.. According to a recent Federal Reserve Board Survey (see Survey of Terms of Business Lending, Federal Reserve Board Statistical Releases (June 2000)), approximately 80% commercial and industrial loans are made under the arrangement of bank loan commitment or line of credit. 9 The most important function of bank L/Cs is that they allow firms quick access to capital. In practice, firms that lack internal cash often use bank L/Cs to meet cash needs and maintain short-term financial health. 10 As a Federal Reserve Board survey (1998) reports, the main reasons for firms to use bank L/Cs are financial flexibility and speed of action (see Avery (1991)). Moreover, a bank L/C is essentially a put option, which protects borrowers from credit rationing in the imperfect capital markets or from their future creditworthiness deteriorations. Finally, due to the uniqueness of bank debt (see James (1987)), and the repeated interaction via bank lending, a bank L/C represents a close relationship between banks and firms. Hence, bank L/Cs are often used to examine value of banking relationship in the literature (see Berger and Udell (1995)). 9 The majority of bank loan commitments are under arrangement of line of credit. 10 See, for example, the article of Marsh Signs Letters to Extend Financing, Meeting Cash Needs, Wall Street Journal, Tuesday, November 23, 2004 C1. 8

2.3 Importance of Bank Line of Credit in REIT Financing First, bank L/Cs have become a significant capital source for REITs during the past decade. Table 1 reports annual capital sources for the REIT industry from 1992 to 2003. The capital offering data are from the NAREIT website, 11 including IPOs, seasoned equity offerings (SEOs), unsecured debt and secured debt. The bank L/C debt and mortgage data are from the SNL REIT database. We only include equity REITs registered with NAREIT in the sample. The total amount of bank L/C debt has been increasing since 1992, and reached its peak in 1998. Since then, it has remained above 10 billion dollars, accounting for about 1/2 to 1/3 of total capital issued each year. 12 This shows that bank L/C debt has become increasingly appealing to REITs in funding investment and operation in recent years. Another interesting pattern from Table 1 is that the amount of unsecured debt offerings parallels with the amount of bank L/C debt issued during the period, while the amount of seasoned equity tend to fluctuate from time to time. This is consistent with the bridge financing strategy where bank L/C debt is used as a temporary financing vehicle by REITs, and retired with proceeds from long-term unsecured debt. Moreover, as indicated in Table 1, we can see that REITs have become less dependent on mortgages and secured debt (i.e., mortgage backed securities). This supports the statement by Rich Horn, the President of Duke Realty, that REITs today prefer to use more corporate debt than traditional secured financing. [Table 1] The importance of bank L/Cs to REITs is also evidenced by a cross-section comparison between REITs and regular C-corporations. Table 2 shows that REITs issue more bank L/Cs to fund their operation and investments relative to C-corporation. The measure of use of bank L/Cs is a ratio 11 see http://www.nareit.com/members/library/industry/offerings.cfm 12 Note that even taking into account the fact that REITs can only draw debt from a bank L/C several times a year, the amount of bank L/C used by REITs is still significant to REIT financing activities. 9

of the total bank L/C debt issued by REITs from 1990 to 2003 (LOC 90 03 ) over the total assets of REITs for that period (K 90 03 ). In addition, we include similarly constructed measures for net cash flow available after dividend payout, retained earnings and cash dividend paid, all of which are scaled down by total assets. [Table 2] Table 2 indicates that REITs are more cash constrained than other public firms. The ratio of Cash t /K t of REITs is 1.6%, which is much lower than that of other public firms, 5.1%. 13 Accordingly, the ratios of LOC t /K t for REITs are higher than that of C-corporations for most of the years during the period. Specifically, the average ratios of LOC t /K t over years are 9.1% and 4.2% for REITs and other public firms, respectively. These results suggest that REITs acquire L/Cs to meet their cash needs. Furthermore, we compare the ratio of dividend payout over total asset (DIV t /K t ) and ratio of retained earning over total asset (RE t /K t ) for the two groups. Interestingly, the results indicate that the lower Cash/K ratio of REITs is mainly due to a higher DIV t /K t ratio (3.7% vs. 1.5%), and a lower RE t /K t ratio ( -4.2% vs. 18.7%) than those of other firms. In sum, these results implies that the financial regulation of REITs (90% dividend payout rule) has a significant impact on REIT financing policy, that is, REITs tend to use more bank L/Cs as a substitute of internal cash flow to meet their liquidity needs. Another aspect that aids in our understanding uniqueness of bank L/C to REITs is to compare bank L/C loan characteristics between REITs and regular C-corporations. Table 3 reports the loan characteristics of REITs bank L/C and C-corporations issued from 1990 to 2003. On average, REITs pay lower price for their bank L/Cs than C-corporations. LIBOR spreads for REIT L/C are about 30 basis points lower than those of C-corporations for bank L/Cs of various purposes. The same pattern exists for commitment fees. REITs typically pay 10 basis points lower on commitment 13 cash flow is defined as total income before extraordinary items + depreciation - cash dividend. 10

