Journal of Financial Economics 18 (1987) 175-181.

North-Yolland

AN ANALYSIS OF GAINS TO ACQUIRING FIRMS SHAREHOLDERS

The Special Case of REITs

Paul R. ALLEN and C.F. SIRMANS*

Louisiana State University. Baton Rouge, L.A 70803, USA

Received August 1985, final version received January 1986

This study uses capital market data to measure the effects of REIT mergers on the wealth of the
acquiring trusts shareholders. A significant increase in shareholder wealth is detected. This differs
from the findings of other acquisition studies. The primary source of the value gain seems to be
improved management of the acquired trusts assets.

1. Introduction
The effect of merger on the wealth of acquiring firms shareholders remains
an issue in financial economics. Theoretically, an equity value maximizing firm
would voluntarily undertake an acquisition for several reasons, such as mo-
nopoly power in product markets, production synergies, and reduction in
bankruptcy costs. However, the empirical evidence indicates that acquiring
firms shareholders do not experience a large wealth increase, and in some
instances suffer a wealth reduction.2 In their summary of the wealth impact of
corporate takeovers, Jensen and Ruback (1983) report that acquiring firms
experience a 4% gain in tender offers and no gain in voluntary mergers. In
comparison, target firms shareholders have averaged gains of 30% and 2055,
respectively, in each transaction.
This paper investigates the acquiring firms stock price reaction to merger
proposals when both buyer and seller are real estate investment trusts (REITs)
over the period 1977-83. We wish to determine whether the same pattern of
wealth distribution exists for REIT mergers as for corporate mergers as a
whole. In addition, there are some unique institutional characteristics that

*The authors acknowledge the comments of Gary Sanger, Michael C. Jensen (the editor),
participants of the finance workshop series at Louisiana State University, and Richard Ruback
(the referee) on earlier versions.
See Copeland and Weston (1984) for a detailed description of these motivations and others.
*For example, the studies of Dodd (1980), Asquith (1983). and Eckbo (1983) find that corporate
acquisition announcements do not increase the wealth of acquiring firms shareholders.

0304-405X/87/$3.50~1987, Elsevier Science Publishers B.V. (North-Holland)

176 P.R. Allen and C. F. Sirmans. Gains to acquinngfirms shareholders

make REIT mergers an interesting economic phenomenon.3 Using standard

event study techniques. the results indicate that, on average, REIT acquisitions
significantly increase the wealth of acquiring REITs shareholders.

2. Institutional background

Real estate investment trusts (REITs) developed as a result of the 1960

amendment to the Internal Revenue Code (Sections 856-858). The amend-
ment provides that a qualified REIT is not taxed, but it is allowed to serve as
a conduit for all income distributed to shareholders. Income, then, is taxed
only at the shareholder level. However, if the trust generates an operating loss
it cannot pass through this loss to shareholders as a tax credit. Other aspects
of the corporate form are retained, such as centralized management, transfer-
ability and limited shareholder liability.
The Tax Reform Act of 1976 made substantive changes in the eligibility and
operational requirements of REITs. In general, the Act conferred corporation
status to the trusts and relaxed disqualification penalties.4 A cursory look at
the evidence suggests that the Act had an influence on the transfer of control
among REITs. In our examination of REIT mergers we could find only one
acquisition prior to 1977.
The key provisions a REIT must meet to be qualified include: (1) 75% of all
assets must consist of mortgages, real estate equities, cash, or government
securities; (2) at least 95% of taxable income must be distributed each year; (3)
at least 75% of gross income must be derived from rents, mortgages, and gains
from the sale of real estate; (4) real property must not be held primarily for
sale in the ordinary course of business; and (5) the number of beneficial
owners typically must exceed 100, with the five largest shareholders owning no
more than 50% of the outstanding shares.
REIT investors are provided with professional real estate management
services and these managers receive various payments for their activities.6
Typically, REIT managers are contracted advisors who are paid fees for

