The effect of capital structure on the profitability of listed real estate invesment trusts (reits) in the united kingdom from 2007 to 2014

THE EFFECT OF CAPITAL STRUCTURE ON
THE PROFITABILITY OF LISTED REAL
ESTATE INVESTMENT TRUSTS (REITS) IN
THE UNITED KINGDOM FROM 2007 TO 2014

By

TRAN VU DANG

Supervised by

Pamela Anderson

A dissertation submitted for the award of the degree of
Master of Finance

The University of Huddersfield
September 2015


ABSTRACT
The regulation for real estate investment trusts (REITs) in United Kingdom is
introduced in January 2007 with the expectation that the REITs will be the solution for
the scarcity of reasonably priced rental housing in UK and so many listed property firms
in UK chose to become REITs (Leone, 2011; Park, 2009). Many property companies have
chosen to convert to REITs or many new REITs have been established since 2007. The
objective of this study is to analyse the effect of capital structure on the profitability of
listed Real Estate Investment Trusts (REITs) in United Kingdom from 2007 to 2014.
A sample of 15 REITs in United Kingdom from 2007 to 2014 has been collected
from the database Osiris, which is the database provided by University of Huddersfield.
Short-term debt ratio, long-term debt ratio and total debt ratio will be used as the

indicators of capital structure of REITs in United Kingdom. Return on asset and return
on equity will be used as the indicators of profitability of REITs in United Kingdom.
This study finds out that there is a significant and negative effect of long-term
debt ratio and total debt ratio on return on asset of REITs in United Kingdom. There is
the negative effect of short-term debt ratio on return on asset; however, this effect is
insignificant. In addition, it also finds out that there is a significant and negative effect of
short-term debt ratio, long-term debt ratio and total debt ratio on return on equity of REITs
in United Kingdom. These results may indicates that REITs in United Kingdom should
use lest debt by reducing either short-term debt or long-term debt in order to increase their
profitability.

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ACKNOWLEDGEMENT
I would like to express my sincere gratitude to my supervisor Pamela Anderson
for her guidance, patience, motivation, and most importantly, her immense knowledge.
Her support in the learning sets helped me in all the time of research and writing of this
dissertation. I could not have imagined having a better supervisor for my master study.
I would also like to thank Kay Smith for her comments in the learning sets. Her
comments has contributed a lot to the writing of this dissertation. Finally, I would like to
thank the Business School, University of Huddersfield has supplied the research resources
like the Osiris database and the learning sets, which have helped me a lot in finishing this
dissertation.

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TABLE OF CONTENTS
ABSTRACT ....................................................................................................................... i

ACKNOWLEDGEMENT ................................................................................................ ii
LIST OF TABLES .......................................................................................................... vii
LIST OF FIGURES ....................................................................................................... viii
LIST OF ABBREVIATIONS .......................................................................................... ix
CHAPTER ONE: INTRODUCTION ..................................................................... 1
1.1. Background of the study ......................................................................................... 1
1.2. Research aims and objectives ................................................................................. 4
1.3. Structure of the study ............................................................................................. 4
CHAPTER TWO: LITERATURE REVIEW ......................................................... 5
2.1. Introduction ............................................................................................................ 5
2.2. The legislation of the Real Estate Investment Trusts (REITs) industry in United
Kingdom ........................................................................................................................ 5
2.3. Profitability of Real Estate Investment Trusts (REITs) in United Kingdom ......... 6
2.3.1. Previous studies about the indicators of profitability of Real Estate
Investment Trusts (REITs) .................................................................................... 6
2.3.2. Explanation of the choice return on asset (ROA) and Return on Equity
(ROE) as indicators of profitability of Real Estate Investment Trusts (REITs) in
United Kingdom .................................................................................................... 7
2.4. Capital structure of Real Estate Investment Trusts (REITs) in United Kingdom .. 8
2.4.1. Theories on capital structure of Real Estate Investment Trusts (REITs) .... 8
2.4.2. Explanation of the choice of short-term debt ratio (STDR) and long-term
debt ratio (LTDR) and total debt ratio (TDR) as indicators of capital structure of
Real Estate Investment Trusts (REITs) in United Kingdom ............................... 10
2.5. Previous studies on the relationship between short-term debt ratio (STDR) and
profitability of Real Estate Investment Trusts (REITs) ............................................... 12
2.5.1. Previous studies about the indicators of short-term debt ratio (STDR) .... 12
2.5.2 Previous studies about the relationship between short-term debt ratio
(STDR) on the return on asset (ROA) ................................................................. 12
2.5.3. Previous studies about the relationship between short-term debt ratio
(STDR) and return on equity (ROE) ................................................................... 13

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2.6. Long term debt ratio (LTDR) ............................................................................... 14
2.6.1. Previous studies about the indicators of long-term debt ratio (LTDR) of
Real Estate Investment Trusts (REITs) ............................................................... 14
2.6.2. Previous studies about the relationship between long-term debt ratio
(LTDR) and return on asset (ROA)..................................................................... 14
2.6.3. Previous studies about the relationship between long-term debt ratio
(LTDR) and return on equity (ROE) ................................................................... 15
2.7. Total debt ratio (TDR) ............................................................................................. 16
2.7.1. Previous studies about the indicators of total debt ratio (TDR) ................ 16
2.7.2. Previous studies about the relationship between total debt ratio (TDR) and
the return on asset (ROA).................................................................................... 17
2.7.3. Previous studies about the relationship between total debt ratio (TDR) and
return on equity (ROE) ........................................................................................ 18
2.8. Size as control variable ......................................................................................... 19
2.8.1. Explanation of choosing size as control variable ...................................... 19
2.8.2. Previous studies about the indicator of size of Real Estate Investment
Trusts (REITs) ..................................................................................................... 20
2.8.3. Previous studies about the relationship of size and return on asset (ROA)
............................................................................................................................. 20
2.8.4. Previous studies about the relationship between size and return on equity
(ROE) .................................................................................................................. 21
2.9. Conclusion ............................................................................................................ 21
CHAPTER THREE: RESEARCH DESIGN AND METHODOLOGY ................ 22
3.1. Introduction .......................................................................................................... 22
3.2. Research objectives and questions ....................................................................... 22
3.3. Research approach ................................................................................................ 22

