CASH FLOW VOLATILITY AND DIVIDEND POLICY

CASH FLOW VOLATILITY AND DIVIDEND POLICY DAI JING (Bachelor of Finance, Fudan Univ., 2003) A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SCIENCE DEPARTMENT OF REAL ESTATE NATIONATIONAL UNIVERSITY OF SINGAPORE 2005

To my supervisor Prof. Ong Seow Eng Thanks for the great guidance, generous help and continuous encouragement To Department of Real Estate, National Universy of Singapore Thanks for all the supports for my master study To all my friends and colleges, especially Dr. Andrew C. Spieler Thanks for the invaluable comments, help and experience in the research work To my dear parents and fiancé Thanks for your love, understanding and care i

Table of Contents Page Acknowledge..i Table of Contents.... ii Summary.. v List of Tables... vii List of Figures viii Chapter 1: Introduction 1.1 Background...1 1.2 Research Objectives...4 1.3 Data Sample...4 1.4 Research Methodology..5 1.5 Hypotheses of Study..6 1.6 Organization of Study 6 Chapter 2: Lerature Review 2.1 Cash Flow Volatily and Dividend Payouts....8 2.2 A Dividend Debate Referring to Cash Flow Volatily..10 2.3 Information Signaling Theory 10 2.4 Agency Cost Theory... 12 2.5 Summary...14 ii

Chapter 3: The Dividend Debate in REIT Industry 3.1 REIT: An Interesting Testing Ground for Dividend Policy......16 3.2 The Dividend Debate between Two Theories... 22 3.3 A Better Measurement for REITs Dividend Policy..24 3.3.1 Definion of Excess Dividend.25 3.3.2 Reasons for Excess Dividend..26 3.4 Summary.......29 Chapter 4: Research Methodology 4.1 Wealth Penalty Caused by Firm Risk.31 4.2 Excess Dividend Payout and Cash Flow Volatily... 33 4.2.1 Excess Dividend Equation....34 4.2.2 Proxies for Cash Flow Volatily...37 4.2.3 Panel Regression Specifications....39 4.3 Other Factors to Influence Dividend Payout Behavior...40 4.3.1 Growth Rate of Asset......40 4.3.2 Return of Asset...42 4.4 Total Dividend Equation....42 4.5 Impact from Change of Statutory Distribution Rate in 2001.43 4.5.1 Dividend Changes in 2001....43 4.5.2 Prob Analysis of Information Content of Current Dividend Payouts.....45 4.6 Summary.....47 iii

Chapter 5: Data Sample and Descriptive Statistics 5.1 Data Sample 49 5.2 Descriptive Statistics 49 Chapter 6: Empirical Results 6.1 Excess Dividend Regression..52 6.2 Excess Dividend and Other Influences..55 6.3 Total Dividend Regression.....56 6.3.1 Comparison between Excess Dividend and Total Dividend 58 6.3.2 Firm Factor Analysis.59 6.4 Impact from Change of Statutory Distribution Rate in 2001.62 6.5 Summary...69 Chapter 7: Summary and Conclusions 7.1 Summary of Main Findings...70 7.2 Research Contributions......72 7.3 Follow-Up Research..74 Bibliography Appendix iv

Summary The dividend debate between agency cost theory and information signaling theory indicates oppose explanations of the relationship between dividend payout and cash flow volatily. According to information signaling theory, managers will lower the dividend in case the firm can not distribute the announced amount when the future cash flow is uncertain. Managers will choose a dividend policy where announced dividend is less than expected income in order to avoid the potential wealth penalties 1. The more volatile future cash flow means higher risk related to the future earning. Thus, the information signaling theory predicts that dividend payout should be lower when future cash flows are more volatile. Grounded in the agency cost theory, an increase in dividends will result in a reduction in free cash flow which will generate agency costs. The larger the cash flow variance, the greater potential agency costs will exist. Higher dividend payout can be used against non-value maximizing investments for firms wh greater cash flow uncertainty. Thus, agency cost theory predicts that firms wh more volatile cash flows would distribute a greater proportion of their cash flows as dividends. This empirical study tests the two theories above, wh a sample of 135 public equy US REIT firms from 1985 to 2003. It explores the role of expected cash flow volatily as a determinant of dividend policy for REIT industry. 1 A stock price drop is usually associated wh cutting dividends, which is also known as wealth penalty for shareholders. v

The study constructs both excess dividend and total dividend panel regression models, which are based on the model from Bradley, Capozza and Seguin (1998) and the concept of excess dividend equation proposed by in Lu and Shen (2003). Our results show strong evidence that REIT firms pay out substantial excess dividends to avoid agency problem when the future cash flows are volatile. The information signaling theory plays a relatively minor role in REIT firms dividend policy. The statutory distribution of dividend is one special characteristic of REIT industry. This ratio was reduced from 95% to 90% in 2001. Our sample shows that most REIT firms were reluctant to reduce the dividend payout in spe of this regulation change. In addion, REIT firms also maintained the dividend payouts even when they have lower earnings. This dividend maintenance behavior over 2001 may provide a significant signal to the market. However, the results from the prob analysis do not show that the dividend changes in 2001 can be considered as accurate signals for future dividend or cash flow changes. vi

