Can Dividend Reinvestment Plans Affect Firm Payout Choices ...

[Pages:48]Can Dividend Reinvestment Plans Affect Firm Payout Choices? Evidence from Real Estate Investment Trusts

Shaun Bond, Yu-Jou Pai, Peng Wang, Suyan Zheng Carl H. Lindner College of Business, University of Cincinnati, Cincinnati, OH 45221

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Can Dividend Reinvestment Plans Affect Firm Payout Choices? Evidence from Real Estate Investment Trusts

Abstract

This study investigates whether firms having Dividend Reinvestment Plans (DRIPs) influence their payout choices. Agency Theory and/or the Signaling Model indicate that dividend-paying firms with DRIPs use a conservative payout policy in order to incentivize shareholders to make long-term investments. We test this prediction using a sample of Real Estate Investment Trusts (REITs) that are required to pay dividends. We provide supportive evidence showing that in comparison to REITs without DRIPs, REITs with DRIPs are less likely to: (1) pay regular dividends with extra dividends and share repurchases and (2) omit all payouts, including dividends and repurchases. We also find that REITs with DRIPs have weaker stock price reactions to announcements of dividend changes due in part to managerial discretion in maintaining a conservative payout policy.

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1. Introduction This study investigates whether firms having Dividend Reinvestment Plans (DRIPs) affect

their payout choices of dividend changes or share repurchases. DRIP provides an opportunity for investors to reinvest cash dividends paid on common shares to purchase additional common shares and, in many cases, make optional cash payments to purchase shares directly from the sponsoring companies. DRIP may allow companies to raise new equity capital with much lower flotation costs and to use the proceeds received from sales of the shares for general corporate purposes. According to a file documented by the U.S. Securities and Exchange Commission (SEC), more than 1,000 U.S. firms had some forms of DRIPs by the year of 19941. However, only a handful of studies on DRIP have been documented so far for lack of data2.

Furthermore, typical industrial firms have a declining propensity to pay dividends in the most recent three decades (e.g., Fama and French, 2001; Grullon and Michaely, 2002; Skinner, 2008), a fact that discourages researchers to delve into the relation between DRIP and payout choice. However, the case of Real Estate Investment Trusts (REITs) provides a natural testing ground for this relation, because: (1) REITs are dividend-paying firms. Following the Internal Revenue Code, REITs are required to pay out at least 90 percent of their taxable income to shareholders as dividends, in order to qualify for tax-exempt status3; ( 2) DRIPs can be an important source of capital for REITs. REITs distribute a large part of operation generated cash flow in the form of dividends. Implementing DRIPs can facilitate REITs to retain some of these cash flow. This is crucial for REITs given their frequent demand for external financing; (3) Data collection process for REITs is relatively feasible and precise. We collect an equity REIT sample

1 See . 2 Companies are not required to report sources and amounts of shares used for DRIPs. 3 See the Internal Revenue Code Sections 856 - 858.

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starting from 1999, due to regulation and policy changes in the REIT industry4. In addition, most REITs started to adopt DRIPs after the SEC simplified the procedures of implementing the plan in December of 1994; (4) DRIPs help REITs obtain wider ownership of shares. The plan requires participants to possess stock certificates issued in their own names, instead of in the name of their brokers. This is meaningful for REITs since these firms are required to be beneficially owned by 100 or more persons and must not be closely held.

In contrast to prior studies on DRIP mainly using survey data, this study employs handcollected data from the SNL financial, the SEC Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database, Google Search, Factiva, and other data sources. Based on the SNL Real Estate database, 262 out of 721 REITs have DRIPs. Many shareholders holding stocks of a particular REIT with DRIP (hereafter, DRIP REIT) elect to participate in the plan. DRIP is well known to many investors in practice. However, to the best of our knowledge, none of the existing literature has investigated any DRIP topics in REITs, and no extant payout studies have examined whether DRIP influences firm payout choices. This study aims to fill these gaps.

Even though REIT dividend payouts are greatly constrained by their internally generated cash flow, REIT managers do not just make payout decisions in accordance with the legislation. These managers seek to smooth dividend payout over time. For example, Wang, Erikson, and Gau (1993) first show that REITs can pay dividends more than their net income. Hardin and Hill (2008) find that REIT dividend payments can be decomposed into mandatory payment and excess payment. The mandatory payment is essential for REIT to stay tax-preferred status and the excess payment (payment above the statutory minimum) is optional. Boudry (2011) proposes

4 See the REIT Modernization Act of 1999 on the website: .

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a new methodology that decomposes REIT dividends into discretionary and nondiscretionary components. All these studies indicate that REIT managers have concerns about firm payout choices.

Firm managers tend to pay extra dividends or repurchase shares when having nonsustainable excess cash, and they increase regular dividends only if they expect sustainable higher future earnings (e.g., Baker and Wurgler, 2004; Li and Lie, 2006). This is because increases in regular dividends may be interpreted by shareholders as the long-term commitment of firm managers to distribute future cash flows (e.g., Brav et al., 2005). Failure to commit sustainable dividend payouts can result in unfavorable market reactions. Share repurchases can be interpreted as a signal of stock undervaluation and lead to temporary increases in stock prices. Scholes and Wolfson (1989) argue that implementing a DRIP may avoid a negative signal that a new equity offering provides; using DRIP to raise equity capital over a long period of time, rather than all at once, can mitigate the adverse selection problem and reduce information asymmetries. In attempt to attract shareholders to participate in DRIPs, managers aim to improve firm performance by investing in positive NPV projects and make conservative payout choices. Additionally, investors are likely to invest in DRIP REITs when these firms consistently pay stable dividends. Therefore, DRIP might align firm management and shareholder interests.

