REIT capital structure, real risk-adjusted performance and the management of exposure to inflation

Research focus: We study the interrelationships between real risk-adjusted returns to REIT firm equity,
inflation hedging characteristics of investments in firm equity, and corporate capital structure choices, in
the presence of nominal and real assets and liabilities. We argue that, ceteris paribus, firms can choose
an optimal capital structure that maximises real risk-adjusted performance by implicitly hedging the real
value of firm equity against erosion through unexpected inflationary shocks.
Background: Investors are commonly thought to maximise expected utility over immediate consumption
and terminal wealth to fund future consumption. However, the ability to consume out of wealth is
determined by its real purchasing power. Moreover, investors are typically concerned about the
efficiency of an investment relative to the risk. Therefore, firm managers may be interested in
maximising real risk-adjusted returns to firm equity.
Method: We model the real risk-adjusted return to firm equity in the presence of real and nominal
assets and liabilities using the real Sharpe ratio. We argue that managers can maximise this measure
by holding nominal (fixed-rate) debt and nominal assets (proxied by the NAV of the firm) in a directly
proportional relationship. We show that adhering to this simple capital structure rule supports real risk-
adjusted performance because it is equivalent to hedging the real value of firm equity against
unexpected inflationary shocks.
Results: We test the empirical implications of our model using a large sample of US equity REITs over
the period 1989 to 2011. We find that managers appear to adhere to the positive linear relationship
between nominal assets and liabilities we propose. As we expect, firms that adhere to the proposed
relationship appear to outperform their peers in terms of their real risk-adjusted performance as
measured by the real Sharpe ratio. Consistent with the implication of our model, firms that adhere to the
proposed relationship between nominal assets and liabilities also appear to provide a stronger hedge
against inflation than their peers. We find additional support for the notion of nominal liabilities as a
buffer against inflationary shocks by providing evidence that firms hold more nominal liabilities in times
of higher inflation uncertainty.
Conclusion and practical implications: We provide evidence that firms can successfully maximise
real risk-adjusted performance by matching nominal assets and liabilities. The underlying mechanism
relies on implicitly hedging the real value of firm equity against unexpected inflationary shocks. Our
results imply that investors can extract information about inflation hedging capabilities from capital
structure data, promoting more efficient investment decisions. Leverage-constrained investors benefit
from the management of inflation risk at no extra cost to unconstrained investors. We view the findings
of this study largely in the context of the REIT capital structure and inflation hedging literature. We
provide insight into the question why tax-exempt REITs may hold more leverage than theory suggests.
REIT leverage choices may be a function of efforts to manage real risk-adjusted performance. We
further contribute to the debate about the inflation hedging characteristics of REITs as a securitised form
of real estate. We highlight the importance of cross-sectional variation in these characteristics and relate
them to firm-level differences in corporate capital structure choices.
Outline of this study: The next section provides the conceptual background for this study, followed by
an outline and derivation of our model of real risk-adjusted performance. We then develop empirically
testable implications of the model. We provide details on data and methodology underlying the empirical
analysis and subsequently discuss the main empirical findings alongside their practical implications.