List of Tables Page Table 3-1 Definion of Excess Dividend 25 Table 3-2: Summary of Excess Dividend Payout 27 Table 3-3: Summary of Excess Dividend Payout when EPS < 0 28 Table 4-1: Table 4-2: Comparison between Agency Cost Theory and Information Signaling Theory Effect from Change of Statutory Distributed Rate from 95% to 90% 39 43 Table 5-1: Summary of Statistics 50 Table 6-1: Excess Dividend Regression 53 Table 6-2: Excess Dividend and Other Influences Regression 55 Table 6-3: Total Dividend Regression 57 Table 6-4: Excess Dividend Regression for Big Firm Subgroup 61 Table 6-5: Table 6-6: Table 6-7: Table 6-8: Excess Dividend Regression for Small Firm Subgroup Prob Analysis of Current Dividend and Future Dividend Changes in 2001 Prob Analysis of Current Dividend and Future Dividend Changes in 2001 Prob Analysis of Current Dividend and Future Cash Flow Changes in 2001 61 62 64 65 Table 6-9: Table 6-10: Prob Analysis of Current Dividend and Future Dividend Changes in 2001 (Robust Test) Prob Analysis of Current Dividend and Future Cash Flow Changes in 2001 (Robust Test) 67 68 vii

List of Figures Page Figures 3-1: U.S. REITs Number from 1980 to 2003 19 Figures 3-2: U.S. REITs Capalization from 1980 to 2003 19 viii

Chapter 2 Chapter 1 Introduction 1.1 Background Dividends are payments made to the firm s shareholders, which are based on the firm s underlying earnings. The determination of the proportion of profs 2 periodically paid out to shareholders is called dividend policy. Firms usually follow deliberate dividend payout strategies that can be driven by several goals. This raises several interesting questions: how do the firms choose their dividend policies? What is the optimal proportion of the earning to be paid out as cash dividend? These questions are considered as a puzzle related to the dividend policy determination process. Researchers have proposed a number of explanations about this dividend puzzle. A substantial theoretical lerature, including Bhattacharya (1979), Kose and Joseph (1985), Miller and Rock (1985), indicates that dividend payout is designed to reveal future earnings prospects to the outside shareholders. However, recent results are more mixed, because the firms current dividend payouts do not actually reflect the changes of firms future earnings. Agency problems between corporate insiders (managers) and outside shareholders are greatly related to the dividend policies (Easterbrook 1984, Jensen1986, Myers 1998). 2 The percentage of earnings paid to shareholders in dividends is called as dividend payout ratio. 1

Chapter 2 Cash flow 3 is usually considered as an important indicator of a firm's financial health. The high volatily of cash flow is associated wh greater market risks and higher operation costs. The cash flow volatily not only increases the likelihood that a firm will need to access capal markets, also increases the costs of doing so. The manager s dividend policy should consider the expected cash flow and s volatily, which indicate the abily of a firm to pay out current or future dividends. Two theories have been advocated to explain the relationship between expected cash flow volatily and dividend payout: information signaling theory and agency cost theory. There is usually a discrete stock price drop or shareholder wealth penalty associated wh cutting dividends. Under the information signaling theory, managers will choose a dividend policy where announced dividends are less than expected income in order to avoid the penalty. This policy allows managers to maintain announced dividends even if subsequent cash flows are lower than anticipation. Thus, the information signaling theory predicts that dividend payout should be lower when future cash flow is more volatile. The agency cost theory suggests that an increase in dividends will result in a reduction in free cash flow thus multiplying agency cost. The larger the cash flow variance, the greater the potential agency costs and the more reliance on dividend distribution to avoid this agency cost. The dividend payout to guard against non-value maximizing investments should be greatest for the firms wh highest cash flow uncertainty. Thus the agency cost theory predicts that firms wh more volatile cash flows would pay out a greater proportion of their cash flows as dividends. Empirical evidence supporting 3 Cash Flow equals to cash receipts minus cash payments over a given period of time. More detailed discussion about cash flow will be included in Chapter 2. 2

Chapter 2 the agency cost explanations can be found from Rozeff (1982), Dempsey and Laber (1992), and Wang, Erickson and Gau (1993). The information signaling theory and agency cost theory provide contrasting explanations between dividend payout and future cash flow volatily. According to information signaling theory, the managers will lower the dividend in case the firm can not distribute the announced amount when the future cash flow is uncertain. While the agency cost theory supports that the greater dividend payout can be used against non-value maximizing investments for firms wh greater cash flow uncertainty. Real Estate Investment Trust (REIT) is a corporation or trust which uses the pooled capal of many investors to purchase and manage income property (equy REIT) and/or mortgage loans (mortgage REIT). It is an organization similar to an investment company in some respects but concentrating s holdings in real estate investments. More and more researches have been done about the dividend policy in REIT industry. The debate between the information signaling theory and agency cost theory has continuously been heated in this area. In this study, the relationship between dividend policy and cash flow volatily will be examined by employing a sample from REITs industry. Two important financial variables, dividend and cash flow, will be jointly analyzed in one theoretical framework regarding to the dividend debate. The special characteristics 4 in REITs industry offer several benefs to overcome some of the obstacles that complicate 4 The details will be discussed in Chapter 3. 3