3.4. Sample selection ................................................................................................... 23
3.5. Data collection methods ....................................................................................... 23
3.6. Data analysis ......................................................................................................... 24
3.6.1. Definition and measurement of variables.................................................. 24
3.6.2. Descriptive statistics .................................................................................. 25
3.6.3. Correlation coefficients ............................................................................. 26
3.6.4. Multicollinearity ........................................................................................ 26
3.6.5. Multivariate linear regression.................................................................... 27

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3.7. Hypothesis development ...................................................................................... 28
3.8. Conclusion ............................................................................................................ 29
CHAPTER FOUR: DATA ANALYSIS AND DISCUSSION ................................ 30
4.1. Introduction .......................................................................................................... 30
4.2. Descriptive statistics ............................................................................................. 30
4.2.1. Descriptive statistics of return on asset (ROA) and return on equity (ROE)
............................................................................................................................. 31
4.2.2. Descriptive statistics of short-term debt ratio (STDR), long-term debt ratio
(LTDR) and total debt ratio (TDR) ..................................................................... 33
4.2.3. Descriptive statistics of size ...................................................................... 37
4.3. Results of correlation and expected relationship between capital structure and
profitability of Real Estate Investment Trusts (REITs) in United Kingdom............... 38
4.3.1. Expected relationship between the indicators of capital structure and
return on asset as the indicator of profitability of Real Estate Investment Trusts
(REITs) in the United Kingdom .......................................................................... 39
4.3.2. Expected relationship between the indicators of capital structure and
return on equity (ROE) as the indicator of profitability of Real Estate Investment
Trusts (REITs) in United Kingdom ..................................................................... 39

4.4. Regression analysis and discussion of the effect of short-term debt ratio (STDR)
on the profitability of Real Estate Investment Trusts (REITs) in United Kingdom .... 39
4.4.1. Effects of short term debt ratio (STDR) on profitability of on return on
asset (ROA) ......................................................................................................... 39
4.4.2. Effect of short-term debt ratio (STDR) on return on equity (ROE) .......... 42
4.5. Effects of long-term debt ratio (LTDR) on profitability of Real Estate Investment
Trusts (REITs) in United Kingdom ............................................................................. 45
4.5.1. Effect of long- term debt ratio (LTDR) on return on asset (ROA) ........... 45
4.5.2. Effect of long-term debt ratio (LTDR) on return on equity (ROE) .......... 48
4.6. Effects of total debt ratio on profitability of Real Estate Investment Trusts
(REITs) in United Kingdom ........................................................................................ 51
4.6.1. Effect of total debt ratio (TDR) on return on asset (ROA) ............................... 51
4.6.2. Effect of total debt ratio (TDR) on return on equity (ROE)...................... 53
4.7. Size as control variable ......................................................................................... 56
4.7.1. Relationship between size and return on asset (ROA) .............................. 56
4.7.2. Relationship between size return on equity (ROE) ................................... 57
4.8. Hypothesis outcome ............................................................................................. 57

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4.9. Conclusion ............................................................................................................ 58
CHAPTER FIVE: RECOMMENDATIONS AND CONCLUSIONS ................... 60
5.1. Introduction .......................................................................................................... 60
5.2. Summary of the study ........................................................................................... 60
5.3. Limitations of the study ........................................................................................ 62
5.4. Recommendations for future studies .................................................................... 62
REFERENCE ....................................................................................................... 64
APPENDICES ...................................................................................................... 70
Appendix 1: Table of 40 listed REITs in UK from Osiris database ............................ 70

Appendix 2: Table of 28 listed REITs in UK chosen for the check of date of
becoming REITs in UK ............................................................................................... 72
Appendix 3: Table of 15 listed REITs in UK chosen for the study ............................ 73
Appendix 4: Table of explanation of how the variable is collected and calculated .... 74
Appendix 5: Table of raw data collected from Osiris ................................................. 75
Appendix 6: Table of the calculated data of variables used in the study .................... 75

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LIST OF TABLES
Table 4.1: Descriptive statistics of dependent and independent variables .................... 30
Table 4.2: Correlations between independent variables and dependent variables ......... 38
Table 4.3: Summary of model 1 .................................................................................... 40
Table 4.4: ANOVA of model 1 ..................................................................................... 40
Table 4.5: Result of the regression model 1 ................................................................... 41
Table 4.6: Summary of model 2 ..................................................................................... 42
Table 4.7: ANOVA of model 2 ...................................................................................... 43
Table 4.8: Result of the regression model 2 .................................................................. 44
Table 4.9: Summary of model 3 ..................................................................................... 45
Table 4.10: ANOVA of model 3 .................................................................................... 46
Table 4.11: Result of the regression model 3 ................................................................ 47
Table 4.12: Summary of model 4 ................................................................................... 48
Table 4.13: ANOVA of model 4 .................................................................................... 49
Table 4.14: Result of the regression model 4 ................................................................. 50
Table 4.15: Summary of model 5 ................................................................................... 51
Table 4.16: ANOVA of model 5 .................................................................................... 51
Table 4.17: Result of the regression model 5 ................................................................ 52
Table 4.18: Summary of model 6 ................................................................................... 54
Table 4.19: ANOVA of model 6 .................................................................................... 54