For an analysis of the financial performance of REITs, see the articles by Cullen and Blake
(1980), and Smith and Shulman (1976). A discussion of the history of REITs is contained in
Arthur Anderson and Co. (1978). Recent literature has examined some of the financial aspects of
REITs. Lee and Kau (1985) examine the effects of dividend yield on stock prices; Solt and Miller
(1985) examine agency aspects; Shilling, Sirmans and Wansley (1985) examine the informational
content of dividend change announcements; and Hite et al. (1984) exanine the spin-off effects of
various real estate operations.
4EngIebrecht and Kramer (1977) provide a detailed description. For a discussion of the tax
aspects of REITs, see Research Institute of America (1985).
sThe impact of the 1976 tax act on the operation and control of REITs has not been addressed
in the literature. This issue will be investigated in a future paper.
6A discussion of the agency problems in REITs is presented in Solt and Miller (1985). Jensen
and Meckling (1976) provide the agency framework as a tool of economic analysis.
 P.R. Allen and C.E Sirmans, Gaw IO acquinngjrm i mareholders 171

administering day-to-day investment operations, advising the trustees with

regard to policy decisions, contracting for services in the trusts name, supply-
ing relevant economic research and data. providing necessary administrative
staff, and taking required action to conduct the business of the trust.
It may be advantageous for a REIT to acquire an existing trust than to
expand internally for a variety of reasons. For example, net operating losses
that can be used to offset capital gains tax liabilities from the sale of trust
property make an existing REIT with these losses an attractive target for
another trust. Furthermore, merger may replace inefficient management in the
acquired trust and result in better utilization of its assets. Some classic
corporate merger motives are ruled out for REITs due to their unique
structure. For example, since 75% of REIT income must come from passive
competitive capital market investments, such as rents and mortgages, it is
unlikely that a business combination of REITs would create any monopolistic
power.

3. Data
Results reported herein are derived from a sample of successful mergers
drawn from Moodys Bank and Finance Manual over the 1977-1983 period.
The initial sample was comprised of 52 successful events. Two preliminary
screening devices were employed. First, the acquiring REIT must have been
included in the CRSP daily returns file around the time of the acquisition. A
second requirement excludes all acquisitions for which no mention could be
found in The Wall Street Journal Index or where the acquisition announce-
ment coincided with another major corporate event such as dividend or
earnings announcements. No additional systematic exclusion of events was
performed. In all, a total of 38 completed mergers satisfied the screening
criteria. Table 1 presents a listing of the number of announcements by year,
month, and day of the week.
The predominant form of the transaction in the final sample was an
exchange of stock between the trusts. Of the 38 events, only three involved
cash tender offers, and one other offered target shareholders a choice between
the two forms. A search through the business press including Business Week,
Forbes, Fortune, Mergers and Acquisitions, and The Wail Street Journal

There were a total of 30 different acquiring firms. There were five instances of two acquisitions
by the same firm and one instance of four acquisitions by the same firm. These multiple
acquisitions typically occurred on different calendar dates. There was one instance where an
acquiring firm later became an acquired firm. The average completion time was about 3.5 months.
As indicated by the data in table 1. there should be no potential clustering effects since the
announcements are distributed across various years, months and days. Thus, the potential for
weekend and turn-of-the-year effects are non-existent.
178 P.R. Allen and C. F. S/mans. Gaim to acquving jrms shareholders

1 able 1
Frequency of sample of 38 real estate investment trust merger announcements by year, month.
and day of week, 1977-1983.=

No. of No. of Day Number of

announce- Month announce- of announce-
Year ments ments week ments

1983 8 January 4 Monday 6

1982 9 April 5 Tuesday 12
1981 6 June 2 Wednesday 9
1980 6 July 7 Thursday 5
1979 4 August 6 Friday 6
1978 3 September 5
1977 2 October 2
November 2
December 5

Total sample size is 38. Sample consists of acquisitions of REITS by other REITs. No
announcements occurred in February, March or May of any year.

revealed little resistance by target REITs to the merger attempts. Only one
event could be classified as a hostile takeover.

4. Methodology
The value creation effect of REIT merger announcements is tested by
employing the standard event-time methodology discussed in Fama (1976) and
elsewhere. The value impact is measured using the mean adjusted returns
method outlined in Masulis (198Q8 In this approach, security js mean return
(pi) is estimated from a time series of the securitys returns over a representa-
tive period (not including the event period) which is defined as the comparison
period. The comparison period employed in this study runs from 120 through
41 trading days prior to the first public announcement of the acquisition. This
yields an unbiased estimate of p, given that the securitys return process is
stationary over the comparison and event periods. Once pj is determined, the
event period disturbance term Ej can be estimated as

Ej, = Rj, - cCj* t= -40,-39 )...) 0 )...) 39,40, (I)

where R, is the realized return on j at t. Hence, El,, is security js

disturbance term on event day (0), the initial announcements publication date
in The Wall Street Journal.

