An Examination of REIT Dividend Payout Policy

An Examination of REIT Dividend Payout Policy

Introduction

The choice of a firm to pay or not pay dividends is a central theme in corporate finance. A vast literature has developed devoted solely to explain why firms choose to pay dividends. The central assumption in this literature is that the firm has a choice in paying dividends. For regular corporations this assumption is quite reasonable. However, when one tries to explore the dividend policy of a real estate investment trust (REIT), the legislative environment in which the REIT operates comes to the fore.

At its simplest, legislative considerations force a REIT to distribute at least part of its cash flows as dividends. In this sense the distribution behavior of a REIT needs to be broken into nondiscretionary and discretionary distributions, because it is the payment of the discretionary distributions that is a choice made by REIT management. What makes this distinction difficult is that the distribution requirements that a REIT faces are largely based on taxable income. As is well known in the tax literature, calculating taxable income based on mandated disclosures from Statement of Financial Accounting Standards No. (SFAS) 109 Accounting for Income Taxes (Financial Accounting Standards Board 1992) is highly problematic (Hanlon 2003).

Having addressed the issue of identifying the discretionary dividends paid by a REIT, the paper examines two main topics. The first is to characterize the magnitude of the discretionary dividends. Although many papers have argued that REITs pay discretionary dividends (Wang, Erikson and Gau 1993) none have accurately described these distributions. Second, I examine whether the competing theories of dividend policy can explain the discretionary dividend policy observed in REITs. Because the total dividend paid by a REIT is composed of both discretionary and nondiscretionary components, accurately identifying the discretionary component gives this study greater power to test the competing theories than previous studies.

Initial review of literature

There is an expansive literature examining the dividend payout policy of regular corporations (Allen and Michaely 2003 for an extensive summary). The REIT literature follows similar themes. Traditionally, the dividend payout policy of a firm is generally argued to be either the outcome of agency costs or dividend signaling. Agency cost models argue that firms should pay higher dividends when they face high agency costs (Easterbrook 1984, Jensen 1986). If managers are free to use excess company cash flows for their own benefit or to empire build this imposes costs on shareholders. Managers may be able to ameliorate some of these agency costs by paying out dividends. Dividend payments reduce free cash flow and can also force the firm to come to the capital markets to raise capital. The additional monitoring that arises from raising new capital should limit the manager's ability to invest in negative net present value projects.

Signaling models of dividend behavior argue that managers may use their dividend payments to signal private information about their expectation of future cash flows (Miller and Rock 1985, Bhattacharya 1979). These models are based on the assumption ...