We formulate hypotheses based on Agency Theory and /or the Signaling Model in the next section. Either theory indicates that dividend-paying firms with DRIPs employ a conservative payout policy in order to incentivize shareholders to make long-term investments. Specially, DRIP REITs rather than non-DRIP REITs tend to conduct a conservative payout policy due to the sensitivity of investor reactions to payout choices.

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We examine the effect of DRIP on REIT payout choices using a multinomial logistic regression model. The sample includes 271 equity REITs over a period from 1999 to 2014. Among these REITs, 127 have DRIPs. After controlling for factors documented in prior studies that affect firm payout choices, we find that DRIP REITs, in comparison to non-DRIP REITs, are less likely either to pay regular dividends with extra dividends and repurchase shares or to omit all payouts, including dividends and repurchases. This indicates that DRIPs influence REIT managers to make conservative payout choices.

We also apply event study methodology to examine differences of the dividend announcement date effect and the dividend payment date effect between DRIP REITs and nonDRIP REITs. We show that (1) the positive market reactions to announcements of regular dividend increases or extra dividends are weaker for DRIP REITs than for non-DRIP REITs and (2) announcements of dividend decreases at date T1 can only cause statistically significant and negative cumulative abnormal returns from (T1 -30) to (T1 + 30) in non-DRIP REITs. We interpret these phenomena as indicating that DRIP REITs have weaker market reactions to dividend changes, due in part to managerial discretion in maintaining a conservative payout policy.

We consider the dividend payment date as the date on which the administrators will invest reinvested dividends for the purchase of common shares5. We find that price reactions around the dividend payment date are greater for DRIP REITs than for non-DRIP REITs, suggesting higher temporary price pressure around the event date in the former case.

5 Unless the dividend payment date is not a trading day, in which case the dividend reinvestment date will be the next trading day. If the administrators purchase common shares in the open market, then they will buy back stocks around the dividend payment date, in most cases, within 30 days after the dividend payment date.

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Our study contributes to the existing literature by providing new evidence showing that DRIP can affect firm payout choices. Most REITs use shares newly issued to investors who participate in the DRIP, converting a portion of internally generated cash flows into new equity with low flotation costs6. DRIPs become an important source of capital for REITs identified in this study. As a consequence, REIT managers tend to make conservative payout choices after adopting DRIP. Our findings may also help to explain (1) why less than 30 REITs choose to distribute elective stock dividends subsequent to the enactment of the new IRS rules during financial crisis and (2) why REIT investors do not seem to favor cash dividends over stock dividends, two facts documented by Devos, Spieler, and Tsang (2014). They attribute their findings to the fact that "under efficient market investors can always convert stock dividends into cash by selling the stock; hence investors are generally not worse off receiving stock dividends". Alternatively, we interpret the behavior of few REITs distributing elective stock dividends as a reflection of REIT managers maintaining a conservative payout policy.

The remainder of this paper proceeds as follows: Section 2 provides related literature review and develops the research hypotheses. Section 3 discusses the sample selection procedures and research design. Section 4 summarizes the empirical results and Section 5 presents robustness test results. Section 6 concludes.

2. Related Literature and Hypothesis Development Like industrial firms, REITs can distribute cash flow back to shareholders in the forms of

regular dividends, extra dividends (including irregular dividends and excess dividends), and stock repurchases. In a sample of 8,290 REIT regular dividend announcements, 91 percent

6 According to security registration fillings in the SEC EDGAR database, companies use Form S-3D, Form S-3 or Form S-3ARS to self-register new shares under DRIPs without using underwriters.

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(about 7,562) of regular announcements are made on a recurring quarterly basis and less than 10 percent of regular dividend announcements recur monthly, annually, or semiannually. Special dividends are usually one-time dividend distributions to shareholders and are considered not to be sustained in the future. Most REITs repurchase stocks using open market stock repurchase programs or tender offers. REITs, rather than industrial firms, have a lower overall level of repurchases because of the regulation on dividend payout policy (Boudry, Kallberg, and Liu, 2013). As such, repurchases cannot be the dominant form of REIT payout, in contrast to industrial firms that use repurchases to substitute for dividend payout in recent decades (e.g., Grullon and Michaely, 2002; Skinner, 2008).

Existing literature has developed four possible hypotheses to explain firm payout policy: Agency Theory, the Signaling Model (or the Information Content of Dividends), the Clientele Effect, and the Tax Effect. Our study builds on Agency Theory and the Signaling Model to develop four main testable hypotheses. Extant studies provide mixed results on the tax and clientele effects on payout choices. While Brav et al. (2005) suggest that taxes play a secondorder role in firm payout choices, Hanlon and Hoopes (2014) provide evidence that managers adjust corporate payout choices in response to changed investor-level taxes. In addition, shareholders who participate in DRIPs have the same federal income tax obligation for dividends reinvested under these plans as for dividends received in cash. The Clientele Effect concerns the reactions of institutional investors. Interestingly, DRIPs limit the allowable periodic investment to attract individual clients, but to prevent institutional investors and corporate insiders from exploiting large economies of scale. These stylized facts suggest that estimating possible links between tax or clientele effects and REIT payout choices are complicated and thus deserve another independent study. We leave it to the future work.

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