Chapter 2 previous studies in the dividend policy. REIT industry is considered as a good testing ground for the dividend policy, which can contribute 5 to further understandings about different factors related to the dividend policy. This study constructs both excess dividend and total dividend panel regression models, which are based on the model from Bradley, Capozza and Seguin (1998) and the concept of excess dividend equation proposed by in Lu and Shen (2003). Our results show strong evidence that REIT firms pay out substantial excess dividends to avoid agency problem when the future cash flows are volatile. The information signaling theory plays a relatively minor role in REITs dividend policy. In addion, a group of prob models has been employed and results show that the dividend changes in 2001 can not be considered as accurate signals for future dividend or cash flow changes. 1.2 Research Objectives There are two main objectives in this study: firstly, investigates the role of expected cash flow and s volatily as determinants of dividend policy. Which theory dominates the explanations for dividend payout behaviors? Secondly, focuses on the extent to which the different factors associated wh cash flow volatily will influence dividend policy. 1.3 Data Sample The data in this study is collected from Compustat database and CRSP (Centre for 5 The contributions of this study will be summarized in Chapter 7. 4

Chapter 2 Research in Secury Prices). The sample contains a sample of 135 public equy US Real Estate Investment Trusts (REITs) from 1985 to 2003. The database focuses on equy REITs and excludes all mortgage REITs and hybrid REITs due to their different business characteristics and asset structure. REITs that are not traded on the NYSE, AMEX or NASDAQ are also excluded from our sample. 1.4 Research Methodology This study considers excess dividend as a better measurement for REITs dividend policy. Based on Bradley, Capozza and Seguin (1998) and Lu and Shen (2003), an excess dividend panel regression model is constructed to test the relationship between dividend payout and cash flow volatily. Three kinds of Panel regressions are included in the empirical process: OLS, fixed effect and random effect. In addion to the variables associated wh cash flow volatily, firm growth rate and return rate are also discussed in the regression models. The total dividend regression model is conducted as a robust test for excess dividend regression model. Covering the same firm and same time period, the comparison between excess dividend payout and total dividend payout will help the investors have a better understanding of REITs dividend payout strategies and make a more accurate expectation of future cash flow volume and s volatily. The statutory distribution in REIT dividend was reduced from 95% to 90% in 2001. However, most of REITs in our sample were reluctant to reduce the dividend payouts in spe of the regulation change or lower earnings. This dividend maintenance 5

Chapter 2 behavior in 2001 provided a significant signal to the market. A prob analysis is employed to explore the relationship between the current/future dividend changes and cash flow changes. 1.5 Hypotheses of Study According to the research objectives and methodology, following hypotheses are formulated in this study: (1) According to information signaling theory, the managers will lower the excess dividend payouts when the future cash flow is uncertain. If the future earning is unexpected low, the REITs may not distribute the announced amount of dividend and a wealth penalty may happen. As a result, the higher future cash flow volatily, the fewer dividends will be paid out. (2) According to the agency cost theory, greater excess dividend payout can be used against non-value maximizing investments for firms wh greater cash flow uncertainty in the future. The higher future cash flow volatily, the more dividends will be distributed to shareholders. These two theories give totally oppose predictions on the relationship between dividend payout and future cash flow volatily. 1.6 Organization of Study The study is organized into seven chapters. The structure is listed as follows: 6

Chapter 2 Chapter 1 provides an introduction comprising the background, objectives, data sample, methodology and main hypotheses of this study. Chapter 2 provides a brief review of the dividend debate between information signaling theory and agency cost theory. Chapter 3 begins wh an introduction about the characteristics of REITs. The following is a review of lerature on the divided debate in REITs industry. Then the reasons to choose excess dividend as a better measurement are discussed. Chapter 4 discusses the research methodology: excess dividend regression, total dividend regression and other influences including the influences from regulation changes. Chapter 5 presents a detailed description of the dataset used in this study. Chapter 6 presents the empirical results and makes a discussion based on them. Chapter 7 summarizes the findings from the empirical analysis, gets main conclusions and points the contributions of this study. Finally, also indicates important directions for further research. 7

Chapter 2 Chapter 2 Lerature Review This chapter focuses on the debate on the relationship between cash flow volatily and dividend policy in a general financial concept. A lerature review shows that information signaling theory and agency cost theory have given oppose explanations on this topic. The first part will review the important basic concepts of cash flow volatily and dividend payout. The following parts seek to summarize the main findings on the relationship between cash flows and dividends, which will show us a picture of the dividend debate based on different theories 6. 2.1 Cash Flow Volatily and Dividend Payout Cash flow equals cash receipts minus cash payments over a given period of time. We can also calculate cash flow, equivalently, by adding amounts charged off for depreciation, depletion, and amortization to net prof. 7 A complete statement of cash flows includes three parts: cash flow from operation (CFO), cash flow from investing activies (CFI) and cash flow form financing activies (CFF). The analysis on cash flows provides information not only about the cash receipts and cash payments during an accounting period, but also about the firm s operating, investing, and financing activies. Therefore, cash flow is usually considered as a measurement of a firm's financial health. 6 This chapter focuses on the lerature review of the dividend debate in general financial area. The lerature review about REITs will be discussed in details in next chapter. 7 The two ways mentioned about the cash flow calculation are described orderly as direct way and indirect way. 8