fees than C-corporations. Additionally, the ratios of REIT L/Cs with a MAC clause are much lower than those of C-corporations, and REITs are less likely to pledge collateral for their bank L/C. These differences suggest that REITs do enjoy more favorable pricing and covenant terms than regular C-corporations. One implication is that REITs tend to develop good relationships with banks. Another could be that REITs are considered high credit quality firms thanks to their high level of asset tangibility. 2.4 Development of Testable Hypotheses Based on the discussion above, we hypothesize that use of bank L/C is positively related to REIT investment and growth. Moreover, the investment-bank L/C sensitivity of REITs should be different across groups of REITs based on priori criteria designed to differentiate firms by their intrinsic characteristics. There are several previous theoretic studies supporting our hypotheses in the previous literature. First of all, the importance of bank L/C to REITs can be seen from Holmström and Tirole (1998). In their paper, they set up a moral hazard model in which credit-constrained firms have a demand for liquidity, i.e., firms need advance financing. Because firms have to rely on external finance to fund investment, in a dynamic setting, liquidity shocks could lead to a termination of a positive NPV project. One efficient way to protect firms from such risks is to obtain a credit line from a financial intermediary. This model fits the case of REITs very well, implying that it is desirable for RETIs to use bank L/Cs to fund investment and growth, and thus protect them from liquidity shock. Second, following Kaplan and Zingales (1997), we can derive the dependence of investment on liquid capital for profit maximizing firms in a two-period model with costly external finance as, di db = C 11 C 11 F 11 (1) 11

In the model, F (I) is the return to investment I, B is the amount of bank L/C ( external-source liquidity ), and c(e, κ) is the cost wedge between bank L/C and public capital offerings (E), where the parameter κ measures the magnitude of the cost wedge. C 11 (.) and F 11 (.) represent the second partial derivative of C(.) and F (.) with respect to its first argument. As C 11 > 0 and F 11 < 0 by assumption, di db is positive, indicating that a positive relation between investment and availability of liquid capital. While this dependenc e is not necessarily increasing in the degree of κ, as suggested by Fazzari, Hubbard, and Peterson (2000), we can compare the sensitivity across different groups of firms classified by priori criteria. Hence, one prediction we can develop in this context is that large firms should exhibit a lower investment-bank L/C sensitivity than small firms. Compared to small firms, large firms have a smaller cost wedge between bank L/Cs and public capital as they are less likely to suffer from capital market frictions. Third, Martin and Santomero (1997) develop a theoretic model of bank L/C demand using a continuous-time finance framework. In their model, firms need speed and financial flexibility to make investment, which is precisely what bank L/Cs provide. They conclude that firms optimal demand for bank L/Cs should be positively related to firms growth rate. By the same token, we expect high growth REITs to have use more bank L/C to fund investment. Similarly, as bank L/Cs relax firms liquidity constraint, REITs with higher dividend payout ratios will have a higher investment-bank L/C drawn sensitivity. Another metric that can be used to examine the impact of use of bank L/C on REIT investment is investment-bank L/C available sensitivity. The bank L/C available is the total bank L/C available of a firm during year t, which indicates the financial capacity of the firm. The significance of this measure can be seen as follows: firms all prefer to acquire bank L/C as a short-term financing vehicle, but only firms with limited financial capacity will find it difficult or costly to acquire bank L/C in advance because of the high commitment fees. Hence, investment of firms that have more 12

