Do Residential Property Companies Systematically Adjust Their Capital Structure? The Case of Germany

Our paper analyzes the corporate financing behavior of German residential property companies. The German residential property industry is characterized by a predominance of nonlisted companies with different legal forms and a large variety of company sizes. Not much is known about the considerations driving the choice of the capital structure of these smaller, non-listed companies, since previous research has almost exclusively focused on listed companies. We test whether adjustments in the financing structure of residential property companies can be explained by one or both of the dominating principles of corporate capital structuring: the pecking order theory and the trade-off theory. The pecking order theory argues that, due to information asymmetries in external finance, internal financing out of the cash flow is the preferred source of corporate finance. If internal financing is not available, the first resort is debt, while equity is only issued if the other forms are unavailable or only available at unreasonable cost. The trade-off theory suggests that a firm’s optimal level of debt balances the benefits and costs of debt. The benefits of debt are mainly seen in tax savings and disciplining effects on managers, thereby mitigating conflicts between managers and owners of a firm. Countervailing costs of increasing debt are a growing risk of bankruptcy and rising costs of financial distress. We find that capital structure adjustment behavior differs largely among property companies of different legal form. In general, we find support for pecking order considerations in capital structuring decisions of German residential property companies. The strongest effects are observed for housing cooperatives. This is the only category of firms in which we can observe capital structure targeting behavior as explained by the trade-off theory of capital choice. The fact that the strongest effects in the pecking order theory regressions and the trade-off theory regressions are observable for housing cooperatives reflects both the strong propensity of these organizations for targeting a conservative financing structure and the limited flexibility in adjusting their equity basis. As a consequence, housing cooperatives must finance additional investments first through debt and can only successively raise new equity. Independent from the legal form, we find an indication for a size effect in that larger companies - other things being equal - rely less on debt financing than smaller ones, which is in accordance with the pecking order theory.

Kurzrock, Björn-Martin, Frieder Mokinski, Felix Schindler and Peter Westerheide (2011), Do Residential Property Companies Systematically Adjust Their Capital Structure? The Case of Germany, ZEW Discussion Paper No. 11-014, Mannheim.