Real Estate Investment Trusts (hereinafter, REIT) are investment companies which
capitalize real estate assets by offering company shares on the stock markets.
The recent economic upturn has led to a sharp increase in the constitution of REITs.
Nevertheless, real estate managers should weigh up the advantages of these securities
compared to other alternatives of financing real estate activity. Variables affecting REIT
performance that managers should analyse include market price and market capitalization
(compared to net asset value), expected liquidity, start-up costs, systematic risk, finance
costs and tax benefits, and also other aspects such as company control, transparency
requirements and regulatory limits.
REITs have become a competitive way to finance real estate activity, especially in the light
of the credit constraints that still affect the industry. This paper analyses the factors that
managers should take into account when considering whether to set up a REIT.Peer ReviewedPostprint (published version

García Cueto, Jose Ignacio

Roig Hernando, Jaume

Soriano Llobera, Juan Manuel

Real Estate Investment Trusts (hereinafter, REIT) are investment companies which

capitalize real estate assets by offering company shares on the stock markets.

The recent economic upturn has led to a sharp increase in the constitution of REITs.

Nevertheless, real estate managers should weigh up the advantages of these securities

compared to other alternatives of financing real estate activity. Variables affecting REIT

performance that managers should analyse include market price and market capitalization

(compared to net asset value), expected liquidity, start-up costs, systematic risk, finance

costs and tax benefits, and also other aspects such as company control, transparency

requirements and regulatory limits.

REITs have become a competitive way to finance real estate activity, especially in the light

of the credit constraints that still affect the industry. This paper analyses the factors that

managers should take into account when considering whether to set up a REIT.Peer Reviewe