Chapter 2 Volatily measures the change in value of a financial instrument wh a specific time horizon, and quantifies the risk of the instrument over that time period. The volatily of cash flow not only increases the likelihood that a firm will need to access capal markets, also increases the costs of doing so. Therefore, the cash flow volatily in the future reflects the potential risk in future operating, investing, and financing activies of a firm. Dividends are a portion of profs distributed by a firm to s shareholders based on the firm s underlying earnings, the type of stock and number of shares owned by the shareholders. Dividends are usually paid in cash, though they may also be paid in the form of addional shares of stock or other properties. The amount of a dividend determined by the inside management of the firm, usually called as dividend policy, is restricted by the amount of cash owned by the firm. In a real world wh taxes and transaction costs, the dividends will greatly influence the firm value. There is a tradeoff for managers between retained earnings on one hand, and dividend distributions to shareholders on the other. The expected cash flow and s volatily reflect the potential business risk of a firm, which also indicate the abily of a firm to pay out dividend. Cash flow and dividend should be jointly analyzed in a consolidated framework, as the firm s management always considers cash flow factors into the dividend policy determination process. 9

Chapter 2 2.2 A Dividend Debate Referring to Cash Flow Volatily How do firms choose their dividend policy? How do managers determine the optimal payout ratio? From cash flow s aspect, two theories have been advocated: information signaling theory and agency cost theory. These two theories offer oppose explanations about the relationship between expected cash flow volatily and dividend payout. Under the information signaling theory, there is a discrete stock price or shareholder wealth penalty associated wh cutting dividends. In order to avoid these penalties, managers will choose a dividend policy where announced dividends are less than expected income. Thus, dividend payout should be lower when future cash flows are more volatile. The agency cost theory argues that an increase in dividends will result in a reduction in free cash flow 8 where the agency problem may exist. The dividend payout investments should be greatest for the firms wh highest cash flow uncertainty to avoid non-value maximizing investment activies. Thus, firms wh more volatile cash flows would pay out a greater proportion of their cash flows as dividends. 2.3 Information Signaling Theory A substantial theoretical lerature suggests that corporate dividend policy is designed 8 Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand the company's asset base. Free cash flow can be a source of principal-agent conflict between shareholders and managers, since shareholders would probably want paid out in some form to them, and managers might want to control. 10

Chapter 2 to reveal earnings prospects and other useful related information to investors. Lintner (1956) first proposed that dividend changes should convey useful information about future earnings. Miller and Mogigliani (1961) advanced this reasoning by proposing that the information content of dividends could be valuable to investors when markets are incomplete. Miller (1987) also contended that dividend changes disclosed information about a firm s permanent income. Dividend signaling models make the more specific predictions that firms raise dividends eher prior to earnings increases or to reveal that an increase is permanent. Several former papers, including Bhattacharya (1979), Miller and Rock (1985), and Kose and Joseph (1985), argue that managers use dividends to signal the changes of future earnings to investors. The cash flow volatily is usually considered as a good proxy for the future earning. The following papers discuss the relation between dividend distribution and cash flow volatilies: Eades (1982), Kale and Noe (1990), and Bradley, Capozza and Seguin (1998). All assume eher explicly or implicly that the managers are perfectly aligned wh current shareholders. Under this assumption, the market can infer firms private information from their managers actions. However, in realy, the managers may not be able to communicate credible signals to the market. Managers in the firms that are not effectively monored may be more likely to maximize their own wealth instead of the shareholders wealth compared to managers in effectively monored firms. Benartzi, Michaely, and Thaler (1997) examine cash flow changes around large samples of dividend changes, and argue that dividend increases are not credible signals of future performance. They find that dividends are related to past earnings but 11

Chapter 2 not future earnings. Their results seriously challenge information signaling as an important component of dividend policy. Dividend policy can also be evaluated based on how dividends evolve before and after large cash flow changes. DeAngelo and Skinner (1996) find that dividend changes lag earning changes in a sample of 145 firms that suffer decreased earnings after ten straight years of rising earnings. Only in two cases, firms cut dividends before the earnings drop. They conclude that managers do not signal the negative information wh dividends and the small cash obligations associated wh increasing dividends reduce the reliabily of dividends as a signaling mechanism. 2.4 Agency Cost Theory Agency problem comes from the conflicts of interest among the outside stockholders and the inside managers. The incremental costs of having an agent (manager) to make decisions for a principal (shareholder) are known as agency cost. According to Jensen s (1986) free cash flow hypothesis, the management has an incentive to maximize the free cash flows at his discretion by distributing minimum dividends. The excess cash flow is wasted on value-destroying spending. This suggests a policy of encouraging cash-flow payout to minimize inefficient investment spending. The dividend payout to shareholders is considered as a disciplinary mechanism, reducing the agency cost associated wh the free cash flow and overinvestment. Rozeff (1982) indicates that paying dividends will reduce the resources under mangers control, and thus make firms issue new securies resulting in capal market 12

