Question

why are REITs a unique vehicle for studying capital structure decisions? What does the research suggest regarding the optimal capital structure of REITs?

Answer 1

REITs are Real Estate Investment Trusts. REITs are considered as a unique vehicle for studying capital structure decisions due to the fact that REITs do not use the conventional models and approaches like the net income approach or the net operating income approach or the Modigliani and Miller approach to determine their capital structure. Their capital structure usually exhibits use of low leverage with use of debt that has longer maturity. REITs maintain a much higher proportion of fixed rate debt and tend to avoid or reduce its dependence on secured debts. REIT shuns the use of variable rate debt and there exists an inverse relationship between the value of REIT and leverage.

Research and empirical studies suggests that the optimal capital structure of REITs is one that has the highest “q ratio”, low leverage, and higher proportion of fixed rate debts.