Reference-Dependent Analysis of Capital Structure and REIT Performance

Abstract

Using prospect theory, we develop a theoretical framework to examine the relationship between leverage and Real Estate Investment Trust (REIT) returns by introducing the concept of reference point. We postulate that firms’ capital structure decisions are affected by a target leverage ratio (i.e., the reference point) as well as the observed leverage ratio. Firm-specific and time-varying target leverage determines a firm’s leverage position, which when combined with market conditions will put firms in either loss or gain domains, where firms behave differently. In general, the effect of leverage on returns is positive in the gain domain and negative in the loss domain. Two hypotheses are derived and tested by using US REITs data from 1993-2013. Our empirical evidence shows strong support for our theoretical model. Compared to the conventional approach where only observed leverage is used, our model is more flexible and realistic in revealing the underlying structure of the leverage-returns relationship. It is also a potential solution to reconcile conflicting findings in the literature.