Chapter 2 monoring, thereby reducing agency costs. Several other studies have also presented empirical evidence supporting the agency cost explanation as Dempsey and Laber (1992), and Wang, Erickson and Gau (1993). In addion, the evidence also shows that those explanations based on agency cost theory are applicable over different economic condions (Dempsey and Laber, 1992). The dividend policy can also be explained from other aspects in an agency problem framework. Myers (1984) advocates the pecking order theory that firms prefer retained earnings as their main source of funds for investment 9. Therefore a growth firm tends to have a lower payout ratio and preserve more cash for expansion. The firm will try to restrain self from the debt also because: first, to avoid any material costs of financial distress; and second, to reserve the borrowing power for future expansion. Thus, the growth opportuny of a firm will influence the consideration of dividend policy, which is also linked to the investment and financing decisions. Easterbrook (2001) discusses whether dividend distribution is a method of aligning managers interests wh those of investors. He suggests that the monoring of managers in open capal market is available at low cost. Dividend distribution can reduce the internal funds and keep firms in the capal market. This can used to explain why firms simultaneously pay out dividends and raise new funds in the capal market. The internal monoring costs can be reduced by distributing dividend and using external financing. 9 Firms prefer the internal funds to external funds, and debt to equy if the external funds are needed. The firm will choose a dividend payout ratio which can meet the required rate of return of equy investment by internally generated funds. 13

Chapter 2 Grounded in agency cost theory, substution concept 10 is raised by some researchers. Easterbrook s (1984) rationale of substution among agency cost control devices suggests the agency cost explanations are only valid for firms that are not effectively monored. Noronha, Shome, and Morgan (1996) show that dividends as an agency cost control device are effective only for firms wh low growth opportuny or whout the presence of alternative no-dividend monoring devices. Filbeck and Millineaux (1999) also produce evidence consistent wh the substution concept. Some researchers connect the substution hypothesis wh the shareholder rights in the discussion of dividend policy. La Porta et al (2000) examine dividend policies of firms in 33 countries and argue that firms wh weak shareholder rights pay dividends more generously than do firms wh strong shareholder rights. Gompers, Ishii, and Metrick (2003) investigate how the market for corporate control (external governance) and shareholder activism (internal governance) interact. Agency costs can influence dividend payouts on one hand; one the other hand, they are related to the strength of internal governance. Therefore, the dividend payouts should be linked to the strength of internal governance. Dividends play the role as a substute for internal governance. 2.5 Summary This chapter analyses the relationship between dividend payouts and cash flow volatily. Cash flow volatily reflects the business risk of a firm and s abily to distribute dividends. When managers determine the payout proportion, cash flow and s volatily always play important roles. 10 The dividend policy is only a substution for other monoring devices to avoid the agency cost. 14

Chapter 2 How do cash flows affect the dividend policy? There are two leading theories related to this dividend debate: information signaling theory and agency cost theory. The first idea argues that dividend policy is designed to reveal earnings prospects and other useful related information to investors. The managers will lower the dividend in case the firm can not distribute the announced amount when the future cash flow is more volatile. While the agency cost theory supports that the greater dividends should be paid out for firms wh greater cash flow uncertainty against non-value maximizing investments. Main findings about the two theories from lerature are summarized in this section. This dividend debate related to the cash flow volatily raises many interesting questions. However, the results seem to be more mixed recently. 15

Chapter 3 Chapter 3 The Dividend Debate in REIT Industry This chapter introduces the characteristics of Real Estate Investment Trust. The reasons and advantages to choose REIT data in this study are discussed based on these characteristics in this industry. The following part is the lerature review about the dividend debate in REIT industry. The definion of excess dividend is advocated in the third section. This study argues that excess dividend is a better measurement for REIT industry compared to total dividend and three main reasons are proposed in the discussion. 3.1 REIT: An Interesting Testing Ground for Dividend Policy The majory of dividend policy lerature uses data from a wide variety of industries in their investigation. The use of multiple industry firm data may be advantageous in testing theory, as different business natures of firms in the sample will provide sufficient cross sectional variations. However, the same factor may carry different weights in the decision-making process for firms in different industries. It will be difficult to distinguish the effects between industry factors and the factors directly related to dividend policy. The dividend policy and related important variables will vary from industry to industry, because asset risk, asset type and requirement for funds (internal or external) also vary by industry (Myers 1984). In other words, wide differences in firms business nature will complicate the suation. This study chooses a single industry as the sample, which will eliminate the industry effects and highlight the importance of firm-specific volatily. 16

