Options trading, information flow, and the capital structure of real estate investment trusts

Abstract Traditional capital structure theories face severe limitations when applied to securitized real estate and real estate investment trust (REIT) markets. Of note, the regulatory environment faced by these firms dramatically alters their economic incentives and limits their ability to self‐finance growth and expansion activities. As such, firms in this industry with continuing needs for external capital are uniquely positioned to benefit from reduced valuation uncertainty engendered by enhanced information flow. Against this backdrop, the current investigation examines whether, and to what extent, options market trading intensity serves as a value‐relevant, noise‐reducing information signal that may be used to inform REIT borrowing and capital structure decisions. Specifically, we document that increased REIT options market trading activity is strongly associated with reductions in overall firm leverage levels through the channel of enhanced equity issuance. Additionally, increased options market trading intensity is associated with a relative increase in the use of unsecured debt and a corresponding reduction in the use of collateralized bank debt and term loans. Importantly, these results appear to be most pronounced within firms that are financially constrained and/or informationally opaque. Taken together, and consistent with predictions derived from pecking order theory, these findings suggest that the enhanced information flow and resulting price discovery attributable to options market activity allow REITs to retain financial flexibility and ensure continuing access to credit.