THE EFFECT OF CAPITAL STRUCTURE ON THE PROFITABILITY OF LISTED REAL ESTATE INVESTMENT TRUSTS (REITS) IN THE UNITED KINGDOM FROM 2007 TO 2014 By TRAN VU DANG Supervised by Pamela Anderson A dissertatio[.]
Background of the study
In the past decade, there has been significant growth in global investment in the real estate sector, particularly in Real Estate Investment Trusts (REITs) A REIT is defined as a security that trades on major exchanges and invests directly in real estate, either through properties or mortgages Essentially, it serves as an investment vehicle that enables real estate investors to participate similarly to shareholders in mutual funds.
Real Estate Investment Trusts (REITs) are subject to varying legislation across countries, but they generally receive distinct tax treatment, offering shareholders high returns and serving as a highly liquid investment option in the real estate market Since their introduction in the United States and other nations in the 1960s, the UK has only recently adopted a similar regime.
2007 to introduce its REIT legislation (Park, 2009) The UK property industry has increased with this legislation (Alias & Soi, 2011)
The growing interest in the capital structure of real estate firms stems from their unique characteristics, which are considered "safe and low risk stocks with high underlying collateral value" (Westgaard et al., 2008) In the UK, real estate firms operate within a distinctive environment shaped by comprehensive legislation governing Real Estate Investment Trusts (REITs) According to Westgaard et al (2008), UK real estate firms that opt to become REITs can benefit from avoiding double taxation and enjoy lower tax rates on equity financing.
According to Feng, Ghosh, and Sirmans (2007), Real Estate Investment Trusts (REITs) can avoid corporate taxes by distributing over 90 percent of their profits as dividends, which eliminates two key benefits of debt financing Firstly, this results in the loss of tax deductibility for interest payments Additionally, Howe and Shilling (1988) suggest that without these tax advantages, REITs may face challenges in accessing debt markets, as other tax-paying firms retain the benefit of interest payment deductibility.
Investors who can handle higher interest rates than those offered by Real Estate Investment Trusts (REITs) will likely favor debt securities over REITs in the debt markets Additionally, the significant distribution of profits by REITs affects their attractiveness to investors seeking alternative investment opportunities.
Debt servicing plays a limited role in reducing agency costs associated with free cash flow, as the benefits of debt financing are often overshadowed by the costs of financial distress (Feng et al., 2007, p.85).
High dividend payouts in Real Estate Investment Trusts (REITs) reduce the retained earnings available for reinvestment, thereby constraining financing options to either debt or equity (Feng et al., 2007).
Morri and Cristanziani (2009) highlight that high dividend payouts hinder REITs' ability to maintain sufficient free cash flow for financing future positive NPV projects Consequently, REITs must rely on debt for investment financing, resulting in increased leverage ratios Additionally, Baum and Devaney (2008) note that a high gearing ratio can influence the volatility of net income for UK REITs Since net income is crucial for calculating return on assets and return on equity, it serves as a key indicator of REIT profitability.
UK (Tang & Jang, 2008) Therefore, it can be indicated that the high gearing ratio could affect the volatility of profitability of REITs in UK
The relationship between capital structure and profitability in Real Estate Investment Trusts (REITs) can be understood through theories such as trade-off theory and pecking-order theory (Anwar & Ali, 2014) According to trade-off theory, REITs typically maintain a low debt ratio because they do not incur corporate taxes, thereby missing out on the tax benefits associated with interest deductibility (Feng et al., 2007) Consequently, if REITs opt for a higher debt ratio, they risk facing financial distress costs that outweigh any potential advantages from tax deductions Thus, trade-off theory suggests that REITs are inclined to adopt a low debt ratio (Feng et al., 2007).
The pecking order theory argues that firms will finance through retained earnings as the first choice, debt as the second choice and new equity as the final option (Abor,
REITs are required to distribute 90% of their profits, which limits their ability to retain earnings and constrains their financing options to debt and equity Due to the complexities involved in valuing REITs, financing through debt or retained earnings is often favored over equity.
Despite the removal of tax deductibility for interest payments on debt, the pecking order theory suggests that firms, including REITs, may still prefer debt financing to avoid the potential devaluation of new equity caused by adverse selection and information asymmetry Consequently, this theory indicates that REITs are likely to maintain a high leverage ratio by opting for debt over issuing new equity.
Profitability in firms is often linked to internal cash flows and lower debt ratios (Feng et al., 2007) However, there may be a positive relationship between leverage and profitability for Real Estate Investment Trusts (REITs), as they are required to distribute a significant portion of their profits, resulting in lower cash reserves A high leverage ratio can enhance REIT profitability when interest rates are low and real estate returns are robust; yet, this relationship becomes uncertain as interest rates rise and profit margins shrink in declining markets (Park, 2009) Thus, the impact of capital structure on REIT profitability remains mixed.
Research on the relationship between capital structure and profitability primarily examines how profitability influences a company's capital structure, as seen in the works of Morri and Beretta (2008) and Chikolwa (2011) However, there are notable studies that investigate the reverse effect, analyzing how capital structure impacts the profitability of listed companies, including the findings of Abor (2005), Anwar and Ali (2014), Claudiu (2013), and Mehdi et al (2013), as well as Salawu's research.
Despite the existence of studies on capital structure's impact on profitability in various industries, there is a notable lack of research specifically focused on Real Estate Investment Trusts (REITs) in the United Kingdom The unique legislative framework governing UK REITs distinguishes them from other sectors, highlighting the necessity for targeted investigation into how capital structure influences their profitability This study aims to fill this gap by analyzing the relationship between capital structure and profitability within the UK REITs market.
Research aims and objectives
The objective of this study is to analyse the effect of capital structure on the profitability of listed Real Estate Investment Trusts (REITs) in United Kingdom from
Structure of the study
This study will consist of the following chapters
Chapter One is the introduction, which will present the background of the research and its objective
Chapter Two is the literature review, which will review the prior studies relating to profitability and capital structure of REITs in United Kingdom
Chapter Three is the research design and methodology, which will explain how the data is collected and the methodology is used to analyse the data
Chapter Four is data analysis and discussion, which will present the analysis and discussion of the results
Chapter Five is conclusions and recommendations, which will provide the main lessons learnt from this research and indications that need for further research
Introduction
This chapter will examine relevant literature to integrate into the research, aiming to fulfill the study's objectives.