financial capacity to acquire bank L/Cs should exhibit a stronger relation to the increase of bank L/C holdings than firms with less such capacity. Houston and James (2001) demonstrate that banking relationship plays a role in influencing a firm s investment-cash flow sensitivity. They conclude that a close banking relationship facilitates bank capital flow into firms and relaxes firms liquidity constraint. Accordingly, we hypothesize that REITs with a close banking relationship will have a stronger correlation between investment and their bank L/C holding (financial capacity). Moreover, we follow Whited (1992) to divide the sample based on whether REITs have bond ratings or not. The idea is that firms that do not use the corporate bond market have undergone less investor scrutiny so that they are more affected by problems of information asymmetries. In other words, firms should be separated by their access to organized bond markets or their financial constraint. We expect that the investment-bank L/C available sensitivity should be stronger for REITs which issue public debt. Brown and Riddiough (2003) study the stated use of proceeds from public capital offerings, and find that proceeds from equity offerings are more likely to be used to fund investment, whereas public debt offering proceeds are typically used to reconfigure the liability structure of the firm. We investigate the relation between use of bank L/C, seasoned equity offerings, and public debt offerings using a multivariate regression framework. Other interesting aspects to examine are how use of bank L/C is related to REIT dividend payout, asset growth rate, and performance measure of REITs. By doing so, we can explore the relationship among the three major financing sources and derive implications for the design of optimal financing policy for REITs. To summarize, we develop the following predictions for our empirical exercise. Prediction 1 : (Investment-Bank L/C Sensitivity Hypothesis) There should be a positive relation between bank L/C drawn in year t and firm investment in year t, and the relation is stronger 13

for those firms with larger cost wedge between bank L/C and external finance, such as smaller and younger firms, and for firms that have higher dividend payout ratio. Prediction 2 : (Financial Capacity Hypothesis) REIT investment in year t should be positively related to bank L/C available (financial capacity) in year t 1. Moreover, this relation should be stronger for REITs with greater financial capacity and with banking relationship. Prediction 3 : (Bridge Financing Hypothesis) Use of bank L/C by REITs in year t should be positively related to public debt issuance in year t+1, and negatively related to public debt issuance in year t. For equity issuance, there is no such a pattern, i.e., the relation should be positive in both year t and year t + 1. 3 Data and Methodology 3.1 Data The primary data used in the investment and bank L/C analysis is an unbalanced panel data of REITs from SNL s REIT database. The SNL REIT database include detailed firm classification and financial information of REITs. For example, we can identify whether or not a REIT is an equity REIT, and the property type focus of a REIT. Besides detailed financial information such as total assets, real estate investment, asset growth rate and market capitalization for each REIT, we also obtain REIT bank L/C usage information, i.e., total bank L/C holdings during year t, total amount of debt drawn from bank L/C during year t, and average drawn ratio of bank L/C for a REIT each year. To be included in the sample, REITs have to meet the following criteria: (1) listed in NYSE, AMEX or NASDAQ, and elected REIT tax status at the beginning of the sample 14

year (1990); (2) registered with NAREIT are included, given that we need match public capital offering information into the firm financial and credit line usage data set. The original sample from the SNL REIT database has 3,667 firm-year observations. To add REIT capital offering information to the database as a control variable, we obtain REIT capital offering data from NAREIT Capital Offering Database, which consists of 1,401 seasoned equity offerings, 950 public data offerings, and 156 REIT IPOs. Then, we hand match the data to obtain one single data set containing both the bank L/C usage information and the capital offering information. The final sample consists of 1, 499 firm-year observations from 1990 to 2003, which allows us to conduct a meaningful analysis on the relation between REIT investment and use of bank L/C. To examine the investment-bank L/C available sensitivity through banking relationship, we create a dummy variable for bank relationship. The bank L/C loan data are from the DealScan database of Loan Pricing Corporation. There are 1,248 bank loans of REITs in the sample. We then follow the same methodology by Bharat et al. (2004), where a REIT in a certain year is considered having a close banking relationship with its lead bank if the REIT borrows from the same bank twice over the past five years. By so doing, we obtain 685 (823) firm-year observations with (without) a banking relationship. Furthermore, depending on whether a REIT repeatedly borrows from different lead banks, we create a dummy variable (M ultiple) to indicate whether the REIT has a multiple banking relationship. Summary statistics for the main sample are presented in Table 4. We present mean, median, standard deviation, and nonzero observations of the main sample in the left panel. In the right panel, the values of the distribution are reported at the 10th, 25th, 75th, and 90th percentile of the sample. All the numeric values are scaled by the beginning of year balance of total assets, except for T Q t 1 and AGE. Net real estate investment is calculated as the difference between real estate 15