Chapter 3 A Real Estate Investment Trust is a company dedicated to owning, and in most cases, operating income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also engage in financing real estate. The U.S. Congress created the legislative framework for REITs in 1960 11 to enable the investing public to benef from investments in large-scale real estate enterprises. REITs are traded on major exchanges just like stocks. They provide ongoing dividend along wh the potential for long-term capal gains through share price appreciation, and can also serve as a powerful tool for portfolio balancing and diversification. 12 REIT industry is highly regulated. U.S. Internal Revenue Code (IRC) requires REIT to distribute 90% of taxable income 13. However, 90% or 95% rule is applied to earnings after allowable non-cash depreciation expenses have been deducted. The calculation of taxable income for REIT is complicated because of the variance of depreciation of property asset, which is also a significant non-cash em. Thus, REIT managers still have reasonable discretion in the percentage of earning paid out to shareholders despe the statutory payout requirement. For some REITs wh high leverage or wh tax loss carryforwards 14, the 90% or 95% rule is completely non-binding so that zero dividend payouts are observed in our sample. This indicates 11 Real Estate Investment Trust Act of 1960 The federal law authorized REITs. Its purpose was to allow small investors to pool their investments in real estate in order to get the same benefs as might be obtained by direct ownership, while also diversifying their risks and obtaining professional management. 12 http://www.investinres.com Investor Guide 13 REIT Modernization Act of 1999 Distribution requirement is effective in 2001. (H.R. 1180) will return the distribution requirement from 95% to the 90% level that applied to REITs from 1960 to 1980. In our sample, 95% of taxable income must be paid out to shareholders during time period from 1985 to 2000, while 90% from 2001 to 2003. 14 Tax loss carryforward is a technique for applying a loss or cred from the current year to a future year. 17

Chapter 3 that although REIT has strict regulations about the dividend payouts, actual dividend policy is not restricted by the regulations because of large amount of non-cash ems such as depreciation. Managers still can decide the dividend distribution. The differences of dividend payout between REIT industry and other industries are not so significant. The discussion about the dividend policy in general financial area is applicable in REIT industry. Researches have also found some interesting behaviors in dividend payouts of REIT industry. For the majory of the REITs, the median payout ratio is often larger than 1.0 15, which echoes Su, Erickson and Wang (2003) s observation that REITs pay out more than what is required. Li and Ooi (2004) find that there is considerable variation in the payout ratios of REITs, because the dividends of REITs are sticky while the earnings are more volatile. In the mid-1990s, U.S. REITs experienced rapid growth fueled by available external equy and debt financing. There were a number of REIT IPOs and a number of large acquisions by REITs. Figure 3-1 and Figure 3-2 show that the numbers and market capalizations of REITs increased fast in the mid-1990s. The dividend policy is generally evaluated by examining cash flow changes around large samples of dividend changes. So the increasing number of REITs can give us a big sample which is more convincing in exploring the role of cash flow volatily as a dividend policy determinant. 15 In the sample of this study, average REIT payout ratio is 1.14. Please refer to Table 5-1: Summary of Statistics, Page 50. 18

Chapter 3 Figures 3-1: U.S. REITs Number from 1980 to 2003 U.S. REITs Number 1980-2003 250 200 150 100 50 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Number Source: http://www.nare.com Figures 3-2: U.S. REITs Capalization from 1980 to 2003 250000 200000 150000 100000 50000 0 Source: http://www.nare.com U.S. REITs Capalization 1980-2003 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Given these corporate organizational changes together wh the REITs rapid growth, a key question is whether the change of REIT status affects the firm s performance. Recent research demonstrates a strong relationship between dividend policy and 2000 Capalization 2001 2002 2003 19

Chapter 3 operating performance of over-investing firms. Koch and Shenoy (1999) find that dividend policy provides more predictive information for over-investing firms than for value-maximizing firms. The argument about the REIT status enhances the importance of information content when we discuss the REITs dividend policy. Another advantage to test dividend policy in REIT industry is their public and transparent structures. Gentry and Mayer (2002) point out that REITs industry can supply more accurate account data. REIT share valuation and accounting data are based on a number of relatively transparent factors: 16 (1)Net Asset Value Calculation Unlike other public companies, many REITs, as well as REIT analysts, perform regular (annual and often quarterly) valuations of their company property holdings. The value of a REIT s total assets, minus liabilies, divided by the number of s shares outstanding results in what is called the Net Asset Value (NAV) per share of the company. Thus, the value of a REIT s shares is, to a significant degree, based on the value of s tangible real estate holdings. (2)Property Portfolio Enhancements The value of a REIT s property portfolio can frequently be eher maintained or enhanced through consistent capal expendures. This is significant because strategic property portfolio enhancements help to maintain or increase NAVs and provide the 16 http://www.investinres.com Investor Guide 20

Chapter 3 basis for price appreciation of a REIT s shares. Many factors that can influence the value of a REIT s property portfolio are easily understood, beginning wh the obvious economic fundamentals of supply and demand that effect valuation. Other considerations may include demographic information such as population size, population growth, employment growth and the level of overall economic activy. All of these factors, while differing from region to region, typically have a direct impact on rents and occupancy rates, which in turn drive both projected cash flow and affect property values. In addion, Funds from Operations (FFO) was defined by NAREIT in 1991. FFO adjusts the net income of equy REITs for non-cash charges such as depreciation and amortization of rental properties, gains on sales of real estate and extraordinary ems. Management considers FFO to be a useful financial performance measurement because provides investors wh an addional basis to evaluate the performance. And also helps investors evaluate the abily of a REIT to incur and service debt and to fund acquisions and other capal expendures. FFO was promoted as an appropriate measure of performance in REIT industry. Users of the industry's financial statements have accepted FFO 17 as a starting point from which to analyze the historical, as well as prospective profabily and value of firms. In this study, the dividend policy and cash flow volatily will be examined by employing a sample from REIT industry. The special characteristics in REIT industry offer several benefs to overcome some of the obstacles that complicate previous 17 The FFO per share (basic / diluted) is reported according to Guidelines for Reporting Performance on a per Share Basis. 21

