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The Corporate Wealth Effect: From Real Estate Shocks (...)

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The Corporate Wealth Effect: From Real Estate Shocks to Corporate Investment

Thomas Chaney, David Sraer, David Thesmar

In the presence of financial frictions, the value of a firm’s collateral plays a key role in determining the amount a firm can borrow, and the projects it can invest in. In spite of an important theoretical literature, there is scant evidence on the role of collateral in determining corporate investment.

This paper attempts to understand how firms transform capital gains on their real estate into additional collateral and investment. This paper investigates the effect of corporate wealth shocks on capital structure.

The study was based on a sample of 21,122 US firms and a total of 185,300 firm year observations. The real estate prices are measured both at the level of the state and of the Metropolitan Statistical Area (MSA), where the firm’s headquarters are located.

The first main regression model explores the consequences of variation in real estate prices on investment policy. Investment policy proxied by the ratio of investment to previous year capital stock is regressed upon variables of real estate ownership, measures of normalized real estate prices in state, ratio of cash flow to assets, lagged market to book value of assets, firm age, capital intensity, cash flows, firm profitability measures, Tobin q, personal income in state, firm fixed effect and state year dummies (to capture firm specific shocks). The second model measures the effect of an increase in land value on debt issues. The final model relates corporate governance to investment quality proxied by return on assets.

The results signify that firms transform capital gains on land into new investment. Firms invest more when their land value increases. Instead of selling the land, they finance this additional investment by issuing new debt. Increased land value seems to decrease the risk and asymmetric information attached to these new loans. New debt contracts are more long term, more likely to be syndicated, and are less likely to include covenants protecting the creditors. Such a relaxation of financing constraints reduces average profitability of capital for firms whose shareholders are weak and increases it for firms with strong shareholders. The real estate inflation has a positive and significant impact on the investment behavior.

The results also reveal that more liquid assets (or more redeployable assets) are financed with loans of longer maturities and durations. The results also suggest that while firms with sound corporate governance do not translate a positive collateral shock into higher performance, profitability declines among badly governed ones. Measures of corporate governance therefore seem to entail informational content about a firm’s ability to transform financing into value.

Large exogenous shifts in the value of shareholder’s equity have sizeable effects on corporate demand for equipment goods. Such a “corporate wealth effect” might explain how purely financial stocks generate persistent macroeconomic fluctuations. In a normative sense, positive shocks to land value alleviate financing constraints. Holding real estate on the balance sheet may provide a useful corporate hedging instrument. The analysis suggest that firms should benefit more from holding land if their returns are less correlated with their liquidity needs.

http://www.haas.berkeley.edu/groups/finance/chaney_sraer_thesmar.pdf

 

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