investments of a REIT in the consecutive years. NET I t /K t 1 has a mean value of 20.5% of the total assets and a median of 9%. While the 90% percentile has a value of 62%, the 10th percentile has a negative value of -0.04%. This indicates that although most of the REITs increased their investments during the sample period, some experienced negative growth. [Table 4] A proxy for Tobin s Q is constructed as the market-to-book ratio of firm assets, that is, market value of equity plus total book assets minus book value of common equity divided by total book assets. T Q t 1 has a mean of 1.23, and a median of 1.17 in the sample. The cash flow variable, Cash t, is calculated by adding the extraordinary income plus depreciation and amortization minus cash dividend paid. As REITs have to pay out most of their taxable income as dividend, deducting the dividend payout from the total cash provides a better measure of cash flow available to REITs. Not surprisingly, the mean and median value of Cash t /K t 1 are only 0.01 and 0.02, respectively, which is consistent with our belief. The two most important independent variables are bank L/C usage measures, i.e., Creditg/K t 1 and Locg t /K t 1. The former is defined as the ratio of net increase of bank L/C available of a REIT during year t over its total assets at the end of year t-1, which has a mean value of 0.17 and a median of 0.15. The later is defined as ratio of net increase of actual debt drawn from bank L/Cs of a REIT during year t over its total assets at the end of year t-1. The mean and median of this variable are 0.09 and 0.06, respectively. The total assets of REITs in the sample have a mean of 1, 574 million dollars, and a median of 743 million dollars. Moreover, the average firm age is 11 years, and median firm age being only 7 years. This indicates that most of the REITs are still small and young firms (Also see Ott, Riddiough, and Yi (2004)). 16

3.2 Methodology First, to show REITs with high asset growth use more bank L/Cs, we classify the firm-year observations into five groups based on the average asset growth rate (g) of REITs over the two consecutive years. Specifically, the five groups are: g < 0%, 0 < g < 25%, 25 < g <50%, 50% < g <100%, g > 100%. The measures used to represent the usage of bank L/C are the total bank L/C available, the total bank L/C drawn by a REIT, and the average drawn ratio of bank L/C by a REIT. To control the firm size effect, we scale the first two measures by the total asset of a REIT. Namely, for each group we calculate the following three ratios: Loc it /K it 1, which is the ratio of total bank L/C drawn over total assets of a REIT in year t; Credit it /K it 1, which is the ratio of total bank L/C available at the end of year t-1 over total asset of a REIT at the end of year t-1; and Drawnratio it, which denotes average drawn ratio of bank L/Cs for a REIT during year t. As discussed above, we expect fast growing REITs to have greater usage of bank L/C than low growing REITs. Our approach to examining the relation between firm investment and use of bank L/Cs is similar to that suggested by the investment-cash flow sensitivity literature (see Fazzari, Hubbard, and Peterson (1988)(FHP), and Houston and James (2001)). These papers estimate a general form of investment equation from the q model of investment (see Hayashi (1982)). According to the q model, there is a linear relationship between investment and marginal Q as firms pay adjustment costs (I, K), where I is linear in I/K. Intuitively, net investment of a firm is primarily driven by average Q, defined by the sum of the book value of equity and debt divided by the replacement cost of the capital stock. When average Q of a firm is greater than one, it is more likely that the firm will invest. Furthermore, FHP motivates the inclusion of cash flow in this augmented version by arguing that financing also plays a part in firms investment decision due to capital market frictions. Specifically, firms facing financing frictions prefer to use internal finance to fund 17

investment. Thus, supply of low-cost finance should enter the general form of investment equation while average Q is used for controlling growth opportunities of a firm. The common feature of these specifications is to scale variables by total assets or capital stock at the end of year t-1 and estimate a fixed effect (year and firm dummies) model as follows, I it K it 1 = β 0 + β 1 CF it K it 1 + β 2 T Q it 1 + ɛ it (2) where the dependent variable is the ratio of capital expenditures (I i,t ) over total asset at the end of year t-1 (K it 1 ), and CF i,t is the internal cash flow measure. When different samples of firms based on certain grouping criteria are estimated, β 1 can be used as an indicator for differential financing constraints. Note there are a number of recent papers criticizing the validity of this approach to detect financing constraints (see Kaplan and Zingales (1997) and Erickson and Whited (2000)). They argue that the high sensitivity can not be used to detect financial constraints of a firm. Instead, the difference in investment-cash flow sensitivity may come from managers risk aversion or measure error problem from the Q variable. To respond to these critiques, Fazzari, Hubbard, and Peterson (2000) argue that as long as one classifies firms according to a priori criteria designed to give large differences in the slope of the external financing schedule, C 11, across groups, and make a certain assumption on the production technology, F 11, the sensitivity can be used to detect financial constraint. In our paper, we argue that bank L/C ( external-source liquidity ) is a close substitute to internal cash flow for REITs, as they have to rely on external financing to meet their liquidity needs. Thus, a bank L/C usage variable (either bank L/C drawn or total bank L/C available) is used to replace the internal cash flow variable in the traditional specification. In addition, to capture the influence from other financial claims on firm investment, we add two dummy variables 18