UPCommons

Factors influencing the decision to set up a REIT

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259FACTORS INFLUENCING THE DECISION TO SET UP A REITROIG HERNANDO, J.SORIANO LLOVERA SÁEZ, J.M.GARCÍA CUETO, J.IResearch and Development Centre for Companies Improvement and Innovation (CERpIE), Polytechnic University of CataloniaDepartment of Management, Polytechnic University of Catalonia andNumerary member of The Royal Academy of DoctorsLL.B. and Master of Laws, ESADE (Barcelona, Spain) and LL.M. in International Legal Studies, Georgetown University Law Center (Washington, D.C.)jaume.roig.hernando@upc.edu , jsoriano@terra.com, joseignacio@garciacueto.comAbstractReal Estate Investment Trusts (hereinafter, REIT) are investment companies which capital-ize real estate assets by offering company shares on the stock markets.The recent economic upturn has led to a sharp increase in the constitution of new RE-ITs. Nevertheless, real estate managers should weigh up the advantages of these securities compared to other alternatives of financing real estate activity. Variables affecting REIT performance that managers should analyse include market price and market capitalization (compared to net asset value), expected liquidity, start-up costs, systematic risk, finance costs and tax benefits, and also other aspects such as company control, transparency require-ments and regulatory limits.REITs have become a competitive way to finance real estate activity, especially in the light of the credit constraints that still affect the industry. This paper analyses the factors that managers should take into account when considering whether to set up a REIT.Key words: Real Estate, Real Estate Investment Funds, Sociedades Anónimas Cotizadas de Inversión en el Mercado Inmobiliario (SOCIMI), Real Estate Financing. 260Factors inFluencinG tHe decision to set uP a reitResumenReal Estate Investment Trusts (en adelante, REIT) son vehículos de inver-sión que capitalizan los activos inmobiliarios mediante la venta de partici-paciones en los mercados financieros.El reciente inicio de la recuperación económica ha llevado a un incremento en el ritmo de constitución de nuevos REITs. No obstante, los gestores in-mobiliarios deberían evaluar las ventajas de financiarse mediante la consti-tución de un REIT respecto a otras alternativas de financiación de la activi-dad inmobiliaria. Las variables que influyen en los resultados de los REIT y que deberían ser consideradas van desde la cotización y capitalización en el mercado (respecto el valor neto de los activos), la liquidez esperada, los costes de salida, el riesgo sistemático, costes financieros e impuestos, así como otros aspectos como la posible pérdida del control de la compañía, requisitos de transparencia y requerimientos regulatorios.Los REITs se han convertido en un instrumento competitivo para finan-ciar la actividad inmobiliaria, especialmente en un entorno de restricción de crédito que todavía afecta al sector inmobiliario. El presente artículo analiza los factores que los gestores inmobiliarios deberían tener en cuenta al considerar la posible constitución de un REIT.PalaBras clave: Real Estate, Real Estate Investment Funds, Sociedades Anónimas Cotizadas de Inversión en el Mercado Inmobiliario (SOCIMI), Real Estate Financing. 1. IntroductionIn recent years, the real estate industry has faced its worst crisis since the 1930s. Real Estate Investment Trusts (hereinafter, REIT), investment compa-nies which capitalize real estate assets by trading company shares in the securi-ties markets (Kroszner & Shiller, 2011), were badly affected.However, the incoming macroeconomic data are showing signs of change for financial and real estate markets. As part of this positive economic trend, the reforms introduced by the Spanish government have made the Spanish REIT regime, known as Sociedad Anónima Cotizada de Inversión en el Mercado In-mobiliario (hereinafter SOCIMI) more attractive. This has led to a significant intensification of REIT start-ups, not only at local level but also among large international investors.261roiG Hernando, J. soriano llovera sáez, J.m. García cueto, J.iReal estate managers should weigh up the advantages of setting up a REIT over  alternative methods for financing real estate activity. They must analyse a variety of factors affecting REIT performance, such as market price and market capitalization (compared to its Net Asset Value (hereinafter, NAV)), expected liquidity, constitution costs, systematic risk, finance costs and tax benefits, as well as other aspects such as company control, transparency requirements and regulatory limits.REITs have become a competitive way to finance real estate activity, es-pecially in the light of the credit constraints the industry is still experiencing. This paper examines the factors that managers should take into account when deciding whether to establish a REIT.2. Methodology, data and hypothesisThe methodological approach applied in