THE IMPACT OF CREDIT RATINGS ON THE PROPERTY MARKET

Abstract

This study aims to provide insights regarding the role of credit ratings in a Real Estate Investment Trusts (REIT) cost of capital, an area which has been largely overlooked in the field of credit rating literature thus far. This is done by exploring the influence of credit ratings in 96 United States REITs, comprising both the equity and mortgage types over a sample period from 1994 Q1 to 2017 Q4. For the study, the dependent variables comprise both cost of equity and cost of debt because they determine the average cost a firm can borrow from the debt and equity markets. Utilizing both variables also allows for a comparison to determine different effects that control variables have on either source of financing. The main determinants of cost of capital are credit ratings, bond yields, profitability, leverage, market timing, firm size, REIT sector and market conditions. This paper adopts various aspects of credit ratings such as broad rating categories (Investment-Speculative-Vulnerable), micro ratings and rating changes across several multiple linear regression models to provide a holistic view of credit rating impacts. In addition, various proxies of other independent variables like firm size and profitability have been adopted to test the robustness of findings and identify variables specific to the property sector. It was found that credit ratings do indeed have a significant impact on a REITs cost of capital and results remain significant even after the inclusion of other control variables. Results have also shown that REIT managers should target specific minimum ratings as any worse-off rating would increase the cost of capital, implying that there are certain rating level cut-offs after which it is no longer worth having a rating. Last of all, the impact of credit rating downgrades was found to be negligible during a market downturn. Governmental actions lowering interest rates near zero during downturns decrease borrowing costs by such a significant amount that it overshadows the opposing effect of a credit rating drop.