Debt capacity of Real Estate Collateral

Real Estate Investment Trusts (REITs) pay no corporate taxes, yet surprisingly, their average leverage ratio is more than twice that of taxable firms (46% vs. 20%). We develop and test a model that helps explain this puzzle. The primary result of the model is that credit constrained firms' assets tangibility is positively related to their leverage. We test the relation on a large sample of COMPUSTAT firms because they invest in both real estate and other tangible assets. We find a significant positive relation between tangibility and leverage, which is strongest for real estate collateral (land & building). Furthermore, we find that the relation holds only for credit constrained firms, consistent with our theoretical prediction. The implication is that, compared to other assets like machinery, real estate can improve a firm's borrowing capacity, therefore, knowing the composition of a firm's tangible assets is important in understanding its leverage.