the study is as follows. First, we review the global scientific literature on REITs, in particular with reference to aspects related to REIT start-ups. Second, though the state of the art has been analysed at international level, we conduct a market study focusing on Span-ish REITs in order to identify the advantages and disadvantages of setting up a SOCIMI. Third, we compile data from the National Stock Market Commis-sion (hereinafter, CNMV) and the Alternative Investment Market (hereinafter, MAB), as well as on-line information from Spanish REIT websites and inter-views.3. Factors that managers should analyse when considering the constitution of a REITIn this section we analyse the main decision factors that managers should take into account when considering setting up a REIT.3.1 Financing costs Several studies have demonstrated that REITs enjoy better access to credit than non-traded real estate companies (Hardin and Hill, 2011; RREEF Re-search, 2010; Deloitte, 2011). According to Hardin and Hill, the credit avail-ability for REITs is associated with the historical data on dividend distributions. 262Factors inFluencinG tHe decision to set uP a reitThus, when assessing the credit risk of a REIT, lenders may consider its capacity of generating dividends as an equivalent of cash flows. If they see that REIT managers are reluctant to shorten dividends and that a greater distribution is required by law, lenders could consider dividends as a cash flow guarantee, which in the worst-case scenario can be used as repayment for the debt. Data in Figure 01 indicate the credit spread decline of REITs, a trend that started in Australia, and continued in the UK and the US (RREEF, 2010).Figure 01. Spreads of Credit Default Swaps of REIT Evolution Source: RREEF, 2010.3.2 Cash obtained through the sale of sharesObtaining liquidity through the constitution of a REIT has been shown to be a competitive strategy for real estate finance compared with other alternatives such as mortgages (Roig and Soriano, 2015). Nevertheless, managers should analyse, on a case-to-case basis, whether the establishment of a REIT (which involves the sale of shares in the financial markets) is at least equivalent to other scenarios such as property disposals or mortgages.3.3 LiquidityIn other investment instruments in the real estate industry, such as direct investment in properties, liquidity may be significantly lower than other types of assets. However, REIT liquidity is closer to that of other listed companies in the financial markets (Marcato & Ward, 2007).263roiG Hernando, J. soriano llovera sáez, J.m. García cueto, J.iHowever, the moderate liquidity of the underlying assets has a negative im-pact on REIT liquidity; this leads to lower share switching than in other listed companies in the industry. Table 01 displays a clear difference between REITs and non-REIT real estate companies (Ghosh, Miles & Sirmans, 1996).This liquidity advantage of REITs over non-REIT companies is clearly re-flected in REITs share prices, with a quantified impact between 12 and 22% (Beneviste, Capozza and Sequin, 2001). REITs are obliged to publish more information regarding their financial situation; this increases transparency and, in turn, their liquidity.Table 01. A Liquidity Comparison between REIT and Non-REIT companiesyearMarket value (Millions of $)Daily Trading volume  (% market shares)REITNon-REIT companiesREITNon-REIT companies1987 154 162 0.14 0.431988 178 186 0.09 0.251989 195 203 0.11 0.51990 160 170 0.09 0.411991 176 188 0.09 0.671992 248 265 0.14 0.411993 371 389 0.23 0.631994 402 372 0.18 0.451995 456 434 0.15 0.52Mean 260 263 0.14 0.47Source: Ghosh, Miles, Sirmans (1996), Real Estate FinanceMoreover, according to Demsetz (1968), Stoll (1978) and Ho and Stoll (1981), the factors underlying liquidity are the financing costs, the expected return, and risk. Consequently, present liquidity is estimated to be moderate in the present context with its high financing costs – even though the Euribor is at a record low, the expected return is moderate, and the risk premium and the perceived risk in the real estate market are both high. 264Factors inFluencinG tHe decision to set uP a reit3.5 Discounts to Net Asset ValuesREIT share prices in the financial markets are affected by volatility and systematic risks which lead to disparities between the quotation and the NAV. These differences can be attributed, in particular, to rational factors such as the size of the REIT, country effect, liquidity and transparency, or to irrational fac-tors such as investment sentiment and real estate expectations.3.6 Flotation costsThe costs of being listed on the financial markets should not be ignored. First there is the cost of going public, and then the cost of trading on the finan-cial markets. Although it is possible to quote in markets with lower costs such as the MAB, REITs should set aside a non-negligible budget for this area and scale economies should be studied.Conducting external audits and valuations and employing share issue con-sultants or fiscal advisors are some of the costs of establishing a REIT.3.7 Company controlThe sale of shares to third parties is a transparency requirement and to some extent represents a loss of company control. Managers should value the poten-tial negative impact that the sale of the share framework may have on share-holders. 