Debt Capacity of Real Estate Collateral

Abstract

Real Estate Investment Trusts (REITs) pay no corporate taxes, yet surprisingly, their average leverage ratio is more than twice that of taxable firms (46% vs. 20%). We develop and test a model that helps explain this puzzle. The primary result of the model is that credit constrained firms' assets tangibility is positively related to their leverage. We test the relation on a large sample of COMPUSTAT firms because they invest in both real estate and other tangible assets. We find a significant positive relation between tangibility and leverage, which is strongest for real estate collateral (land & building). Furthermore, we find that the relation holds only for credit constrained firms, consistent with our theoretical prediction. The implication is that, compared to other assets like machinery, real estate can improve a firm's borrowing capacity, therefore, knowing the composition of a firm's tangible assets is important in understanding its leverage.

Keywords: land & building, machinery & equipment, leverage, credit constraints