Table 4.20: Result of the regression model 6 ................................................................ 55
Table 4.21: Hypothesis outcome .................................................................................... 57

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LIST OF FIGURES
Figure 4.1: Normality histogram of ROA ...................................................................... 31
Figure 4.2: Normality histogram of ROE ...................................................................... 32
Figure 4.3: Normality histogram of STDR .................................................................... 33
Figure 4.4: Normality histogram of LDTR .................................................................... 34
Figure 4.5: Normality histogram of TDR ...................................................................... 35
Figure 4.6: Normality histogram of SIZE ...................................................................... 37

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LIST OF ABBREVIATIONS
REITs

: Real Estate Investment Trusts

ROA

: Return on asset

ROE

: Return on equity

STD

: Short-term debt

LTD

: Long-term debt

TD

: Total debt

STDR

: Short-term debt ratio

LTDR

: Long-term debt ratio

TDR

: Total debt ratio

UK

: United Kingdom

EBIT

: Earnings before interest and taxes

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CHAPTER ONE: INTRODUCTION

1.1. Background of the study
Over the last decade, there is a crucial rise of investment into the real estate
industry in the world, especially in the Real Estate Investment Trust (Park, 2009). The
Real Estate Investment Trust (REIT) is defined as “a security that sells like a stock on the
major exchanges and invests in real estate directly, either through properties or
mortgages” (Ciartano, 2012, p.32). In other words, it is an investment vehicle, which
allows the real estate shareholders to be like the shareholders in mutual funds (Park,
2009).
Each country has slightly different legislation on REITs but in common, the
REITs will be considered a different tax treatment; moreover, the shareholders usually
receive high return and considered it as a highly liquid way of investment in real estate
market (Alias & Soi, 2011; Ciartano, 2012). Although the REIT regime has been
introduced in the United States and many countries from 1960, the UK has to wait until
2007 to introduce its REIT legislation (Park, 2009). The UK property industry has
increased with this legislation (Alias & Soi, 2011).
There is also the increase in the interest in the capital structure of the real estate
firms because they have unique features, which are “safe and low risk stocks, with high
underlying collateral value” (Westgaard, Eidet, Frydenberg & Grosas, 2008). Moreover,
real estate firms in the UK has a distinctive operating environment with the existence of
a richer legislation of REITs (Westgaard et al., 2008). Westgaard et al. (2008) argued that
for the UK real estate firms choosing to become REITs, they would avoid the double
taxation and receive lower tax rate on financing with equity.
Feng, Ghosh and Sirmans (2007) indicate that REITs would not pay the corporate

tax if they distribute more than 90 percent of its profit as dividends. This will lead to the
nullification of the two crucial advantages of debt. The first one is the loss of tax
deductibility of interest (Feng et al., 2007). In addition, Howe and Shilling (1988) argue
that with the loss of the tax benefits, REITs will also have difficulty in the debt markets
because the other tax-paying firms, which have the tax deductibility on interest payment

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on debt and can afford for higher interest than REITs, will be preferred over REITs in the
debt markets. The second one is because of the distribution of most of its profits, the
“debt servicing is not critical in mitigating agency cost of free cash flow” and the value
of debt financing will be decreased by the financial distress costs (Feng et al., 2007, p.85).
In addition, the high dividend payout in the case of REITs also decreases the retained
earnings available for investment, which will limit the financing choice to debt or equity
(Feng et al., 2007).
Morri and Cristanziani (2009) argue that the high dividend payout also made
REIT difficult to keep “an adequate level of free cash flows able to finance possible future
positive NPV projects”. With the low level of free cash flow, in either the situation of
high profitability or low profitability, REITs have to use debt to finance their investment,
which will increase the leverage ratio of REITs (Morri & Cristanziani, 2009). In addition,
Baum and Devaney (2008) indicate that high gearing ratio could affect the volatility of
net income of REITs in UK. Net income is one of the factors in calculating return on asset
and return on equity, which can be used as the indicators of the profitability of REITs in
UK (Tang & Jang, 2008). Therefore, it can be indicated that the high gearing ratio could
affect the volatility of profitability of REITs in UK.
There are theoretical arguments to support both high and low gearing ratios.
Anwar & Ali (2014) imply that the relationship between capital structure and profitability
could be explained by some theories like trade-off theory or pecking-order theory.
According to the trade-off theory, REITs will tend to have a low debt ratio because REITs

do not have to pay corporate tax so they lose the benefits of the tax deductibility of
interest, which is a motivation for debt (Feng et al., 2007). Therefore, if REITs choose to
have high debt ratio, they will face the cost of financial distress, which will not be offset
by the value of the tax deductibility of interest. As a result, trade-off theory indicates that
REITs will tend to have a low debt ratio (Feng et al., 2007).
The pecking order theory argues that firms will finance through retained earnings
as the first choice, debt as the second choice and new equity as the final option (Abor,
2005). REITs paying out 90% of profits will decrease the retained earnings so the
financing choice of REITs is restricted to debt and equity (Feng et al., 2007). It is
indicated that the valuation of REITs is quite complicated; therefore, financing through
debt or retained earnings would be preferred over equity (Feng et al., 2007). In addition,