Chapter 3 studies in the dividend policy. Based on the discussion above, I summarize the reasons why REIT industry is considered as a good and interesting testing ground for dividend policy. (1) Single industry can eliminate the industry effects and highlight the importance of firm-specific volatily. (2) REITs are found usually paid more than required and payout ratios are very volatile. Actual dividend policy is not restricted by the statutory distribution regulations and REIT managers still can decide the distributions to shareholders. The discussion about the dividend policy in general financial area is applicable in REIT industry. (3)REIT industry experienced a rapid growth in mid-1990s, which supplied a larger sample for empirical study. In addion, organizational changes of REITs structure enhance the importance of information content related to dividend policy. (4) REITs public and transparent structure can offer more useful financial data. FFO is accepted as an appropriate measure of performance in REIT industry. 3.2 The Dividend Debate between Two Theories in REIT Industry In the REIT s lerature, more and more researches in dividend policy have been done. The debate between the information signaling theory and agency cost theory has continuously been heated in this area. 22

Chapter 3 Some researchers argue that the tax rule requires REITs to pay out 90% of earnings and forces the REIT to seek the external financing in open capal market. Under the scrutiny form capal market, the agency problems should be very minimal. However, Wang, Erickson and Gau (1993) argue that agency cost hypothesis is strongly supported by their empirical results. They indicate that equy REIT has higher agency costs resulted from imperfect information and therefore has higher payout ratio. Bradley, Capozza and Seguin (1998) examine the link between cash flow volatily and dividend payout both theoretically and empirically. Their one period model demonstrates that managers rationally pay out lower levels of dividends when the future cash flows are more volatile. Their empirical results use a sample of REIT from 1985-1992 and confirm that payout ratios are lower for firms which have higher expected cash flow volatily. This is consistent wh information-based explanations of dividend policy. Mooradian and Yang (2001) examine the free cash flow hypothesis by comparing firm performance of hotel REITs and non-reit hotel operating companies from 1993 to 1999. They argue that REITs should be able to migate the agency problem caused by free cash flows as a result of the statutory distribution regulation. There are statistically significant differences in leverage level, dividend policy and cash flow levels in these two types of companies. Their findings clearly show that a firm s performance (the market to book ratio) is negatively related to free cash flow proxies which is consistent wh Jensen s (1986) free cash flow hypothesis. 23

Chapter 3 Lu and Shen (2003) analyze the yearly dividend paying behavior of the publicly traded REITs from 1994 to 2000. They argue that due to large non-cash depreciation expenses, REITs retain much more discretion over free cash flows than what is interpreted by normal accounting methods. Agency costs arise and excess dividend is preferred by shareholders for monoring purpose. They conclude that agency cost theory can well explain the REIT dividend policy. In addion, REITs may voluntarily select appropriate dividend payouts to solve the agency problems in the absence of the government interventions. Lee and Slawson (2004) consider the extent to which a firm is monored may affect the explanation for dividends, especially for those dividends paid in excess of mandatory payout ratio. They obtain different evidence when considering no-mandatory dividends and non-dividend monoring. However their evidence shows that agency cost explanations dominate signaling explanations for relatively less monored REITs. 3.3 A Better Measurement for REITs Dividend Policy One of the characteristics for REIT is the highly regulated dividend distribution. Under the U.S. IRS rule, REIT should distribute 90% of taxable income (95% before REIT Modernization Act of 1999). However, the calculation of taxable income of REITs is complicated because of significant non-cash ems, such as the variance of depreciation of property asset. REIT managers still have reasonable discretion in the actual distributions to shareholders despe the statutory payout requirement. Some REITs wh high leverage or wh tax loss carryforwards, the IRS rule is completely 24

Chapter 3 non-binding to the dividend policy so that zero dividend payouts are also observed in our sample. In addion, the payout ratio for most REITs is often larger than 1.0. Why do the REITs prefer to pay out more than what is required? How do the REITs decide the excess part beyond the requirement as dividends? 3.3.1 Definion of Excess Dividend The excess distribution beyond the statutory required part is known as excess dividend. In this study, excess dividend ( ED ) is defined as: Table 3-1: Definion of Excess Dividend Before 2001 2001and Onward ED EPS 0 D = = D EPS > 0 D 95% * EPS = = D 90% * EPS where D is dividend per share for current year; EPS is earning per share for current year. This is different from Lu and Shen (2003), in which excess dividend is defined as dividend per share minus the earning per share. Excess dividend should be defined as the excess part after the statutory part (90% or 95% of EPS ) deducted from the total dividend payout. When EPS is negative, there is no statutory dividend to be paid out. As such, the actual total dividend paid is considered as excess dividend in this study when EPS is negative. 25

