Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

8 Real Estate, Governance, and the Global Economic Crisis

C h a p t e r 8 Real Estate, Governance, and the Global Economic Crisis Piet Eichholtz, Nils Kok, and Erkan Yonder Introduction The real estate market played an important role in the current economic crisis. Investors’ bullish perspectives regarding the residential and commercial property markets not only allowed borrowers access to cheap and almost unlimited credit but also offered the possibility of raising large amounts of equity on the public capital markets. However, when the property boom eventually came to an end, this changed the situation with regard to these investments rapidly and fundamentally. In retrospect, the recent crisis is to a large extent a governance crisis, in which the lack of transparency of securitized products, such as mortgagebased securities (MBS), collateralized mortgage-based securities (CMBS), and collateralized debt obligations (CDO), played a crucial role. However, this lack of transparency seems to be mostly associated with the securitized debt products created to finance real estate investments. On the real estate equity side, transparency seems to be less of a problem, thanks to the global rise of the real estate investment trust (REIT).1 This REIT market has become of major importance for institutional investors. The REIT structure was primarily created as an avenue for retail investors to gain exposure to (commercial) real estate investments. In the 166 Eichholtz, Kok, and Yonder past two decades, however, institutional investors in many countries shifted their property exposure from direct real estate holdings into listed and private property companies. As a result, REITs have become the key vehicle for real estate investments of institutional investors, who are now the dominant holders of REIT shares. For example, more than 60 percent of the property allocation of Dutch pension funds is now invested through private or public property companies. With property investments mostly allocated to intermediate property vehicles, the governance structures of these vehicles are of real importance to key players in the global capital market—pension funds and insurance companies. The governance structures and their implications for the performance of equity investments in real property are difficult to observe in the market for private funds, but the listed property sector offers a laboratory as to how real estate capital providers integrate and evaluate corporate governance in real estate investment decisions. Interestingly, where many articles have shown the importance of firmlevel governance for common equity investments (see the next section for a detailed review of the literature), the evidence shows that governance has less influence on the performance of REITs.2 The distinct legal setting and organizational structure of REITs—U.S. law requires a 90 percent mandatory payout of net earnings—fundamentally changes the traditional principal-agent setting. The free-cash-flow problem is of less concern for REIT investors, as the legal distribution requirement limits the opportunities for managerial entrenchment.3 Thus, the restricted setting in which managers of REITs operate offers an interesting natural experiment to test the relationship between governance and performance. Under the substitution hypothesis, the legal restrictions that apply to REITs mitigate the need for strong firm-level corporate governance mechanisms.4 Governance may therefore be less important to investors. On the other hand, REIT managers can freely decide on how to use the free cash flow that remains after the mandatory payout. As the depreciation expense is sizable for property companies, the discretionary cash flows can still be substantial. Under the complement hypothesis, it can therefore be expected that the relation between corporate governance and performance, which has been documented in the finance literature, holds for U.S. REITs as well. Moreover, corporate governance is likely to play a more critical role during the current global financial crisis, as the expected return on investment for managers declines during such crises.5 As a result, managers may Real Estate, Governance, and the Global Crisis 167 become more entrenched during the crisis, in order to compensate their losses. Rajan and Zingales have documented how investors shunned Asian markets at the beginning of the Asian crisis, since the legal environment did not sufficiently protect them from losses or downright expropriation.6 And the role of institutional ownership may also change during a crisis. Mitton finds that institutional ownership positively affected returns during the Asian crisis, which was not the case before the market downturn.7 We analyze the impact of the strength of corporate governance on the performance of equity investments in property during the...