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although the benefits of the tax deductibility of interest payment of debt is removed,
pecking order theory argues that firms can still choose to use debt as the source of
financing because the firms want to avoid the probable discount of the value of new equity
due to the adverse selection and information asymmetry (Feng et al., 2007). Overall,
pecking order theory implies that REITs will choose debt over new equity; therefore,
REITs will have high leverage ratio (Feng et al., 2007).
Profitability is often affiliated with the internal cash flows available to the firms,
which indicate lower debt ratio (Feng et al., 2007). However, Feng et al. (2007) indicate
that there could be a positive association between leverage and profitability because
REITs will have to distribute most of its profit so they will not keep much cash. The high
leverage ratio of REITs is expected to have a positive impact on the profitability of REITs
only when the interest rate is low and real estate returns are high; however, it will be
uncertain when the interest rates increase and the profit margins reduce during the
decreasing markets (Park, 2009). It can be seen that there is a mixed prediction on the
impact of capital structure on the profitability of REITs.

Most of the studies in the relationship between capital structure and profitability
are often focusing on analysing the effect of profitability on capital structure of the
companies or profitability as the determinant of capital structure of REITs like the study
of Morri and Beretta (2008) and the study of Chikolwa (2011). There are some researches
in analysing the effect of capital structure on the profitability of listed companies like the
study of Abor (2005), the study of Anwar and Ali (2014), the study of Claudiu (2013),
the study of Mehdi, Farimah, Forough, Seyed and Jamshid (2013) and the study of Salawu
(2009). However, few studies have been done in analysing the effect of capital structure
on the profitability of listed Real Estate Investment Trusts (REITs) in United Kingdom.
Other literatures discuss the effect of capital structure on profitability of other industries
but REITs industry is different from other industries and the REITs’s legislation in UK is
quite different as well so there is a need for more attention and research to investigate that
effect in the UK REITs. Therefore, this study will analyse the effect of capital structure
on the profitability of REITs in United Kingdom.

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1.2. Research aims and objectives
The objective of this study is to analyse the effect of capital structure on the
profitability of listed Real Estate Investment Trusts (REITs) in United Kingdom from
2007 to 2014.
1.3. Structure of the study
This study will consist of the following chapters.
Chapter One is the introduction, which will present the background of the research and
its objective.
Chapter Two is the literature review, which will review the prior studies relating to
profitability and capital structure of REITs in United Kingdom
Chapter Three is the research design and methodology, which will explain how the data
is collected and the methodology is used to analyse the data.

Chapter Four is data analysis and discussion, which will present the analysis and
discussion of the results.
Chapter Five is conclusions and recommendations, which will provide the main lessons
learnt from this research and indications that need for further research.

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CHAPTER TWO: LITERATURE REVIEW

2.1. Introduction
This chapter of the study will review the previous literatures, which are related to
this area, to include them into the research with the aim of achieving the objectives of this
study.
Since the purpose of this research is to examine the effect of capital structure on
the profitability of listed real estate investment trusts in United Kingdom, the second part
of this chapter will present the overview of legislation of the REITs industry in United
Kingdom. In the third part, previous literatures about the profitability of REITs in United
Kingdom will be presented. The fourth part will present the previous studies on the capital
structure. The fifth, sixth and seventh part will present the literature review on the
relationship of the indicators of capital structure and the profitability of REITs in United
Kingdom. The eight part will present previous studies about size as control variable. The
final part will be the conclusion of this chapter.
2.2. The legislation of the Real Estate Investment Trusts (REITs) industry in
United Kingdom
The regulation for UK real estate investment trusts (REITs) is introduced in
January 2007 with the expectation that the REITs will be the solution for the scarcity of
reasonably priced rental housing in UK and so many listed property firms in UK chose to
become REITs (Leone, 2011; Park, 2009). Although the introduction of REITs legislation
in UK is later than other countries but the UK REITs sector quickly becomes the largest

real estate securities sector in Europe and the fourth largest in the world in terms of size
and market capitalization (Alias & Soi, 2011; Liow, 2010). When becoming a REITs in
UK, they have to distribute more than 90 percent of its profits as dividends so the REITs
in UK will not pay the corporate tax (Gaut, Featherstone, Heilpern, & John, 2006; Park,
2009). In addition, the REITs in UK are also required to satisfy the interest cover test
which the interest cover ratio must be higher than 1.25 (Alias & Soi, 2011; Gaut et al.,
2006). The interest cover ratio is the ratio of profit divided by the financing cost (Alias &
Soi, 2011; Gaut et al., 2006). The aim of this test is that the REITs in UK will be not
allowed to have high leverage ratio, “or at least subject to finance costs which reduce the