This research aims to explore the impact of capital structure on the profitability of listed real estate investment trusts (REITs) in the United Kingdom The chapter will begin with an overview of the legislation governing the REITs industry in the UK, followed by a review of existing literature on the profitability of these trusts Subsequent sections will focus on prior studies related to capital structure, examining the relationship between capital structure indicators and the profitability of UK REITs Additionally, the chapter will address the role of size as a control variable in these analyses, culminating in a conclusion that synthesizes the findings.
The legislation of the Real Estate Investment Trusts (REITs) industry in United
The UK introduced regulations for real estate investment trusts (REITs) in January 2007, aiming to address the shortage of affordable rental housing This led many UK property firms to transition into REITs (Leone, 2011; Park, 2009) Despite being late to adopt REIT legislation compared to other countries, the UK quickly established itself as the largest real estate securities market in Europe and the fourth largest globally by market capitalization (Alias & Soi, 2011; Liow, 2010).
UK, they have to distribute more than 90 percent of its profits as dividends so the REITs in UK will not pay the corporate tax (Gaut, Featherstone, Heilpern, & John, 2006; Park,
2009) In addition, the REITs in UK are also required to satisfy the interest cover test which the interest cover ratio must be higher than 1.25 (Alias & Soi, 2011; Gaut et al.,
The interest cover ratio, defined as the profit divided by financing costs, plays a crucial role in assessing the financial health of UK REITs This metric aims to ensure that these real estate investment trusts maintain a manageable leverage ratio, preventing excessive financing costs that could diminish profitability.
REITs in the UK face restrictions on their leverage ratios due to the potential risks associated with high gearing While a high leverage ratio can enhance profitability in low-interest-rate environments with strong real estate returns, it poses uncertainties when interest rates rise and profit margins decline in weaker markets (Luck & Cant, 2008; Park, 2009).
According to Luck and Cant (2008), while UK REITs are not directly restricted in their borrowing, they face tax penalties if they violate the interest cover test, indirectly limiting their gearing ratio to a maximum of 80% (Alias & Soi, 2011; Gaut et al., 2006; Park, 2009) If a UK REIT fails to meet the interest cover ratio of 1.25 or exceeds the 80% leverage threshold, it will incur tax fines on the excess debt (Alias & Soi, 2011) Park (2009) highlights that these legislative limitations significantly contribute to the decline in the market value of UK REITs, leading some to trade at discounts to their net asset value.
REITs are exempt from corporate tax when they distribute over 90% of their profits as dividends and meet the interest cover test However, such regulations can limit retained earnings and affect the debt ratio, potentially impacting the profitability of REITs.
Profitability of Real Estate Investment Trusts (REITs) in United Kingdom
Previous studies about the indicators of profitability of Real Estate
Different perspectives exist regarding the profitability indicators of Real Estate Investment Trusts (REITs) According to Tang and Jang (2008), return on assets (ROA) and return on equity (ROE) are effective measures of REIT profitability Similarly, Ho, Rengarajan, and Lum (2013) support the use of ROA and ROE as key indicators for assessing the profitability of REITs.
Morri and Beretta (2008) and Morri and Cristanziani (2009) both utilize return on assets (ROA) to assess profitability, calculated by dividing earnings before interest and taxes (EBIT) by total assets This approach is particularly applied in the context of European Real Estate Investment Trusts (REITs), as highlighted by their findings.
7 also use the ratio of earnings before interest and taxes (EBIT) divided by total asset to measure the profitability of REITs
Zarebski and Dimovski (2012) measure the profitability of Australian REITs using return on equity, defined as net income after interest and tax divided by total equity Similarly, Ambrose, Highfield, and Linneman (2005) utilize return on equity to assess the profitability of U.S REITs, calculated as the ratio of net income to total equity Additionally, Salim and Yadav (2012) apply the same metric, return on equity, to evaluate the profitability of listed firms in Malaysia, also calculated as net income divided by total equity.
Some studies utilize Return on Assets (ROA) and Return on Equity (ROE) as key indicators of Real Estate Investment Trusts (REITs) profitability, while others incorporate both metrics ROA and ROE are essential measures for assessing the financial performance of REITs.
Explanation of the choice return on asset (ROA) and Return on Equity (ROE) as indicators of profitability of Real Estate Investment Trusts (REITs) in
(ROE) as indicators of profitability of Real Estate Investment Trusts (REITs) in United Kingdom
Return on assets (ROA) measures a firm's profitability in relation to its total assets, encompassing both equity and liabilities, while return on equity (ROE) focuses on profitability relative to equity According to Tang and Jang (2008), companies with higher leverage ratios tend to exhibit greater profitability when assessed using ROE This suggests that ROE may serve as a more effective indicator for analyzing the impact of capital structure on firm profitability.
Return on equity (ROE) is a crucial measure of profitability for Real Estate Investment Trusts (REITs) in the United Kingdom, as it reflects the profits allocated to shareholders who prioritize value maximization (2012) Given that REITs are required to distribute a significant portion of their profits to shareholders, the focus on ROE becomes even more relevant (Feng et al., 2007).
Tang and Jang (2008, p.618) use return on asset as the indicator for profitability because their study wants to measure the profitability of hotel REITs and ROA can reflect
“management’s effectiveness in utilizing all available assets to create profit” This research will investigate the whole REITs sector in UK, which includes the hotel REITs
This article examines the impact of capital structure on the profitability of Real Estate Investment Trusts (REITs) in the UK, utilizing Return on Assets (ROA) and Return on Equity (ROE) as key indicators of profitability.