3.8 TransparencyREITs are listed in the financial markets. Although managers can choose to be in a less regulated public market such as the MAB, information requirements will always be higher than in non-listed companies.The obligation to make greater amounts of information public may initially be costly. The sale of shares to third parties represents a transparency require-ment and to some extent a loss of company control. In the long term it is likely to be especially effective as it reduces the perception of company risk and thus directly increases the value of the REIT (Bushman & Smith, 2003).265roiG Hernando, J. soriano llovera sáez, J.m. García cueto, J.i3.9 Legal constraintsREITs must comply with legal requirements in order to take advantage of tax benefits. These legal requirements, such as a high percentage of dividend distribution, a minimum net capital and the allocation of at least 80% of the property investments for leasing reduce managers’ room for manoeuvre, but recent changes in the Spanish regulations have done a great deal to encourage the constitution of new REITs.3.10 Systematic riskInvestors should bear in mind that REIT shares are listed in the financial markets, and so are subject to far more volatility than their underlying assets (three times more, according to Kallberg, Liu & Srinivasan (1998). In other words, REITs are affected by systematic risk. Daily information has an imme-diate impact on shares but a lower impact on property valuations, resulting in the appraisal smoothing effect (Quan & Quigley, 1991).3.11 REIT risk-return trade-offREIT managers should assess the fact that markets demand a higher level of profitability than other assets because the volatility variable does not include the total risk of the asset (Table 02); that is, in the risk analysis regarding invest-ment decisions of REITs, the study of volatility is necessary but not sufficient. Table 02. A Comparison of the Risk-Return Trade-Off PeriodREITSLarge-Cap CompaniesSmall-Cap CompaniesBondsReturn Risk Return Risk Return Risk Return Risk1972 – 2007 13 17.4 11.2 17 14.3 22.5 8.7 11.51988 – 2007 12.3 17.4 11.8 16.6 13.5 19.9 9.3 10.11998 – 2007 10.5 20.4 5.9 17.3 10.6 22.2 7.3 8.82003 – 2007 18.2 22.3 12.8 9.8 17.2 25.1 5.7 4.1Source: NAREIT, 2010.This is due to  the informational, rational and operational market inefficien-cies in real estate (Figure 02) which mean that the distribution of the returns does not follow a log-normal law. This in turn implies a lower diversification effect in an investment portfolio (McCoy, 2006 and Shleifer, 2000).266Factors inFluencinG tHe decision to set uP a reitFigure 02. An Efficiency Comparison between Stock and Real Estate Markets Source: Sabal (2008).3.12 Departures from NAV in REIT pricingREIT share prices often differ from their NAV. There are many reasons for the differences in the Price to NAV ratio: rational factors such as REIT size, country effect, liquidity, diversification or historic returns, and irrational fac-tors such as investor expectations or investor sentiment (Fernández et al, 2012)If managers expect a market decrease in the Price to NAV ratio, they would have no incentive to establish a REIT because there will be more efficient ways to finance their real estate activity – for instance, mortgages.Figure 03 outlines the evolution of the Price to NAV ratio for European real estate companies and shows that the relation between these two variables varies over time.Figure 03. European Index of the Price to NAV Ratio (FTSE EPRA/NAREIT) Source: RREEF, 2010.267roiG Hernando, J. soriano llovera sáez, J.m. García cueto, J.i3.13 Summary:Table summarizes the decision-making factors involved in the constitution of a REIT.Table 03. Decision-making factors in the constitution of a REIT.  Factor Description    Positive FactorsCash generationThe generation of liquidity via property assets without the need to sell them.Not accounted for as debtThe sale of shares does not affect debt ratios; this means that financing costs remain stable and, in turn, liquidity is obtained. Company managementDepending on the company’s free-float, managers will retain company control.LiquidityReal estate listed companies have more liquidity than property assets; this is positively reflected in their price. Financing costsHistorically, REITs have obtained better competitive financing costs than non-traded real estate companies.Public imageThe constitution of a REIT improves the public perception of the company among stake-holders.Company riskREITs are perceived as being more transparent than non-traded real estate companies. This reduces