5


amount of profits available for distribution to shareholders” (Luck & Cant, 2008, p.4;
Park, 2009 ). The reason for this restriction on leverage ratio of REITs in UK is because
the high gearing ratio of REITs is argued to increase the profitability when there is low
interest rate and high real estate returns; however, it will be uncertain when the interest
rates increase and the profit margins reduce during the decreasing markets (Park, 2009).
Luck and Cant (2008) show that this test does not restrict the money that REITs
in UK want to borrow, however, the REITs in UK will be charged a tax if they violate the
test. This mean the ratio will indirectly not let the gearing ratio of UK REITs to be high
or exceed more than 80% (Alias & Soi, 2011; Gaut et al., 2006; Park, 2009). However, if
the UK REITs do not satisfy the interest cover test and have the interest cover ratio less
than 1.25 or they have the leverage ratio more than 80 %, the UK REITs, they will be
fined by being charged on tax in accordance to the excess of debt (Alias & Soi, 2011).
Park (2009) argues that the limitation on the legislation of REITs in UK is a crucial factor,
which affected on the decrease of market value of REITs in UK. Furthermore, some UKREITs started “trading at discounts to net asset value” (Park, 2009, p.6).
Overall, it can be seen that the REITs will not pay corporate tax if they distribute
more than 90 percent of its profits as dividends and they satisfy with the interest cover
test; (Alias & Soi, 2011; Gaut et al., 2006; Park, 2009). However, these legislations reduce

the retained earnings and restrict the level debt ratio, which may have impact of the
profitability of REITs (Bers & Springer, 1997).
2.3. Profitability of Real Estate Investment Trusts (REITs) in United Kingdom
2.3.1. Previous studies about the indicators of profitability of Real Estate
Investment Trusts (REITs)
There are different views on the indicators of profitability of REITs. Tang and
Jang (2008) indicate that return on asset (ROA) and return on equity (ROE) could be used
as the indicators of profitability of REITs. Similarly, Ho, Rengarajan, and Lum (2013)
also use ROA and ROE as the indicators of the profitability of REITs.
On the other hand, Morri and Beretta (2008) only use return on asset, which is
calculated by dividing EBIT to total assets. Similarly, Morri and Cristanziani (2009) use
return on asset, which is the ratio of earnings before interest and taxes (EBIT) divided by
total asset, to measure the profitability of European REITs. Rovolis and Feidakis (2014)

6


also use the ratio of earnings before interest and taxes (EBIT) divided by total asset to
measure the profitability of REITs.
Zarebski and Dimovski (2012) only use return on equity, which is calculated as
net income or net profit after interest and tax divided by total equity to measure for the
profitability of REITs in Australia. Similarly, Ambrose, Highfield and Linneman (2005)
also use return on equity as the measure the profitability of REITs in the United States,
which is calculated as the ratio of net income divided by total equity. To measure for the
profitability of listed firms in Malaysia, Salim and Yadav (2012) also use return on equity,
which is calculated as the ratio of the net income divided by total equity.
Overall, it can be seen that some studies use ROA or ROE while some studies
uses both ROA and ROE as the indicators of the profitability of REITs. ROA and ROE
are two main indicators of the profitability of REITs.
2.3.2. Explanation of the choice return on asset (ROA) and Return on Equity

(ROE) as indicators of profitability of Real Estate Investment Trusts (REITs) in
United Kingdom
According to Tang and Jang (2008), return on asset indicates the profitability of a
firm in related to its total assets, which include equity and liability, while return on equity
indicates the profitability of a firm relative to its equity. Therefore, a company with
higher leverage ratio will probably have higher profitability with the same amount of
return if using ROE as the indicator of profitability (Tang & Jang, 2008). Therefore, it is
argued that ROE could a better measure for the profitability of the firms in analysing the
effect of capital structure on the profitability (Tang & Jang, 2008). In addition, Gatsi
(2012) argues that return on equity will imply the amount of the profit that will be given
to shareholders, who are extremely interested in the value maximization of the firms.
REITs have to distribute most of its profit to shareholders so shareholder will be more
concerned of the profit distributed (Feng et al., 2007). Therefore, ROE is another
important indicator of profitability of REITs in United Kingdom.
Tang and Jang (2008, p.618) use return on asset as the indicator for profitability
because their study wants to measure the profitability of hotel REITs and ROA can reflect
“management’s effectiveness in utilizing all available assets to create profit”. This
research will investigate the whole REITs sector in UK, which includes the hotel REITs

7


and other REITs sector, and the effect of capital structure on the profitability of REITs in
UK; therefore, both ROA and ROE will be used as the indicators for the profitability of
REITs in UK.
2.4. Capital structure of Real Estate Investment Trusts (REITs) in United
Kingdom
2.4.1. Theories on capital structure of Real Estate Investment Trusts (REITs)
The capital structure of a company is about the how the company uses the debt,
equity to finance for its business (Abor, 2005). Bers and Springer (1997) argue that the

level of gearing will have the effect on the profitability of REITs. The two main theories
on capital structure are the trade-off theory and pecking order theory, which support both
high and low level of gearing (Anwar & Ali, 2014; Morri & Beretta, 2008).
2.4.1.1. Trade-off theory
According to the trade-off theory, REITs will tend to have a low debt ratio because
REITs do not have to pay corporate tax so they lose the benefits of the tax deductibility
of interest, which is a motivation for debt (Feng et al., 2007). Therefore, if REITs choose
to have high debt ratio, they will face the cost of financial distress, which will not be
offset by the value of the tax deductibility of interest. As a result, trade-off theory
indicates that REITs will tend to have a low debt ratio (Feng et al., 2007).
Ertugrul and Giambona (2011) also indicate that REITs will tend to have a low
debt ratio because the underlying assumption of pecking order theories and trade-off
theory are weakened in part by the legislation requirement of REITs. For instance, REITs
will distribute most of its profits as dividends and it will not have to pay the corporate
tax. Otherwise, dead weight costs are involved with the financial distress so the trade-off
theory would say that REITs would have zero leverage ratio (Ertugrul & Giambona,
2011). However, the leverage ratio average of REITs in practice are approximately 45%,
which are twice the average leverage ratio of manufacturing companies (Ertugrul &
Giambona, 2011; Faulkender & Petersen, 2006). Similarly, Morri and Beretta (2008)
argue that there is no empirical evidence in the REITs sector to support the trade-off
theory; therefore, there is not clear association between leverage and profitability. Morri
and Beretta (2008, p.24) indicate that with the trade-off theory, the gearing will lead to
an increase in the likelihood of the bankruptcy and it let the companies to reduce “interest
expenses from taxable income, thus making convenient for highly profitable firms to take