Capital structure of Real Estate Investment Trusts (REITs) in United Kingdom
Theories on capital structure of Real Estate Investment Trusts (REITs)
The capital structure of a company refers to its use of debt and equity to finance its operations (Abor, 2005) According to Bers and Springer (1997), the level of gearing significantly impacts the profitability of Real Estate Investment Trusts (REITs) Two primary theories on capital structure, the trade-off theory and the pecking order theory, suggest that both high and low levels of gearing can be beneficial (Anwar & Ali, 2014; Morri & Beretta, 2008).
The trade-off theory suggests that Real Estate Investment Trusts (REITs) typically maintain a low debt ratio due to their exemption from corporate taxes, which eliminates the tax benefits associated with interest deductibility (Feng et al., 2007) Consequently, opting for a higher debt ratio could lead REITs to incur financial distress costs that outweigh any potential advantages from interest tax deductions Thus, according to this theory, REITs are inclined to keep their debt levels low (Feng et al., 2007).
Ertugrul and Giambona (2011) suggest that Real Estate Investment Trusts (REITs) typically maintain a low debt ratio due to the constraints imposed by legislation, which diminishes the effectiveness of pecking order and trade-off theories Specifically, REITs are required to distribute the majority of their profits as dividends and are exempt from corporate taxes This structure leads to the conclusion that REITs could potentially operate with a zero leverage ratio, as financial distress incurs deadweight costs that further support this low leverage stance.
In 2011, research indicated that the average leverage ratio of Real Estate Investment Trusts (REITs) stands at approximately 45%, which is double that of manufacturing companies (Ertugrul & Giambona, 2011; Faulkender & Petersen, 2006) Morri and Beretta (2008) further assert that there is a lack of empirical evidence in the REIT sector to validate the trade-off theory, suggesting no clear link between leverage and profitability They note that according to the trade-off theory, increased gearing heightens the risk of bankruptcy while allowing companies to deduct interest expenses from taxable income, making it advantageous for highly profitable firms to leverage more.
9 on large amounts of debt” However, REITs do not have to pay tax so debt will not force the high-quality companies to have higher gearing ratio (Morri & Beretta, 2008)
Studies on the trade-off theory's application to REITs reveal varying perspectives Ertugrul and Giambona (2011) and Feng et al (2007) suggest that REITs typically maintain a low debt ratio Conversely, Ertugrul and Giambona (2011) along with Morri and Beretta (2008) argue that the trade-off theory has limitations in analyzing REIT capital structures due to a lack of empirical evidence in this sector.
The pecking order theory argues that firms will finance through retained earnings as the first choice, debt as the second choice and new equity as the final option (Abor,
2005) This also means that when the retained earnings are not enough, the firms will prefer debt to equity (Mehdi et al., 2013)
REITs, which distribute 90% of their profits, face limitations in their financing options, primarily relying on debt and equity (Feng et al., 2007) The complex valuation of REITs suggests a preference for financing through debt or retained earnings rather than equity (Feng et al., 2007) Despite the removal of tax deductibility for interest payments, pecking order theory posits that firms may still opt for debt financing to avoid potential value discounts on new equity caused by adverse selection and information asymmetry (Feng et al., 2007) Consequently, this theory indicates that REITs are likely to favor debt, resulting in a high leverage ratio (Feng et al., 2007) Furthermore, according to Myers (1984, cited in Ooi, 1999b, p 469), increased debt levels can lead to decreased profitability, suggesting that REITs may experience lower profitability as their leverage ratio rises Overall, the pecking order theory implies that REITs will maintain high leverage, ultimately impacting their profitability negatively.
Ertugrul and Giambona (2011) contend that the pecking order theory has limitations when it comes to analyzing the capital structure of Real Estate Investment Trusts (REITs), similar to the trade-off theory They emphasize that a key assumption of this theory is that external investors possess less insight into a company's investment opportunities compared to its management.
According to Ertugrul and Giambona (2011), managers are likely to finance new projects with equity when they perceive it to be overvalued However, Real Estate Investment Trusts (REITs) experience reduced adverse selection due to their obligation to distribute over 90% of profits as dividends, which limits their access to internal funding Consequently, this allows REITs to have less constrained external equity financing Ultimately, the pecking order theory falls short in explaining the high gearing ratios of REITs, as their requirement to pay out most earnings as dividends leaves them with minimal retained earnings.
Various studies present contrasting perspectives on the pecking order theory in relation to Real Estate Investment Trusts (REITs) Feng et al (2007) suggest that this theory anticipates a high leverage ratio for REITs, leading to decreased profitability In contrast, Ertugrul and Giambona (2011) contend that the pecking order theory has limitations when analyzing the capital structure of REITs, similar to the trade-off theory.
Explanation of the choice of short-term debt ratio (STDR) and long-term
This study utilizes short-term debt ratio (STDR), long-term debt ratio (LTDR), and total debt ratio (TDR) as key indicators of the capital structure of Real Estate Investment Trusts (REITs) in the United Kingdom, as varying characteristics among REITs lead to differing levels of short-term, long-term, and total debt.
In the UK property sector, companies typically rely on two main sources of debt: short-term and long-term debt (Ooi, 1999a) Larger listed firms are more likely to utilize long-term debt, whereas smaller firms tend to favor short-term debt (Ooi, 1999a).
Ertugrul and Giambona (2011) identify two primary types of REIT capital structures within the retail property sector Safer REITs typically opt for a capital structure that includes a higher proportion of long-term debt, resulting in more stable cash flows, albeit with limited opportunities to capitalize on favorable market conditions (Giambona et al., 2008, cited in Ertugrul & Giambona, 2011, p 507) In contrast, aggressive REITs prefer a capital structure with increased short-term debt, leading to more volatile cash flows.
Aggressive real estate investment trusts (REITs) may benefit from favorable future market conditions, despite the need for more frequent renegotiation of rental contracts (Ertugrul & Giambona, 2011).
Aggressive Real Estate Investment Trusts (REITs) typically exhibit higher leverage compared to their safer counterparts, indicating a tendency to utilize varying debt structures Some REITs favor short-term debt, while others lean towards long-term debt Consequently, it is essential to analyze the impact of short-term and long-term debt on the profitability of REITs in the United Kingdom.
