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Real Estate Investment and Leverage: In Good Times and in Bad

Working paper #764
Andrey D. Pavlov, Eva Steiner and Susan M. Wachter

The recent real estate bubble was arguably facilitated by the ready availability of low-cost debt underwritten at ever-increasing loan-to-value ratios. It has been asserted that sustained growth in leverage reflects myopia and irrational optimism amongst financial managers. We argue, however, that this rationale fails to take into account the incentives to managerial borrowing decisions induced by the fact that real estate debt can be collateralised against specific assets, rather than the firm overall. We derive a set of empirically testable hypotheses surrounding a rational strategy for pessimistic managers to increase non-recourse, asset-backed leverage in anticipation of a significant downward correction in underlying asset values. This strategy allows managers to reduce equity exposure to market declines in some sectors or regions, while protecting the remainder of the firm’s asset base. We find empirical evidence consistent with this hypothesis in a sample of listed US real estate investment firms. Consistent with our rationale, we also find that pessimistic borrowing is insensitive to the cost of debt, uses shorter maturities, and is inversely related to future investment, suggesting that pessimistic borrowing is indeed focused on recovering equity. WORK IN PROGRESS – DO NOT CITE

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