8


on large amounts of debt”. However, REITs do not have to pay tax so debt will not force
the high-quality companies to have higher gearing ratio (Morri & Beretta, 2008).

Overall, it can be seen that different studies have different views on the application
of the trade-off theory in explaining the capital structure of REITs. Ertugrul and
Giambona (2011) and Feng et al. (2007) argue that REITs will tend to have a low debt
ratio. On the other hand, Ertugrul and Giambona (2011) and Morri and Beretta (2008)
indicate that trade-off theory is limited in applying for analysing the capital structure of
REITs as there is no empirical evidence in the REITs sector to support the trade-off
theory.
2.4.1.2. Pecking order theory
The pecking order theory argues that firms will finance through retained earnings
as the first choice, debt as the second choice and new equity as the final option (Abor,
2005). This also means that when the retained earnings are not enough, the firms will
prefer debt to equity (Mehdi et al., 2013).
REITs paying out 90% of profits will decrease the retained earnings so the
financing choice of REITs is restricted to debt and equity (Feng et al., 2007). It is
indicated that the valuation of REITs is quite complicated; therefore, financing through
debt or retained earnings would be preferred over equity (Feng et al., 2007). In addition,
although there benefits of the tax deductibility of interest payment of debt is removed,
pecking order theory argues that firms can still choose to use debt as source of financing
because the firms want to avoid the probable discount of the value of new equity due to
the adverse selection and information asymmetry (Feng et al., 2007). Overall, pecking
order theory implies that REITs will choose debt over new equity; therefore, REITs will
have high leverage ratio (Feng et al., 2007).

According to Myers (1984, cited in

Ooi,1999b, p. 469), the pecking order theory also argues that using more debt will lead
to lower profitability so REITs is expected to have lower profitability when using more
debt. Overall, the pecking order theory indicates that REITs is expected to have high
leverage ratio, which will result to low profitability.
On the other hand, Ertugrul and Giambona (2011) argue that the pecking order

theories is limited in applying for analysing the capital structure of REITs like the tradeoff theory. This theory’s fundamental assumption is that outsider investor will have less
knowledge of company’s investment opportunities than its management (Ertugrul &

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Giambona, 2011). As a result, the manager will tend to finance new projects with equity
when equity is believed to be overvalued (Ertugrul & Giambona, 2011). Nevertheless,
the adverse selection is diminished for REITs because the requirement of payout more
than 90 percent of its profits as dividends restrict REITs’s access to internal funding
(Ertugrul & Giambona, 2011). As a result, the “external equity financing should be less
constrained for them” (Ertugrul & Giambona, 2011, p. 508). In conclusion, the pecking
order theory is unable to analyse why REITs will have high gearing ratio because REITs
are required to distribute most of their earnings as dividends so REITs have a very small
amount of retained earnings (Ertugrul & Giambona, 2011).
Overall, it can be seen that different studies have different views on the pecking
order theory. Feng et al. (2007) argue that pecking order theory predicts that REITs is
expected to have high leverage ratio, which will result to low profitability. Ertugrul and
Giambona (2011) argue that the pecking order theories is limited in applying for analysing
the capital structure of REITs like the trade-off theory.
2.4.2. Explanation of the choice of short-term debt ratio (STDR) and long-term
debt ratio (LTDR) and total debt ratio (TDR) as indicators of capital structure of
Real Estate Investment Trusts (REITs) in United Kingdom
The first reason that this study use short-term debt ratio (STDR) and long-term
debt ratio (LTDR), total debt ratio (TDR) as indicators of capital structure of Real Estate
Investment Trusts (REITs) in United Kingdom is because REITs with different
characteristics will have different level of short-term debt, long-term debt and total debt.
It is indicated that two sources of debts for property companies in UK are short-term debt
and long-term debt (Ooi, 1999a). Listed firms in property sector in UK with bigger size
will tend to use more long-term debt while firms with smaller size will tend to use more

short-term debt (Ooi, 1999a).
On the other hand, Ertugrul and Giambona (2011) argue that there are normal two
kinds of REITs’s capital structure in the retail property sector. The safer REITs will
choose to adopt capital structure with more long-term debt so the cash flows will be more
stable but there will be fewer chances for them to take advantage of the possible market
conditions in the future, which favours them (Giambona et al., 2008, cited in Ertugrul, &
Giambona 2011, p. 507). Unlike the safer ones, the aggressive REITs tend to adopt capital
structure with more short-term debt, which will bear more unstable or volatile cash flows