This study employs short-term debt ratio (STDR), long-term debt ratio (LTDR), and total debt ratio (TDR) as indicators of capital structure in UK Real Estate Investment Trusts (REITs) due to a gap in existing literature regarding the impact of capital structure on REIT profitability Most prior research has primarily used TDR as the main indicator for capital structure, focusing on profitability as a determinant (Erol & Tirtiroglu, 2011; Ghosh et al., 2011; Morri & Cristanziani, 2009) Conversely, studies examining the effect of capital structure on profitability have utilized TDR, STDR, and LTDR for a broader sample of listed companies across various industries, neglecting REITs specifically (Abor, 2005; Gatsi, 2012; Salim & Yadav, 2012) Ooi (1999a) highlights significant changes in the debt composition of firms in the property sector over the years Giambona et al (2008) suggest that REITs with a high TDR tend to have a higher LTDR, while those with a low TDR exhibit a higher STDR This indicates that both LTDR and STDR may influence REIT profitability, necessitating an analysis of these ratios to fully understand their effect on the capital structure and profitability of UK REITs.
This study aims to address the gap in existing literature by analyzing the impact of capital structure on the profitability of Real Estate Investment Trusts (REITs).
This article examines the impact of total debt ratio, short-term debt ratio, and long-term debt ratio on the profitability of Real Estate Investment Trusts (REITs) in the UK It reviews existing literature on the relationship between total debt and REIT profitability, as well as studies on the effects of these debt ratios on the profitability of all listed companies, since REITs are categorized as listed entities (Abor, 2005; Gatsi, 2012; Salim & Yadav, 2012).
Previous studies on the relationship between short-term debt ratio (STDR) and
Previous studies about the indicators of short-term debt ratio (STDR)
Short-term debts are debts that have the maturity less than one year (Fosberg,
Morri and Beretta (2008) and Capozza and Seguin (2001) both define the short-term debt ratio of Real Estate Investment Trusts (REITs) by calculating the ratio of short-term debt to total assets This consistent methodology highlights the importance of assessing short-term debt in relation to overall asset value in the REIT sector.
In 2014, a study analyzed the short-term debt ratio of Real Estate Investment Trusts (REITs) in three Asian countries—Hong Kong, Japan, and Singapore—by calculating the ratio of short-term debt to total assets.
Previous studies about the relationship between short-term debt ratio (STDR) on the return on asset (ROA)
(STDR) on the return on asset (ROA)
Numerous studies have identified a negative correlation between the short-term debt ratio and the return on assets (ROA) of Real Estate Investment Trusts (REITs), suggesting that REITs utilizing short-term debt tend to experience lower profitability This relationship can be attributed to the fact that REITs are exempt from paying taxes, which diminishes the advantages of tax shields associated with debt financing Consequently, the interest payments incurred from short-term debt represent an additional cost, leading to decreased profitability as measured by ROA.
Research by Chikolwa (2011) reveals a negative correlation between short-term debt and return on assets for listed REITs in Australia from 2003 to 2008 Likewise, Morri and Beretta (2008) identify a similar negative relationship for US REITs between 2002 and 2005 These findings highlight a consistent trend of adverse effects of short-term debt on the return on assets of REITs across different regions and time periods.
Thirteen countries share similar indicators for short-term debt ratio and return on assets, highlighting a common financial framework Notably, the REITs market in Australia is comparable in size to that of the United States, as noted by Newell & Peng (2009).
Research indicates a negative correlation between long-term debt ratios and the return on assets (ROA) of listed companies, including REITs Salim and Yadav (2012) identified a significant negative relationship between short-term debt ratios and ROA in Malaysia's property sector from 1995 to 2011 Similarly, Ebaid (2009) demonstrated that short-term debt ratios adversely impact ROA in Egyptian listed companies from 1997 to 2005 Furthermore, Olokoyo (2013) found a negative relationship between short-term debt ratios and ROA in Nigerian listed companies from 2003 to 2007.
Research indicates that studies concentrating solely on Real Estate Investment Trusts (REITs) and those incorporating REITs in their samples may yield similar findings This similarity arises from the consistent use of metrics for short-term debt ratios and return on assets, which also apply to the publicly listed companies that include REITs (Chikolwa, 2011; Ebaid, 2009; Morri & Beretta, 2008; Olokoyo, 2013; Salim & Yadav, 2012).
Previous studies about the relationship between short-term debt ratio (STDR) and return on equity (ROE)
(STDR) and return on equity (ROE)
Salim and Yadav (2012) identify a negative correlation between the short-term debt ratio and return on equity among listed firms in Malaysia's property sector, including REITs, from 1995 to 2011 Their findings suggest that REITs opting for short-term debt experience decreased profitability, as indicated by lower return on equity This negative relationship can be attributed to the fact that REITs, which are tax-exempt, forfeit the advantages of a tax shield associated with debt (Feng et al., 2007) Consequently, the interest payments incurred from short-term debt increase overall costs, further diminishing profitability as measured by return on equity (Claudiu, 2013).
Numerous studies indicate a negative correlation between the short-term debt ratio and the return on equity (ROE) of publicly listed companies, including Real Estate Investment Trusts (REITs) Specifically, Ebaid (2009) demonstrates that in Egypt, the short-term debt ratio positively influences ROE for listed companies, including REITs, during the period from 1997 to 2005 Conversely, Olokoyo (2013) identifies a negative relationship between these financial metrics.
A study examining the relationship between short-term debt ratio and return on equity for listed companies in Nigeria from 2003 to 2007 found different results compared to Abor (2005), which reported a significantly positive correlation in Ghana This discrepancy may be attributed to the potentially lower interest rates on short-term debt in Ghana, making it more cost-effective and allowing companies to achieve higher returns on equity by utilizing more short-term debt.
Long term debt ratio (LTDR)
Previous studies about the indicators of long-term debt ratio (LTDR) of
Long-term debts are debts that will be paid off more than one year (Fosberg,
Morri and Beretta (2008) and Lim and Sing (2014) both define the long-term debt ratio of Real Estate Investment Trusts (REITs) by calculating the ratio of long-term debt to total assets This consistent approach highlights the importance of understanding REITs' financial leverage through their long-term debt metrics.
