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Operating Lease as Alternative Financing for REITs: a Viable Strategy or a Sign of Trouble?

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Abstract

Extant REIT research largely overlooks operating leases as an alternative source of financing. In this study, we hand-collect lease information of 334 unique REITs over the period of 1993 to 2018, and we document that an increasing number of REITs have been including operating leases in their capital structure to finance income-generating investment properties. We examine the determinants of the operating lease decision and find that REITs which adopt operating leases tend to be larger and have more growth opportunities as measured by Tobin’s Q. But they also have higher leverage, report lower funds from operations, and higher risk. We further find that operating lease intensity for REITs is negatively affected by credit ratings, but not by growth opportunities. Lastly, we examine the market effect related to operating lease decision and find that REITs with operating leases are associated with lower shareholder returns. Overall, our findings imply that operating leases are employed as an alternative financing source by REITs that are highly levered and cannot rely much on their internal funding. As a result, the market does not view the use of operating leases in the REIT sector favorably.

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Notes

  1. Prior to January of 2019, operating leases were reported as an expense in the financial statements, and unlike capital leases, they did not require recognition of lease liabilities and their associated assets for the lessee in the financial statements.

  2. The minimum distribution requirement for REITs was 95% between 1981 and 1999.

  3. The financial statements of Dusit Thani Properties REIT can be found at http://www.dtcreit.com/en/investor-relations/publication-download/annual-report.

  4. For more details, see note 9 of the 2007 financial statements. The financial statements of Alexander Inc. can be found at https://www.sec.gov/Archives/edgar/data/3499/000000349908000003/alx_10k-022408.htm.

  5. Furthermore, REITs are required by law to invest at least 75% of total assets in real estate properties to remain qualified as a REIT.

  6. Albeit less directly related to our research question, this lack of corporate control has enthused another line of REIT literature that examines the impact of corporate governance on capital structure. For example, Ghosh et al. (2011) find that entrenched REIT CEOs use less leverage. Ooi (2000) shows REIT’s ownership structure has significant implication on financing choice. Similarly, Capozza and Seguin (2003) find that REITs prefer debt (equity) when there is low (high) insider ownership. Morri and Christanziani (2009) examine a European REIT sample but find no significant explanatory power of ownership structure on leverage.

  7. For comparison, Hardin et al. (2009) show that REITs’ cash holdings have a mean of 2.19% of total assets, and Hardin and Hill (2011) show that amounts drawn from line of credit are roughly 8% of net assets. Our operating lease intensity translate into a mean of about 2.08% of market value.

  8. We are cautious to not use operating lease expense on the income statement to measure Lease, because lease expense captures the operating expense for the current fiscal year, yet operating lease decision of the current fiscal year could represent rental commitments in the future years.

  9. In additional analysis, we also examine the leasing decision of REITs’ operational properties.

  10. Including operating lease for operational properties in our lease intensity analysis does not significantly change our findings.

  11. Scaling the present value of lease obligations by fixed claims will cause a mechanic negative relationship between operating lease intensity and leverage, because long-term debt, the primary component of fixed claims, is the numerator of leverage. Therefore, in the regressions, we calculate OPL using the market value deflator.

  12. Recent anecdotal evidence of WeWork also shows firms that operate with a much higher degree of risk tend to take on more risks with significantly more operating lease commitments (Trainer, 2019).

  13. Available from the authors upon request.

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Acknowledgements

A previous version of this paper was circulated under the title “REITs as Lessees.” We thank our discussants Mike Highfield and Eva Steiner, and participants at the 2018 ARES and 2019 AREUEA annual meetings for their helpful comments. The authors retain the responsibility for any remaining errors.

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Authors and Affiliations

  1. Department of Accounting and Information Science, University of Texas at El Paso, El Paso, TX, USA

    Elizabeth Devos

  2. Department of Economics and Finance, University of Texas at El Paso, El Paso, TX , USA

    Erik Devos

  3. Department of Finance and Business Law, University of Wisconsin, Whitewater, Whitewater, WI, USA

    He Li

  4. Desautels Faculty of Management, McGill University, Montreal, QC, Canada

    Desmond Tsang

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  1. Elizabeth Devos
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  2. Erik Devos
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Correspondence to He Li.

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Devos, E., Devos, E., Li, H. et al. Operating Lease as Alternative Financing for REITs: a Viable Strategy or a Sign of Trouble?. J Real Estate Finan Econ 65, 153–180 (2022). https://doi.org/10.1007/s11146-021-09820-w

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