LEVERAGE IN REAL ESTATE INVESTMENT TRUSTS : THE OPTIMAL LEVERAGE LEVEL

Abstract

This research hypothesizes that an optimal leverage level for real estate investments is attained where the marginal increase in expected return of a unit of extra risk from leverage equals the marginal cost for that extra risk. We test this hypothesis with data on Singapore Real Estate Investment Funds (REITs) and their respective portfolios of direct real estate investments from 2002 to 2011. Based on an optimal leverage ratio equation derived from the capital asset pricing model, the expected returns are computed and compared with the actual performance of REITs. Based on whether ex-post REITs returns exceed, meet, or underperform the expected returns, the REITs are classified into the three sub groups and the selected independent variables are tested in multiple regressions relationships of the actual returns and the robustness of the analysis is tested by conducting a regression of the difference between the expected and actual return with the same independent variables. Finally, the second order of the optimal leverage level is derived to explain the variation between the actual and expected return. The optimal leverage is thus concluded to be a combination of both the optimal leverage level equation as well as the convexity equation.