Debt diversification in the European listed real estate companies

European listed real estate investment companies have traditionally relied on bank lending, whereas the use of alternative funding sources has remained modest. After the global financial crisis (GFC), European listed real estate companies have started to diversify their debt sources more.

Ranoua Bouchouicha
Heidi Falkenbach
Alexey Zhukovskiy
This raises the question whether the companies benefit from diversified debt structures, especially when the main lending source is shrinking. In this regard, we have analysed whether debt diversification (the diversification of the company’s debt into several sources and instruments of debt) has a material effect on the firm’s performance. More specifically, we have looked into how debt diversification affects the company’s cost of debt, as well as its investment activity.

Debt diversification: From private to public

We analysed the changes in debt structures of 102 European listed real estate companies, constituents of the EPRA Developed Europe Index, during the period from 2001 to 2016. Figure 1 illustrates the development of the average use of various debt sources over the examined period. Private borrowing has remained the most important source of financing for the listed real estate companies, even though its relative role is decreasing. The maximum relative usage of private borrowing coincided with peaks of economic crises in 2001 and 2008. After both crises, private borrowing declined, increasing the volumes of borrowings from capital markets. At the end of the period, the average share of private borrowings constituted 70%, the average share of the borrowings from capital markets was 22% and the shares of other debt sources, such as capital leases, convertible debt and money market instruments, were below the 5% level, having remained relatively stable over the whole examined period.
Figure 1: Use of different debt types by European listed real estate companies from 2001 to 2016
To analyse the effects of these changes on company performance, we created a debt specialisation measure based on the Herfindahl-Hirschman Index (HHI). The development of debt diversification is illustrated in Figure 2, where higher values of HHI correspond to a lower degree of debt diversification. After the early 2000s recession as well as the GFC, there was a notable trend for increasing debt diversification due to an increase in public borrowings (both bonds and money market instruments). The variation in debt diversification between companies is, however, large. Almost one-third of companies in our sample borrow using just one type of debt, typically private loans, indicating that the majority of the companies have not yet benefited from debt diversification.
Figure 2 : Debt specialisation of European REITs and REOCs from 2001 to 2016

Implications of debt diversification for company performance

Our analysis of the relationship between debt diversification and performance metrics has shown that in the presence of credit supply constraints, debt diversification is associated with a lower cost of debt for the European listed real estate companies. In particular, one standard deviation increase in debt diversification level is associated with a 0.3 percentage point decrease in the cost of debt.
A second important metric affected by the degree of debt diversification is the degree of investment activity. Listed real estate companies, and especially REITs, are dependent on debt financing in their acquisitions due to their limited ability to generate capital internally. Having a diversified debt structure could lead to competitive advantages if the companies are able to seize opportunities when their competitors face credit constraints. Our analysis of the relationship between debt diversification and investment ratios of the companies has shown that in the presence of credit constraints, companies with a more diversified debt structure have significantly higher investment ratios. A company with just one source of debt on average would have a 2.4 percentage point lower investment ratio than its peer with a perfectly diversified debt structure.
To conclude, from a company management point of view, a diversified debt structure provides benefits to listed real estate companies through lower costs of debt and independence from single lending source. From an investor perspective, investing in real estate companies with a diversified debt structure is advantageous since they have a better ability to seize investment opportunities, particularly in the presence of tight credit supply.