the perceived company risk and mitigates the decrease in the price to Net Asset Value.Tax benefitsBy fulfilling the legal requirements, the SOCIMI and its shareholders receive tax benefits not available to other real estate companies.Price-discount to NAVIf shares are sold at a price higher than the Net Asset Value, shareholders obtain more profitability than in a scenario in which assets are sold.268Factors inFluencinG tHe decision to set uP a reit  Factor Description    Negative FactorsFlotation costs of firmsBeing listed in the financial markets entails significant costs for companies – not only initially, but throughout the time the company is listed.Company controlThe sale of shares involves a certain loss of control over the company. More information must be provided, and the strategy must be shared with new shareholders.Management costsInvestors’ expectations regarding property prices are reflected in both the appraisals and stock prices. Nevertheless, future price expectations influence appraisers less than investors. TransparencyTrading on the financial markets obliges firms to report more information – a possible entry barrier.Legal constraintsThe legal requirements imposed on REITs reduce management flexibility.Price-discount to NAV If shares are sold at a price lower than the Net Asset Value, shareholders obtain more profitability than in a scenario in which assets are sold.Systematic riskIn trading on the financial markets, REITs will be affected by idiosyncratic risk but by systematic risk as well.Source: Compiled by authors.4. ConclusionsBefore establishing a REIT, managers must analyse a large number of fac-tors, both positive and negative.Certain additional external factors represent opportunities or threats that have a significant influence on the decision-making process. For example, the economic context and the real estate cycle are currently recovering, but during the financial crisis they represented a major obstacle. It seems that the factor valued most highly by managers is the advantageous tax treatment. Other positive and negative aspects do not tend to be considered in the decision-making process. However, positive aspects such as liquidity, 269roiG Hernando, J. soriano llovera sáez, J.m. García cueto, J.icash generation, not being accounted for as debt, financing costs, public im-age, company risk and company management, and negative aspects such as company control, flotation costs, management costs, transparency, legal con-straints, price-discount to NAV and systemic risk are also key success factors that should be taken into account.References*Beneviste, L.; Capozza, D.R.; Seguin, P.J.; 2001. The Value of Liquidity. Real Estate Economics, Vol. 29, p.p. 633-660. Available at: http://dx.doi.org/10.1111/1080-8620.00026.Bushman, R. M., Smith, A. J.; 2003. Transparency, financial accounting infor-mation, and corporate governance. Financial Accounting Information, and Corporate Governance. Economic Policy Review, 9(1).Deloitte; 2011. Commercial Real Estate Outlook: Top Five Issues 2011. Sus-taining the recovery momentum. Available at: http://goo.gl/v6EI4.Fernández, J., Llovera, F.J, Roig, J.; 2012. Los REITs españoles como vehículo de inversión y financiación de la actividad inmobiliaria: las SOCIMI; Intan-gible Capital, Vol. 8 (2), pp. 308-363.Ghosh, C.; Miles, M.; Sirmans, S.F; 1996. Are REITs stocks?. Real Estate Fi-nance, Vol. 13 (3), pp. 46-53.Hardin, W.G.; Hill, M.D.; 2011. Credit Line Availability and Utilization in RE-ITs. Journal of Real Estate Research, Vol. 33 (4), pp. 507-530.Kallberg, J., Liu, C. H. & Srinivasan, A.; 1998. Evaluating stock price volatil-ity: The case of REITs. Stern School of Business in its series New York Uni-versity, Leonard N. Stern School Finance Department Working Paper Series with number 99-081.Krozner, R.; Shiller, R.J.; 2011. Reforming U.S. Financial Markets: Reflections before and beyond Dodd-Frank. The MIT Press.McCoy, Bowen H.; 2006. The Dynamics of real estate capital markets. A prac-titioner’s perspective. Urban Land Institute.NAREIT; 2010. Investing for Dividends and Diversification. Available at: http://goo.gl/K9Nr1Z270Factors inFluencinG tHe decision to set uP a reitQuan, D. C.; Quigley, J. M; 1991. Price formation and the appraisal function in real estate markets. The Journal of Real Estate Finance and Economics, Vol. 4 (2), pp. 127-146.Roig, J; Soriano, J.; 2015. Liquidez y cotización respecto al valor neto de los activos de los REIT españoles (las SOCIMI). Revista Europea de Dirección y Economía de la Empresa, Vol 24 (2). Available at: http://goo.gl/kr6gQwRREEF Research; 2010. Global Real Estate Securities: The Outlook for 2010 and Beyond. Available at: http://goo.gl/XzrXdo.Sabal, J.; 2008. Finance in Real Estate. Programa de Licenciatura y Máster en la Escuela Superior de Administración y Dirección de Empresas (ESADE).Shleifer; 2000. A. Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press.

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