10


because they will have to renegotiate the rental contracts more often (Ertugrul, &
Giambona 2011). However, the aggressive REITs can have more chances to take
advantage of the possible market conditions in the future, which favours them (Ertugrul,
& Giambona 2011). The aggressive REITs are anticipated to have higher leverage than
the safer ones (Maksimovic & Zechner, 1991). Overall, it can be seen that there will be
some REITs tend to use more short-term debt while there will be some REITs tend to use
more long-term debt. Therefore, there is a need to analyse how short-term debt or longterm debt affects on the profitability of REITs in United Kingdom.
The second reason that this study use short-term debt ratio (STDR) and long-term
debt ratio (LTDR), total debt ratio (TDR) as indicators of capital structure of Real Estate
Investment Trusts (REITs) in United Kingdom is because there is the gap of previous
literature of not focusing on analysing the effect of capital structure on the profitability
of REITs. Most of the studies investigating that profitability as the determinant of the
capital structure in REITs use total debt ratio as the main indicator for capital structure of
REITs (Erol & Tirtiroglu, 2011; Ghosh, Giambona, Harding, & Sirmans, 2011; Morri &
Cristanziani, 2009). On the other hand, studies investigating the effect of capital structure
on profitability use total debt ratio, short-term debt ratio and long-term ratio as the
indicators for capital structure of listed companies, which have sample size including all
industries and not focusing on REITS (Abor, 2005; Gatsi, 2012; Salim & Yadav, 2012).

Moreover, Ooi (1999a) implies that not only the total debt but also the use of short-term
debt and long-term debt of firms in property sector has changed a lot over years.
Giambona, Harding and Sirmans (2008) argue that REITs that have high total debt ratio
will tend to have high long-term debt ratio while REITs that have low total debt ratio will
tend to have high short-term debt ratio. It can implied that if REITs have high total debt
ratio and there is an effect of total debt ratio on profitability of REITs, there could be also
an effect of long-term debt ratio on the profitability of REITs. On the other hand, if REITs
have low total debt ratio and there is an effect of total debt ratio on profitability of REITs,
there could be also an effect of short-term debt ratio on the profitability of REITs.
Therefore, there is a need to analyse the short-term debt ratio and long-term debt ratio to
understand the effect of capital structure on profitability of REITs in United Kingdom.
In order to fill the gap of previous literature of not focusing on analysing the effect
of capital structure on the profitability of REITs, this study will examine the impacts of

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total debt ratio, short-term debt ratio and long-term ratio, which will be used as the
indicators for capital structure, on the profitability of REITs in UK. In addition, not only
the previous literatures about the relationship between total debt and profitability of
REITs but also previous literatures about impacts of total debt ratio, short-term debt ratio
and long-term ratio on the profitability of all listed companies will also be reviewed
because REITs is listed company and also included in the sample of the literatures of
listed companies (Abor, 2005; Gatsi, 2012; Salim & Yadav, 2012).
2.5. Previous studies on the relationship between short-term debt ratio (STDR) and
profitability of Real Estate Investment Trusts (REITs)
2.5.1. Previous studies about the indicators of short-term debt ratio (STDR)
Short-term debts are debts that have the maturity less than one year (Fosberg,
2012). Morri and Beretta (2008) calculate short-term debt ratio of REITs by dividing
short-term debt to total assets. Capozza and Seguin (2001) also use ratio of short-term

debt divided by total assets as the short-term debt ratio of REITs. Similarly, Lim and Sing
(2014) also use ratio of short-term debt divided by total assets as the short-term debt ratio
of REITs in three Asian countries, which are Hong Kong, Japan and Singapore.
2.5.2 Previous studies about the relationship between short-term debt ratio
(STDR) on the return on asset (ROA)
There are many studies finding a negative relationship between short-term debt
ratio and return on asset of REITs (Chikolwa, 2011; Morri & Beretta, 2008). These
results indicates that REITs choose to use short-term debt will have lower profitability
measured by return on asset. In addition, the negative relationship between short-term
debt and return on asset can be explained by the argument that REITs do not have to pay
tax so they will lose the benefits of tax shield of using debt (Feng et al., 2007). Therefore,
there will be interest payment as the cost of using short-term debt. This means using more
short-term debt will result to lower profitability measured by return on asset because there
will more costs associated with more short-term debt (Claudiu, 2013).
Chikolwa (2011) indicates that there is a negative relationship between short-term
debt and return on asset for listed REITs in Australia from 2003 to 2008. Similarly, Morri
and Beretta (2008) find out that there is a negative relationship between short-term debt
and return on asset of REITs in US from 2002 to 2005. The similarity for the negative
relationship between short-term debt and return on asset of REITs in two different

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countries could be because both use the same formula for the indicators of short-term debt
ratio and return on asset. In addition, the size of REITs market in Australia is nearly the
same the size of REITs market in the United States (Newell & Peng, 2009).
There are also other studies indicating about the negative relationship between
long-term debt ratio and return on asset of listed companies, which include REITs in their
sample. Salim and Yadav (2012) find a significant negative relationship between shortterm debt ratio and return on asset of listed firms in property sector in Malaysia from
1995-2011. Similarly, Ebaid (2009) also shows that short-term debt ratio will negatively