The long-term debt ratio of Real Estate Investment Trusts (REITs) is commonly measured by the ratio of long-term debt to total assets, as highlighted by Capozza and Seguin (2001) and further supported by the findings of 2011.
Previous studies about the relationship between long-term debt ratio (LTDR) and return on asset (ROA)
Morri and Beretta (2008) also find out that there is a negative and significant relationship between long-term debt and return on asset of REITs in US from 2002 to
Research from 2005 indicates that Real Estate Investment Trusts (REITs) face a decline in profitability, as measured by return on assets, when they finance operations with long-term debt This negative correlation arises because REITs are exempt from taxes, thus missing out on the tax shield benefits typically associated with long-term debt (Feng et al., 2007) Consequently, the associated interest payments become a cost that diminishes profitability As a result, increased reliance on long-term debt correlates with lower return on assets due to the higher costs incurred (Claudiu, 2013).
Erol and Tirtiroglu (2011) discovered a significant correlation between the long-term debt ratio and return on assets in Turkish REITs during the 1998 to 2007 period, with return on assets calculated as net income before interest and taxes divided by total assets.
The relationship between long-term debt ratio and profitability in Turkish REITs is found to be negative but insignificant, suggesting that different legislative frameworks may influence these results Unlike their U.S counterparts, Turkish REITs are exempt from corporate tax but are not mandated to distribute dividends, which could impact their financial performance (Erol & Tirtiroglu, 2011; Morri & Beretta, 2008).
Numerous studies have highlighted the negative relationship between long-term debt ratio and return on assets (ROA) among listed companies, including REITs Liow (2010) asserts that in the real estate sector, a higher long-term debt to total asset ratio adversely impacts the profitability of 24 real estate firms across Asia, Europe, and North America from 2000 to 2006 Similarly, Salim and Yadav (2012) observed a negative correlation between long-term debt ratio and ROA in Malaysia's property sector from 1995 to 2011 Ebaid (2009) demonstrated that the long-term debt ratio negatively influences the ROA of listed companies in Egypt, including REITs, between 1997 and 2005 Furthermore, Olokoyo (2013) identified a similar negative relationship in Nigeria's listed companies from 2003 to 2007 Overall, Booth et al (2001) confirm that a higher long-term debt ratio is linked to lower profitability, as indicated by ROA in listed companies.
Studies focusing exclusively on REITs (Erol & Tirtiroglu, 2011; Morri & Beretta, 2008) show similar findings to those that include REITs in their sample (Ebaid, 2009; Liow, 2010; Salim & Yadav, 2012), likely due to the consistent use of long-term debt ratio and return on asset metrics Furthermore, the inclusion of REITs within the broader real estate industry and the similarity in investigation periods contribute to these comparable results.
Previous studies about the relationship between long-term debt ratio (LTDR) and return on equity (ROE)
Salim and Yadav (2012) discovered a significant negative correlation between the long-term debt ratio and return on equity among listed firms in Malaysia's property sector, including REITs, from 1995 to 2011 This finding suggests that financing through long-term debt negatively impacts the profitability of REITs, as reflected in their return on equity.
The relationship between long-term debt and return on assets in Real Estate Investment Trusts (REITs) can be understood through the fact that REITs are exempt from taxes, which leads to the loss of the tax shield benefits associated with long-term debt (Feng et al., 2007) Consequently, interest payments become a cost of utilizing long-term debt, resulting in reduced profitability as measured by return on equity, since increased long-term debt incurs higher associated costs (Claudiu, 2013).
Studies indicate a negative relationship between long-term debt ratio and return on equity for listed companies, including REITs Ebaid (2009) found that in Egypt, from 1997 to 2005, a higher long-term debt ratio adversely impacted the return on equity of listed companies Similarly, Olokoyo (2013) observed this negative correlation in Nigeria from 2003 to 2007 Additionally, Abor (2005) reported a significant negative relationship between return on equity and long-term debt ratio among listed companies in Ghana.
Total debt ratio (TDR)
Previous studies about the indicators of total debt ratio (TDR)
Total debt, defined as the aggregate of short-term and long-term debt, is commonly assessed in real estate investment trusts (REITs) through the total debt ratio, which is calculated by dividing total debt by total assets This approach has been consistently adopted by several researchers, including Lim and Sing (2014), Morri and Cristanziani (2009), Huang, Liano, and Pan (2009), and Capozza and Seguin (2001), highlighting its significance in evaluating the financial structure of REITs.
Ho, Rengarajan, and Lum (2013) utilize the debt-to-equity ratio to assess the total debt ratio of REITs in Singapore, focusing specifically on those that develop green buildings This approach differs from other studies that examine a broader range of REITs In contrast, this study analyzes the impact of capital structure on the profitability of various types of REITs in the United Kingdom, employing the total debt ratio as a key indicator of capital structure.
Previous studies about the relationship between total debt ratio (TDR) and
Numerous studies, including those by Erol & Tirtiroglu (2011), Ghosh et al (2011), and Morri & Cristanziani (2009), have consistently demonstrated a negative correlation between the total debt ratio and the return on assets (ROA) in Real Estate Investment Trusts (REITs), indicating that higher debt levels can adversely affect profitability.
2008) These findings from previous studies indicate that when REITs choose to use debt, the profitability of REITs measured by return on asset will decrease
Research indicates a significant negative relationship between total debt ratio and profitability in Real Estate Investment Trusts (REITs) Erol and Tirtiroglu (2011) found that in Turkish REITs, profitability, measured by net income before interest and taxes over total assets, declines as total debt increases Similarly, Ghosh et al (2011) analyzed 136 equity REITs from 1997 to 2006 and reported a negative correlation between total debt ratio and profitability, assessed through return on assets (ROA) Furthermore, Morri and Cristanziani (2009) observed a comparable negative relationship in European REITs from 2002 to 2006, while Morri and Beretta (2008) confirmed this trend in US REITs, underscoring the adverse impact of high debt levels on asset returns across different regions.