Chapter 3 3.3.2 Reasons for Excess Dividend This study considers the excess dividend as a better measurement for the dividend policy in REIT industry because of the following reasons: (1) Under the IRS rule, managers can only decide how much excess dividend to be paid out but not the total dividend. In this case, the managers can only use excess dividend as a signal indicating the future cash flow s volume and volatily. Meanwhile, the shareholders can only expect the REIT managers to distribute more excess dividend to avoid the potential agency cost when the future cash flow is highly volatile. Table 3-2 describes the excess dividend payouts in two time periods according to different statutory distribution requirements. 72.80% 18 of our observations in our sample 19 pay out excess dividend, which indicates that excess dividend payout is a dominant phenomenon in REIT industry. Thus, will be useful and reasonable to employ excess dividend analysis in this special industry. 18 Table 3-2: 72.80% of the REIT observations in the sample pay out excess dividend (63+787+39+254)/ 1570 * 100% =72.80% 19 Our sample contains a subset of 135 US Equy REITs listed in the NAREIT source books in 2003. The original data ranges from 1985 to 2003, while availabily of individual firm data also depends on their respective listing date. REITs that are not traded on the NYSE, AMEX or NASDAQ are also excluded from our sample. US REITs company fundamental data are obtained from Standard & Poor s Compustat database. REITs firm share price are gained from CRSP. 26

Chapter 3 Table 3-2: Summary of Excess Dividend Payout before 2001 2001 and onward Pay out dividend when EPS < 0 Payout ratio > 0.95 Pay out dividend when EPS < 0 Payout ratio > 0.90 No. of observations 63 787 39 254 Percentage 5.32% 66.47% 10.10% 65.80% Source: Author s compilation Original Data Source: Compustat database &CRSP database Sample: 1570 observations for127 firms Period: 1985 2003 (2) The calculation of taxable income for REITs is complicated because of the significant non-cash ems such as property depreciation. FFO is considered as a useful financial performance measurement of an equy REIT because FFO provides investors wh an addional basis to evaluate the performance and abily of a REIT to incur and service debt and to fund acquisions and other capal expendures. In our sample, the median of Dividend / FFO 20 is 0.62, while the median of payout ratio ( Dividend / EPS ) is 1.20. This indicates that FFO per share is usually much bigger than EPS. REITs dividend policy is not constrained by the statutory distribution requirement and net income, because REITs usually have cash flow beyond earnings to support the excess dividend payouts. The analysis on excess dividend can help us explo further into the dividend policy. (3) REIT managers also try to smoothen the dividend payout. Table 3-3 shows that in 102 instances, REITs distribute excess dividends even when their EPS is negative. 20 The calculation is based on a per share basis. 27

Chapter 3 For more than half of these 102 observations, their current EPS is worse than that of the previous financial year. 52.94% 21 of the observations in the sample pay out excess dividend when EPS decreases. Table 3-3: Summary of Excess Dividend Payout when EPS < 0 before 2001 2001 and onward No. of observations 63 39 EPS decreases EPS increases EPS decreases EPS increases No. of observations 29 34 25 14 Percentage 46.03% 53.97% 64.10% 35.90% Source: Author s compilation Original Data Source: Standard & Poor s Compustat database &CRSP database Sample: 1570 observations for127 firms Period: 1985 2003 Table 3-4 shows the suation when EPS is posive. In nearly half instances (44.76% 22 ), REITs pay out excess dividend even when their current EPS is worse than that of the previous financial year. Table 3-4: Summary of Excess Dividend Payout when EPS >0 Payout ratio > 0.95 before 2001 Payout ratio > 0.90 2001 and onward No. of observations 787 254 EPS decreases EPS increases EPS decreases EPS increases No. of observations 341 446 125 129 Percentage 43.33% 56.67% 49.21% 50.79% Source: Author s compilation Original Data Source: Standard & Poor s Compustat database &CRSP database Sample: 1570 observations for127 firms Period: 1985 2003 21 (29+25)/ 102 * 100% =52.94% 22 (341+125)/ 1041 * 100% =44.76% 28

Chapter 3 From the results in Table 3-3 and Table 3-4, we can find that REIT managers pay out more excess dividend when EPS drops and distribute less excess dividend when EPS increase so as to maintain a stable total dividend payout for each period. The variation in total dividend may not match the actual variation in REIT s earning. During good times, the total dividend will reflect the high earning of a REIT. However, during bad times, the total dividend will not be a good indicator of the REIT s actual earning, because REIT managers strive to smoothen the total dividend compared to previous period. This dividend smoothing strategy may potentially distort the information content behind total dividends. On the other hand, high excess dividend payouts during bad times will reduce the cash flows in current period, which has a substantial effect on future cash flows and incomes. Therefore the analysis on excess dividends can give us a more accurate and practical view on future cash flow and profabily for REITs. 3.4 Summary This section begins wh a discussion about the special characteristics of REITs. Several reasons prove that the dividend policy study in REIT industry can overcome many obstacles that complicate previous studies. This also makes REIT industry become a good and interesting testing ground for information signaling theory and agency cost theory. As the dividend debate in this industry is more and more heated, the lerature review 29