infonet-economy

Given a firms investment policy, its dividend policy is irrelevant (Miller and Modigliani (1961)). REITs, by law, pay at least 90 % of their corporate income as dividends, so that their dividend policy is given. This is a reversal of the dividend irrelevance theorem through regulatory means. Such a high dividend payment also means lower retained earnings, leaving firms with little free cash flow. Jensen (1986) argues that lower free cash flow results in mitigated agency problems. In this paper, I ask two questions. First, how does an average REIT, given its dividend policy restricted through regulation, respond to its investment opportunities? Second, does an average REIT, with mitigated agency problems, face less severe financing constraints? In response to the first question, I find that an average REITs investment responsiveness (as measured by Tobins q) is higher than that of firms in other industries. In response to the second question, I find that, despite mitigated agency costs, an average REIT faces, in fact, more severe financing constraints (as measured by sensitivity to cash ow) than other firms. Finally, using the natural experiment provided by the 2001 REIT Modernization Act (RMA) that allowed REITs to own taxable REIT subsidiaries (TRS) and reduce their dividend distribution from 95% to 90%, I show that, for a given increase in internal funds, the negative impact arising from increased agency problems dominates the positive impact of the wealth effect, resulting in a lower overall responsiveness of REITs to their investment opportunities.