Between 2002 and 2005, studies consistently found a negative relationship between total debt and return on assets, likely due to the similar calculation methods for total debt ratios and asset returns, as well as comparable REIT legislation across countries This relationship can be attributed to the fact that REITs, being tax-exempt, forfeit the tax shield benefits typically gained from debt usage, leading to increased interest payments as a cost of debt Consequently, higher levels of debt are associated with reduced profitability, as indicated by lower return on assets, due to the additional costs incurred from increased debt.
Ho et al (2013) discovered a significant positive relationship between the total debt ratio, defined as the ratio of debt to equity, and the Return on Assets (ROA) of Real Estate Investment Trusts (REITs) in Singapore This finding contrasts with earlier studies by Erol & Tirtiroglu (2011), Ghosh et al (2011), Morri & Cristanziani (2009), and Chikolwa (2011), which reported different results The discrepancy may stem from Ho et al (2013) employing a distinct measure for the total debt ratio, specifically total debt divided by total equity, and focusing on a specific context within the REIT sector.
Eighteen types of Real Estate Investment Trusts (REITs) primarily concentrate on the development of green buildings, while other research studies, including those by Erol & Tirtiroglu (2011), Ghosh et al (2011), Morri & Cristanziani (2009), and Chikolwa (2011), explore various categories of REITs.
Several studies have explored the relationship between total debt ratio and return on assets (ROA) in listed companies, including REITs Salim and Yadav (2012) identified a significant negative correlation between total debt ratio and ROA in Malaysia's property sector from 1995 to 2011 Similarly, Booth et al (2001) reported a negative relationship, indicating that higher total debt ratios correlate with lower profitability in listed companies Ebaid (2009) further confirmed that total debt ratios negatively impact the ROA of listed companies in Egypt, reinforcing these findings across different markets.
1997 to 2005 Olokoyo (2013) finds that there is a negative relationship between total debt ratio and return on asset of listed companies in Nigeria from 2003 to 2007 Salawu
(2009) finds that there is a negative relationship between total debt ratio and return on asset of listed companies in Nigeria from 1990 to 2004
This research indicates a negative correlation between return on assets and total debt ratios, observed not only in the REIT sector but across various industries The consistency in findings from studies that exclusively examine REITs and those that incorporate them suggests a common methodology, highlighting the interconnectedness of the real estate sector with all listed companies.
This study examines how capital structure impacts the profitability of publicly listed Real Estate Investment Trusts (REITs) in the UK Given that the UK shares similar REIT legislation with other European countries, the findings are anticipated to align with the literature review by Morri and Cristanziani (2009), which suggests a negative correlation between total debt ratio and return on assets, indicating that higher debt levels may adversely affect the profitability of UK REITs.
Previous studies about the relationship between total debt ratio (TDR) and
Research indicates a significant negative correlation between total debt ratio and return on equity for listed firms in Malaysia's property sector, including REITs, during the period from 1995 to 2011 (Salim & Yadav, 2012) This suggests that higher levels of debt may adversely affect the profitability of REITs in this sector.
Real Estate Investment Trusts (REITs) experience lower profitability, as indicated by return on equity, when financing operations through debt This negative correlation arises because REITs are not subject to taxes and thus miss out on the tax shield benefits typically associated with debt financing (Feng et al., 2007) Consequently, the interest payments incurred represent a cost of debt, leading to decreased profitability, as higher debt levels result in increased associated costs (Claudiu, 2013).
Ho et al (2013) discovered a significant positive relationship between the total debt ratio—defined as total debt divided by total equity—and the return on equity (ROE) for REITs in Singapore This contrasts with Salim and Yadav (2012), who measured total debt as a ratio of total assets Additionally, Ho et al focused specifically on REITs that develop green buildings, while Salim and Yadav examined a broader range of listed REITs across the property sector.
Studies have shown varying relationships between total debt ratio and return on assets (ROA) in listed companies, including REITs Olokoyo (2013) identifies a negative correlation between total debt ratio and return on equity (ROE) for Nigerian companies from 2003 to 2007, while Abor (2005) presents evidence of a positive relationship between total debt ratio and ROE in Ghanaian companies from 1998 to 2002.
A study from 2009 indicates that the total debt ratio positively influences the return on equity for listed companies in Egypt, including REITs, from 1997 to 2005 This finding contrasts with Salim and Yadav's (2012) results on property companies but aligns with Ho et al.'s (2013) findings on REITs.
Size as control variable
Explanation of choosing size as control variable
In our study, we include size as a variable to account for the differences among various UK REITs, as it is considered a key factor influencing their strategic policies and profitability (Morri & Beretta, 2008) Additionally, research by Ambrose and Linneman (2001) suggests a positive correlation between firm size and performance.
Previous studies about the indicator of size of Real Estate Investment
2.8.2 Previous studies about the indicator of size of Real Estate Investment Trusts (REITs)
Various studies have consistently utilized the natural logarithm of total assets to measure firm size across different contexts Morri and Beretta (2008) and Ghosh et al (2011) both apply this metric specifically to Real Estate Investment Trusts (REITs) Similarly, Ebaid (2009) employs the natural logarithm of total assets to assess the size of listed firms in Egypt from 1997 to 2005 Furthermore, Salim and Yadav (2012) adopt the same measurement for listed firms in the property sector, including REITs, in Malaysia during the period from 1995 to 2011.
Previous studies about the relationship of size and return on asset (ROA)
The relationship between size and return on assets, a key profitability indicator for Real Estate Investment Trusts (REITs), is a subject of debate According to Morri and Beretta (2008), there is a negative correlation, suggesting that smaller REITs focus more on maximizing financial returns rather than pursuing economies of scale.
Several studies highlight a negative correlation between company size and return on assets (ROA), particularly among listed firms, including Real Estate Investment Trusts (REITs) Booth et al (2001) demonstrate this negative relationship as a profitability indicator across various countries, a finding echoed by Morri and Beretta (2008) The inclusion of REITs in Booth et al.'s sample may contribute to this trend, given the similarities in REIT legislation across jurisdictions.
Salim and Yadav (2012) discovered a positive correlation between firm size and return on assets, indicating profitability among listed property sector firms, including REITs, in Malaysia from 1995 to 2011 This finding contrasts with Morri and Beretta's (2008) study, which identified a negative relationship through correlation analysis.