into our investment equation for control purpose. This has not been done in previous literature (see Almeida et al. (2004)). The two dummies are used to indicate whether or not a firm issues equity or public long-term debt in year t. We also add an age variable to control for age effect given that young REITs tend to invest more by nature. Finally, we add fixed effect dummies to capture the sources of variation for different year and property type of REITs. These two fixed effects absorb certain sources of variation in bank L/C usage variables that are not desirable due to their correlation with investment opportunities (See Rauh (2004)). For instance, a market downturn in a given year may adversely impact investment opportunities for all REITs, and reduce REITs use of bank L/C. This fact is absorbed by the year dummies. The variation that remains is the variation from different behavior of individual REITs in the same year. Following the standard approach in the literature, we then estimate the investment equation based on different groups of REITs. As such, our empirical model for the Investment-Bank L/C Sensitivity Hypothesis is given as follows: NET I it K it 1 = β 0 + β 1 Locg it K it 1 + β 2 T Q it 1 + β 3 Edummy + β 4 P Cdummy + i γ i Control i + ɛ it (3) where NET I i,t is the net increase of real estate investment made by a REIT during year t. 14 Locg i,t is net increase of total bank L/C drawn from year t-1 to year t. These two variables are scaled by K i,t 1, the book value assets of a REIT at the end of year t 1. We use book value asset to scale the two numerical variables because the book value asset of REITs is very close to its value of property, plant, and equipment, which is commonly used in the literature. Beginning-of-year Tobin s Q (T Q i,t 1 ), defined as the total market cap of a REIT plus total debt divided by the total 14 SNL REIT database does not provide specific information on new capital investment a firm makes each year, which is commonly used in the study. However, we argue that the net increase of real estate investment of a REIT during a certain year can be used a proxy for the capital expenditure measure in investment-cash flow sensitivity literature. 19

asset of the REIT at the end of year t-1, serves as a proxy for growth opportunities of a REIT. The two dummies are Edummy, which is equal to 1 if a REIT issues seasoned equity during year t; P Cdummy, which is equal to 1 if a REIT issues public debt during year t. Finally, we allow Control i to be a vector of controls, including firm age (Lnage), property type and year dummies. We believe that our methodology is less likely to be subject to the critiques in the literature. First, the majority of REIT assets are tangible assets, which provides us with a better measure of q. Therefore, the measurement error problem raised by Erickson and Whited (2000) is mitigated in the case of REITs. Second, REITs are liquidity constrained firms due to the exogenous dividend payout requirement, and bank L/C is an indispensable financing vehicle for REITs to meet their liquidity needs. Hence, the sensitivities across different groups of firms can be used to make inferences on the impact of bank L/C on firm investment, as they are less likely to suffer endogeneity problems raised by Kaplan and Zingales (1997). Finally, as REITs have to pay commitment fees for their bank L/Cs, it is less likely for them to acquire bank L/Cs based on other incentives than make future real estate investments. Hence, investment-bank L/C sensitivity analysis helps mitigate the free cash flow problem in the investment-cash sensitivity literature and provides a better metric for evaluating the impact of financing conditions on firm investment. The β 1 in the equation is the coefficient of interest, which indicates how sensitive a REIT s net investment increase during year t is to its bank L/C drawn during year t. A positive and significant coefficient is expected. Furthermore, as Tobin s Q is used to control for growth opportunities, there should be a positive and significant coefficient associated with T Q it 1. To examine the investment-bank L/C available sensitivity ( Financial Capacity Hypothesis ), we modify the basic model by replacing Loc it with Creditg it 1, which is a measure for the net 20

