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Timothy Riddiough

Against the Conventional Wisdom: Why Firms Choose Secured Debt During Turbulent Times

by Timothy Riddiough Monday, August 21, 2017
For most families, purchasing their own home remains a symbol of the American Dream as well as the biggest monetary commitment they will ever make. Taking out mortgage debt is usually considered a solid financial decision, an expected next step on the road to transforming the ownership dream into reality.

Unlike with the individual homebuyer, however, there's not always a single optimal path when it comes to corporations and debt utilization. During the past 40 years, much has been written regarding the best way for firms to finance themselves. Conventional real estate wisdom, for example, holds that maximizing available mortgage debt allows firms to conserve their own scarce capital for the times when a new investment opportunity comes along. Real estate has a lot of debt capacity; lenders like to lend against it since it's considered good collateral. Mortgage debt is secured lending, a simple way for commercial firms to finance new investments by pledging specific collateral.

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Professor Timothy Riddiough

Publicly traded firms, on the other hand, have options beyond secured debt, like outside equity and corporate-level debt. We know that when the market functions normally, the better firms—the more productive, active companies—choose unsecured debt. By keeping a strong balance sheet, and with competition among unsecured creditors acting as a natural screen, the higher quality companies can bypass issuing loans specifically guaranteed by real collateral. For lower quality firms, it’s trickier. Since they may not be able to make good on their commitment to maintain a strong balance sheet, they take the easy way out and pledge collateral instead.

In a study with my co-authors—Antonio Mello, a professor of finance and my colleague at the Wisconsin School of Business, and Erasmo Giambona of Syracuse University—we speculate about what might happen during turbulent economic times when the cost of financing unsecured debt is higher.  Specifically, understanding that even the better firms rely on secured debt when they need to, we create a model that predicts the migration of these higher quality firms to the secured debt borrowing pool in a crisis. We anticipated that this shift would increase the pool quality overall. With this design we are the first to provide a sharp test of the asymmetric information (our model) versus moral hazard models of collateralized lending.

To test our model empirically, we used data from the 1998 Russian financial crisis, an economic shock that affected the global economy and was not caused by real estate markets in the US. During this time, the cost of accessing all types of funding became more expensive, but some U.S. apartment real estate investment trusts still had access to secured debt due to support from government-backed lenders Freddie Mac and Fannie Mae.

Results of our empirical study show that when turbulent times hit, both higher and lower quality firms pooled in the secured debt market, thereby raising the overall quality of the pool (in contrast to predictions of moral-hazard models of collateralized lending). The findings also suggest that during these rocky periods, financing choice does not have a significant effect on a firm’s value, given that a firm’s type is not revealed to the market.

The bottom line: Turbulent times aside, if you’re a publicly traded firm, having to pledge collateral as security is a sign of weakness, not strength. The strongest firms make financing decisions based on track record and reputation. When you have access to various forms of capital at an affordable price, such as outside equity or outside unsecured debt, you don’t need to follow real estate’s conventional wisdom.

Read the paper “Real Assets, Collateral, and the Limits of Debt Capacity” published by Real Estate Economics.

Timothy Riddiough is a professor and the James A. Graaskamp Chair in Real Estate in the Department of Real Estate and Urban Land Economics at the Wisconsin School of Business. Riddiough also serves as the academic director for the James A. Graaskamp Center for Real Estate and as director of the Applied Real Estate Investment Track (AREIT).