Salim and Yadav (2012) utilize a regression model with return on assets as the dependent variable and size as a control variable Meanwhile, Morri and Beretta (2008) focus on equity REITs in their analysis, contrasting with Salim and Yadav's broader examination of various types of REITs.
Previous studies about the relationship between size and return on equity (ROE)
Ambrose et al (2005) indicate that there is a positive and significant relationship between return on equity as the indicator of the profitability of REITs and size of REITs
Research indicates that larger Real Estate Investment Trusts (REITs) tend to have lower general and administrative fixed costs, leading to increased profit margins (Ambrose et al., 2005, cited in Morri & Beretta, 2008) Additionally, Salim and Yadav (2012) found a significant positive correlation between the size of firms in the property sector, including REITs, and their return on equity in Malaysia from 1995 to 2011 The similarity in findings may be attributed to the use of comparable formulas for calculating return on equity and firm size in both studies.
Conclusion
This chapter reviews the impact of capital structure on the profitability of listed Real Estate Investment Trusts (REITs) in the United Kingdom It identifies return on assets and return on equity as key indicators of profitability, while long-term debt ratio, short-term debt ratio, and total debt ratio serve as measures of capital structure The relationship between these capital structure indicators and profitability is debated among scholars Additionally, the study will incorporate the size variable to account for its influence on profitability The following chapter will outline the research design and methodology.
CHAPTER THREE: RESEARCH DESIGN AND
Introduction
This chapter outlines the research design and methodology essential for collecting and analyzing data to address the research objectives (Sekaran & Bougie, 2010) It begins by detailing the data collection process and the methodology employed to achieve the research goals Following this, the chapter presents the research objectives and questions, followed by the research approach It then discusses the sample selection process and the methods used for data collection Additionally, the chapter explains the data analysis techniques and concludes with the development of hypotheses, summarizing the key elements of the research methodology.
Research objectives and questions
The objective of this research is to analyse the effect of capital structure on the profitability of listed Real Estate Investment Trusts (REITs) in United Kingdom since
2007 With this objective, this research has only one main following question:
1 What is the effect of capital structure on the profitability of listed Real Estate Investment Trusts (REITs) in United Kingdom from 2007 to 2014?
Research approach
According to Saunders, Lewis, and Thornhill (2009), research approaches can be categorized as either deductive or inductive The deductive approach involves developing a theoretical framework before collecting data to test the research question, while the inductive approach entails gathering data first and formulating theories afterward This study adopts the deductive approach, as it has established a theoretical framework from the literature to analyze the impact of capital structure on the profitability of REITs in the United Kingdom Consequently, this chapter will focus on data collection and methodology development to address the research question.
Sample selection
This study will analyze the impact of capital structure on the profitability of listed Real Estate Investment Trusts (REITs) in the United Kingdom, using data from the Osiris database provided by the University of Huddersfield The research will focus on the period from 2007 to 2014, as the law for REITs in the UK was introduced in January 2007, leading to the conversion of some property organizations into REITs and the establishment of new ones that year (Leone, 2011) The most recent data available for UK REITs in Osiris extends to 2014.
Sample construction starts by identifying all REITs listed in UK from 2007 to
In 2014, this study will analyze accounts from that year, despite the varying publication periods for each UK REIT, which can occur in March, June, August, September, and December According to the Osiris database, there are currently 40 listed REITs in the United Kingdom; however, INVESCO PROPERTY INCOME TRUST LIMITED has been suspended from listing since July 28, 2014, leaving a total of 39 active REITs from 2007 onward.
In our study, we have excluded INVESCO PROPERTY INCOME TRUST LIMITED, TALIESIN PROPERTY FUND LIMITED, and GLOBALWORTH REAL ESTATE INVESTMENTS LIMITED While TALIESIN and GLOBALWORTH are listed in the UK, their investments are focused in Germany and Romania, making them irrelevant to our research scope.
After excluding REITs with incomplete data, our research focuses on 28 suitable REITs (see Appendix 1) Each REIT has a different timeline for achieving REIT status, so we will only consider those that became REITs from 2007 onwards and have comprehensive data from 2007 to 2014 (see Appendix 2) Ultimately, the final sample comprises 120 observations from 15 listed REITs that maintained their REIT status throughout the entire period (see Appendix 3).
Data collection methods
There are two different kinds of data, which are primary and secondary data (Sekaran & Bougie, 2010) Primary source refer to “information obtained first-hand by
24 the researcher on the variables of interest for the specific purpose of the study” (Sekaran
Secondary data refers to information gathered from existing sources, which can be accessed online or through published materials (Sekaran & Bougie, 2010, p 184) This type of data is generally more cost-effective and less time-consuming to obtain compared to primary data (Sekaran & Bougie, 2010, p 180).
This research will utilize secondary data, as all Real Estate Investment Trusts (REITs) are publicly listed companies Consequently, data can be easily accessed from their annual reports, which are freely available online in the UK, fulfilling the requirements to address the research question.
Data analysis
Definition and measurement of variables
Based on the research on of the study of Tang and Jang (2008) and the study of
Ho et al (2013), both return on asset (ROA) and return on equity (ROE) will be chosen as the indicators of profitability of REITs in the United Kingdom
Return on asset is calculated as the ratio of earnings before interest and tax (EBIT) divided by total asset like the studies of Morri and Beretta (2008), Morri and Cristanziani
Return on equity (ROE) is determined by dividing net income, which is the profit remaining after interest and taxes, by total equity, as demonstrated in the research conducted by Ambrose et al (2005) and Zarebski and Dimovski (2012).
According to the studies by Abor (2005) and Ooi (1999a), the capital structure of Real Estate Investment Trusts (REITs) in the United Kingdom will be assessed using three key indicators: short-term debt ratio (STDR), long-term debt ratio (LTDR), and total debt ratio (TDR).
The short-term debt ratio (STDR) is determined by dividing short-term debt by total assets, as demonstrated in studies by Capozza and Seguin (2001), Morri and Beretta (2008), and Lim and Sing (2014).