increase of total bank L/C holding during year t. NET I it K it 1 = β 0 + β 1 Creditg it 1 K it 1 + β 2 T Q it 1 + β 3 Edummy + β 4 P CDummy + β 5 Inage + ɛ it (4) An important issue in our empirical specification is the potential endogeneity problem resulting from the simultaneous bias between firm investment and use of bank L/C. To address this issue, we use an instrumental variable approach to demonstrate that the potential simultaneous bias should not systematically affect our estimation results. Specifically, we estimate the following simultaneous equation system, NET I it K it 1 = β 0 + β 1 Y it K it 1 + β 2 X it + ɛ it (5) Y it K it 1 = β 0 + β 1 NET I it K it 1 + β 2 Z it 1 + β 3 REL + β 4 SP LT + β 5 X it + ɛ it (6) Where NET I it is net increase (decrease) of REIT investment during year t, Y it is either net increase of bank L/C debt drawn by a REIT in year t (Locg it ), or net increase of bank L/C available at the end of year t-1 (Creditg it ). The equation (5) is the one of interest. In the other equation, we include a key instrumental variable, Z it 1, which is the ratio of total cash dividend paid in year t-1 over the total assets at the end of year t-1, Lagdr. To satisfy the rank condition required for a valid instrument, we need test the validity of this instrumental variable, that is, it should be exogenous to the bank L/C debt drawn during year t, but not significantly correlated with the net investment increase during year t. The vector X it include all the control variables such as Q t 1, a Tobin s Q measure, Lnage, natural log of firm age, Edummy and P CDdummy are defined as before. Besides, two control variables are also included in the second equation, that is, SP LT, a dummy indicating whether a REIT has a long-term bond rating from S&P, and REL, a dummy indicating whether a REIT is 21

considered having a banking relationship with its banks. Again, the models are two-way (year and property type) fixed effect models using REIT firm-year data from 1990 to 2003. For each specification, we split the full sample based on various priori criteria on firm characteristics, following the standard approach in the investment-cash flow sensitivity literature. These criteria include firm size, whether a firm has a bond rating or not, dividend payout ratio, and strength of banking relationship. Finally, to check the robustness of our estimation between use of bank L/C and REIT investment and growth, we examine the impact of bank L/C on firm growth, dividend payout and the issuance of other financial claims (equity, public debt and mortgage) using a similar fixed effect model. The only difference is that the original dependent variables are replaced with those variables. In case that the dependent variables are left truncated, we estimate the equation using a Tobit model. 4 Empirical Results In this section, we first analyze the nonparametric relationship between use of bank L/C and REIT growth, and then discuss the regression results of the main specifications. The effects of bank L/C on REIT investment are presented using different samples grouped by hypothesized observable measures of financing constraints. Finally, we discuss the role of bank L/C and bank relationship in REITs financing structure. 4.1 Descriptive analysis First, to show relationship between use of bank L/C and REIT growth, we use three measures of use of bank L/Cs : (1) total amount of debt drawn by a REIT from its bank L/Cs, (2) total amount of bank L/Cs available to a REIT, and (3) average bank L/C drawn ratio to a REIT. All three variables are scaled by total assets (K t 1 ) of a REIT at the end of year t-1. Specifically, 22

LOC t /K t 1 is defined as the ratio of total amount drawn by a REIT from its bank L/Cs in year t over its total assets in year t-1, Credit t /K t 1 is the ratio of bank L/C available to a REIT over its total assets in year t-1, and Drawnratio t is the average drawn ratio of bank L/Cs by a REIT in year t. We then classify the 1,749 firm-year observations into five groups based on asset growth rates of REITs, and calculate the average ratios for each group. We expect that these measures of use of L/C should be positively related to the asset growth of REITs. [Table 5] Table 5 presents evidence showing that use of bank L/C is positively related to asset growth of REITs: the three ratios monotonically increases with the asset growth rate of REITs. First, the higher the asset growth rate of a REIT in year t, the more the bank L/Cs are issued in year t-1. The ratio Credit t /K t 1 of fast growth REITs (17.4%) is higher than that of slow growth REITs (12.9%). This is consistent with the hypothesis that REIT managers tend to store financial capacity using bank L/Cs for future investment when they anticipate growth opportunities in the coming year. Second, the ratio (LOC t /K t 1 ) of the fast growth REITs (9.6%) is as twice as that of the slow growth REITs (4.9%). Considering the large denominator of this measure (total assets), the difference between these two ratios reflects a sizeable disparity of two groups in using bank L/Cs. This confirms that when REITs experience faster growth, they do borrow more debt from bank L/Cs. Finally, the average bank L/C drawn ratio (Drawnratio t ) of the fast growing REITs is significantly higher than those slow growing REITs (59.4% vs. 31.9%). In sum, these results are consistent with the predictions of Martin and Santomero (1997), which concludes that firms usage of bank L/Cs increases with their growth rates. 23