affect the return on asset of listed companies in Egypt from 1997 to 2005. Olokoyo (2013)
also finds that there is a negative relationship between short-term debt ratio and return on
asset of listed companies in Nigeria from 2003 to 2007.
This similarity between studies focusing only on REITs and studies including
REITs in their sample could be because use the same measure for the short-term debt
ratio and return on asset and the listed companies also include REITs (Chikolwa, 2011;
Ebaid, 2009; Morri & Beretta, 2008; Olokoyo, 2013; Salim & Yadav, 2012).
2.5.3. Previous studies about the relationship between short-term debt ratio
(STDR) and return on equity (ROE)
Salim and Yadav (2012) find a negative relationship between short-term debt ratio
and return on equity of listed firms in property sector, which includes REITs in the
property sector, in Malaysia from 1995-2011. This result indicates that REITs in the
property sector in Malaysia choose to use short-term debt will have lower profitability
measured by return on equity. The negative relationship between short-term debt and
return on equity can be explained by the argument that REITs do not have to pay tax so
they will lose the benefits of tax shield of using debt (Feng et al., 2007). Therefore, there
will be interest payment as the cost of using debt. This means using more short-term debt
will result to lower profitability measured by return on equity because there will more
costs associated with more debt (Claudiu, 2013).
It is indicated by many studies that there is a negative relationship between shortterm debt ratio and return on equity of listed companies, which include listed REITs
(Ebaid, 2009; Olokoyo, 2013). Ebaid (2009) shows that short term debt ratio will
positively affect the return on equity of listed companies in Egypt, which include REITs
in its sample, from 1997 to 2005. Olokoyo (2013) finds that there is a negative

13


relationship between short-term debt ratio and return on equity of listed companies in
Nigeria from 2003 to 2007. On the other hand, Abor (2005) indicates that there is a
significantly positive relationship between return on equity and short-term debt ratio of

listed companies in Ghana. The potential reason for the difference in the result of the
study of Abor (2005) with other studies could be because it is argued that the short-term
debt in Ghana may be cheaper than other countries with lower interest rate; therefore,
using more short-term debt could lead to higher return on equity.
2.6. Long term debt ratio (LTDR)
2.6.1. Previous studies about the indicators of long-term debt ratio (LTDR) of Real
Estate Investment Trusts (REITs)
Long-term debts are debts that will be paid off more than one year (Fosberg,
2012). Morri and Beretta (2008) calculate long-term debt ratio of REITs by dividing longterm debt to total assets. Similarly, Lim and Sing (2014) also use ratio of long-term debt
divided by total assets as the long-term debt ratio of REITs. Harrison, Panasian and Seiler
(2011) use ratio of long-term debt to total asset as the measure for the long-term debt ratio
of REITs. Capozza and Seguin (2001) also use ratio of long-term debt divided by total
assets as the long-term debt ratio of REITs.
2.6.2. Previous studies about the relationship between long-term debt ratio (LTDR)
and return on asset (ROA)
Morri and Beretta (2008) also find out that there is a negative and significant
relationship between long-term debt and return on asset of REITs in US from 2002 to
2005. This finding indicates that if REITs finance their operation through long-term debt,
their profitability measured by return on asset will decrease. The negative relationship
between long-term debt and return on asset can be explained by the argument that REITs
do not have to pay tax so they will lose the benefits of tax shield of using long-term debt
(Feng et al., 2007). Therefore, there will be interest payment as the cost of using longterm debt. This means using more long-term debt will result to lower profitability
measured by return on asset because there will more costs associated with more longterm debt (Claudiu, 2013).
Erol and Tirtiroglu (2011) find similar results for the relationship between longterm debt ratio and return on asset of Turkish REITs in the period from 1998 to 2007,
which is measured by the ratio of net income before interest and taxes over total assets.

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There is a negative but insignificant relationship between long-term debt ratio

profitability of Turkish REITs; however, it is insignificant (Erol & Tirtiroglu, 2011). The
difference in the results could be because Turkey may have the different legislation of
REITs as the United States. The Turkish REITs do not have to pay corporate tax like the
REITs in the United States; however, the Turkish REITs are not required to distribute
dividends (Erol & Tirtiroglu, 2011; Morri & Beretta, 2008).
There are also other studies indicating about the relationship between long-term
debt ratio and return on asset of listed companies, which include REITs in their sample.
Liow (2010) argue that in real estate industry in general, the capital structure, which is
measured by the ratio of long-term debt divided by total asset, negatively affect the
profitability of 24 real estate companies in Asia, Europe and North America in the period
of 2000 to 2006, which is measured by the return on asset. Salim and Yadav (2012) find
a negative relationship between long-term debt ratio and return on asset of listed firms in
property sector in Malaysia from 1995 to 2011. Ebaid (2009) shows that long-term debt
ratio will negatively affect the return on asset of listed companies in Egypt, which include
REITs in its sample, from 1997 to 2005. Olokoyo (2013) finds that there is a negative
relationship between long-term debt ratio and return on asset of listed companies in
Nigeria from 2003 to 2007. According to Booth et al. (2001), there is negative relationship
between long-term debt ratio and return on asset as the indicator of the profitability of
listed companies.
The similarity in the findings of studies focusing only on REITs (Erol &
Tirtiroglu, 2011; Morri & Beretta, 2008) and studies including REITs in its sample
(Ebaid, 2009; Liow, 2010; Salim & Yadav, 2012) and could be because both use the same
ration for long-term debt ratio and return on asset. In addition, the real estate industry or
all listed companies include the REITs and the period of investigation is nearly the same.
2.6.3. Previous studies about the relationship between long-term debt ratio (LTDR)
and return on equity (ROE)
Salim and Yadav (2012) find a significant negative relationship between longterm debt ratio and return on equity of listed firms in property sector, which includes
REITs in the property sector, in Malaysia from 1995-2011. The negative relationship
indicates that when REITs in property sector in Malaysia finance through long-term debt,
their profitability measured by return on equity will decrease. The negative relationship

15