The long-term debt ratio (LTDR) is determined by dividing long-term debt by total assets, as demonstrated in studies by Capozza and Seguin (2001), Harrison et al (2011), Lim and Sing (2014), and Morri and Beretta (2008).
The Total Debt Ratio (TDR) is determined by dividing total debt by total assets, as demonstrated in studies by Capozza and Seguin (2001), Huang et al (2009), Lim and Sing (2014), and Morri and Cristanziani (2009) Total debt encompasses both short-term and long-term debt.
Incorporating size into the regression model is essential for controlling its influence on profitability (Ebaid, 2009) The size of Real Estate Investment Trusts (REITs) is determined by taking the logarithm of total assets, as demonstrated in the research conducted by Ghosh et al (2011) and Morri and Beretta (2008).
Descriptive statistics
Descriptive statistics are essential for identifying the central tendency and dispersion of each variable in the study (Saunders et al., 2009) The analysis will focus on the mean and median to assess the tendency of each variable (Saunders et al., 2009; Sekaran & Bougie, 2010) Additionally, the minimum and maximum values, along with the standard deviation of each variable, will be examined to evaluate their dispersion (Saunders et al., 2009; Sekaran & Bougie, 2010).
To ensure that the sample subjects accurately represent the research properties and are not drawn from extremes, the normal distribution of each variable will be examined (Sekaran & Bougie, 2010, p.266) A sample that closely mirrors the population enhances the generalizability of the study's results, indicating a broader applicability of the findings.
& Bougie, 2010) Saunders et al (2009) also indicates that distribution of the sample is more normal, it will be more robust
The normal distribution will be analyzed through the normality histogram of each variable, as outlined by Saunders et al (2009) This analysis will identify three types of distributions: right-skewed, left-skewed, and normal distributions.
Correlation coefficients
This study examines various variables and, following the analysis of descriptive statistics, will explore the relationships between these variables through correlation coefficients (Sekaran & Bougie, 2010) The correlation coefficient can range from -1 to 1, as noted by Saunders et al (2009).
The correlation test between variables does not determine the impact of independent variables on the dependent variable but rather identifies associations between them (Sekaran & Bougie, 2010) To examine the relationship between independent and dependent variables, the Pearson correlation coefficient will be utilized, as it is suitable for interval and ratio-scaled variables (Sekaran & Bougie).
Multicollinearity
This section will explore the issue of multicollinearity by analyzing the correlations among independent variables (Sekaran & Bougie, 2010) The presence of multicollinearity in the model complicates the assessment of individual independent variables' effects on dependent variables (Saunders et al.).
Research indicates that a correlation coefficient exceeding 0.7 among independent variables can result in multicollinearity issues (Kennedy, 2008; Sekaran & Bougie, 2010).
Table 1 reveals that the majority of correlations among independent variables are below 0.7, with the notable exception of the strong correlation of 0.786 between the long-term debt ratio and total debt ratio, which is significant at the 1% level This high correlation suggests potential multicollinearity issues if both ratios are included in the same regression model To mitigate this risk, each debt ratio will be analyzed separately in distinct models.
Multivariate linear regression
This study employs a regression model to investigate the impact of capital structure on the profitability of Real Estate Investment Trusts (REITs) in the United Kingdom, building on the framework established by Abor (2005) for listed companies in Ghana Unlike previous research, this analysis will utilize specific formulas tailored for REITs, focusing on two profitability indicators—Return on Assets (ROA) and Return on Equity (ROE)—and three capital structure indicators: Short-Term Debt Ratio (STDR), Long-Term Debt Ratio (LTDR), and Total Debt Ratio (TDR) Consequently, the study will present six distinct models to comprehensively assess these relationships.
- ROAi is the return on assets for the ith observation;
- ROEi is the return on equity for the ith observation;
- STDRi is the short term debt ratio for the ith observation;
- LTDRi is the long term debt ratio for the ith observation;
- TDRi is the total debt ratio for the ith observation;
- SIZEi is the size for the ith observation;
- β0 is the intercept coefficient of the model;
- β1, β2 are respectively coefficients for each independent variables of each regression model;
- ε is the error term of the model
The R-square of each regression model will be analyzed to determine the percentage of variability in the dependent variable explained by the independent variable (Saunders et al., 2009; Sekaran & Bougie, 2010) The significance of the model will be assessed using analysis of variance (ANOVA) (Saunders et al., 2009; Sekaran & Bougie, 2010) Subsequently, the coefficients of each independent variable will be evaluated to identify their positive or negative effects on the dependent variable, along with an analysis of the significance level to ascertain whether these effects are statistically significant or insignificant.
Hypothesis development
This research investigates the impact of capital structure, specifically short-term, long-term, and total debt ratios, on the profitability of Real Estate Investment Trusts (REITs) in the United Kingdom, measured through return on assets and return on equity The study aims to develop testable hypotheses that predict the expected outcomes based on the data analysis (Sekaran & Bougie, 2010) Consequently, six null hypotheses will be evaluated to determine the relationship between capital structure and REIT profitability.
Ho1: There is an effect of short-term debt ratio (STDR) on return on assets (ROA) of listed REITs in United Kingdom
Ho2: There is an effect of short-term debt ratio (STDR) on return on equity (ROE) of listed REITs in United Kingdom
Ho3: There is an effect of long-term debt ratio (LTDR) on return on assets (ROA) of listed REITs in United Kingdom
Ho4: There is an effect of long-term debt ratio (LTDR) on return on equity (ROE) of listed REITs in United Kingdom
Ho5: There is an effect of total debt ratio (TDR) on return on equity (ROA) of listed REITs in United Kingdom
Ho6: There is an effect of total debt ratio (TDR) on return on equity (ROE) of listed REITs in United Kingdom
Conclusion
This chapter outlines the research design and methodology for analyzing the impact of capital structure on the profitability of REITs in the United Kingdom, along with the data analysis approach The subsequent chapter will focus on the analysis and discussion of the findings.
CHAPTER FOUR: DATA ANALYSIS AND DISCUSSION