Effects of Regulatory and Market Constraints on the Capital Structure and Share Value of REITs. Evidence from the Italian Market.

In contrast to the US experience, most international (European) REITs are subject to prudential regulation. This paper investigates the effects on capital structure and, consequently, on REITs’ share value of the major legal and market constraints (i.e. leverage limitations, market discount on NAV, tax controls) affecting non-US REITS. Italian market data are used for the empirical analysis. Our hypothesis is that in a constrained environment the effects on share price significantly depend on the adopted valuation perspective, i.e. if shares are valued following a NAV or a financial approach. The logic for this hypothesis is that the two valuation methodologies perceive leverage and implied financial risk differently. In particular, we argue that NAV valuation techniques incentivise REITs to maximize leverage regardless of financial theory indicating a contrasting impact of debt on shares’ market value. Differences in financial risk perception could so also partially explain market prices discounts on NAV. The empirical results seem to support these expectations. Almost all Italian REITs tend to increase debt ratios over time. NAV discounts are significantly related to leverage. The discount effect is largely attributable to NAV increases that result from rising debt levels. On the contrary, share market prices tend to be independent from leverage. The latter result may indicate that classic capital theory applies and that current debt ratios do not imply bankruptcy risk. The results have significant policy implications in terms of optimal regulatory design.