To check the sensitivity of our results to methodology, the tests reported in the next section
were redone using parameters generated from the market model. The qualitative results were
unchanged. For a discussion of methodological sensitivity of event studies using daily data, see
Brown and Warner (1985).
 P.R. Allen and C. E Sirens, Gains to acquiring firm i shareholders 179

Following Masulis (1980); the average disturbance term for a portfolio of N

firms is

c= (l/N) 5E,t,
j=l
(2)

where the null hypothesis is that the merger announcement has no effect on
shareholder wealth (E,, = 0).
To determine the statistical significance of E,,, the estimated standard

l/2
deviation of the average disturbance term is computed as

GE= i
(l/79)
-41
c
I==-120
(E,-xE)2
1 , (3)

where

- 1.
t= (4
-41
x,= (l/80) c E,
[ 120

The following r-statistic is employed to determine whether E, differs signifi-

cantly from zero with 79 degrees of freedom,

t = Eo/s,. (5)

This test is appropriate under the assumption that the J?~ are drawn from a
stationary and independent normal distribution.
The cumulative error over particular event time intervals is defined as

CE(a, 6) = fy A?,, -4Osa<b<40. (6)

1-o

For example, CE( - 40,O) represents the sample average cumulative error from
40 days prior to the announcement through the event date.

5. Event study results

Table 2 presents average and cumulative disturbance terms for equally
weighted portfolios of acquiring REITs where time is measured in relation to
the first public announcement of an acquisition bid. Additional relevant

9A potential problem is non-normality in daily return data. However, our empirical results
indicate that non-normality of the portfolio returns is not a serious problem. For a discussion of
these issues, see Brown and Warner (1985).
180 P.R. Alien and C. F. Sirmans. Gains to acquiringfirm P shareholders

Table 2
Daily prediction errors (E) and cumulative daily prediction errors (CE) (based on the mean
adjusted returns model) in the 80 days surrounding the acquisition announcement day for
acquiring firms in 38 REIT acquisitions of other REITs, 1977-1983.

Event CE Event
day ((6) day

0.089 0.09 0.592 8.60

13: - 0.836 -0.75 0.667 9.26
-38 0.180 -0.57 0.952 10.21
-37 0.041 -0.53 - 0.707 9.51
-36 - 0.068 -0.59 - 0.008 9.50
-35 - 0.238 -0.83 - 0.303 9.20
- 34 - 0.285 0.547 9.74
-33 0.006 1:::; 0.057 9.80
-32 - 0.259 - 1.37 -0.109 9.69
-31 0.644 -0.73 - 0.024 9.67
-30 - 0.325 - 1.05 0.620 10.29
-29 - 0.010 - 1.06 - 0.652 9.64
-28 0.075 - 0.99 -0.214 9.42
-27 - 0.589 - 1.58 0.568 9.99
-26 0.271 - 1.30 15 0.200 10.19
-25 0.143 - 1.16 16 - 0.837 9.35
-24 0.498 -0.66 17 0.016 9.37
-23 0.424 - 0.24 18 0.561 9.93
-22 0.219 - 0.02 19 - 0.436 9.49
-21 -0.412 - 1.43 - 0.288 9.21
-20 0.534 -0.90 :: 0.333 9.54
-19 0.015 -0.88 22 -0.333 9.21
-18 0.000 -0.88 23 - 0.423 8.78
-17 - 0.896 - 1.78 24 -0.177 8.61
-16 0.034 - 1.75 0.875 9.48
-15 0.051 - 1.69 -o.isi 8.70
- 14 -0.110 - 1.80 27 0.327 9.03
-13 0.929 -0.88 28 - 0.362 8.66
-12 0.006 -0.87 0.552 9.22
-11 0.406 - 0.46
- 10 0.504 0.04 - %! ;:L?
-9 0.175 0.22 32 - 0.608 8.76
- 8 - 0.254 -0.04 0.483 9.24
- 7 0.454 0.42 3: - 0.064 9.18
0.289 0.71 35 0.162 9.34
1; 0.789 1.49 36 -0.x74 x.47
0.238 1.73 0.540 9.01
1, - 0.217 1.52 ;: 0.561 9.57
0.713 2.23 39 - 0.970 8.60
1: 1.954 4.18 40 0.107 8.71
0 3.821 8.00

Variable Value (%) f-statistic

E-1 1.95 2.4ca

3.82 4.69=
&-LO) 5.78 5.10=
CE( - 5.0) 7.30 3.65
CE( - 10.0) 8.47 3.12=
CE(1.5) 1.50 0.82
CE(1, lb, 1.66 0.64
CE(1.40) 0.71 0.22

aStatistically significant at the 2.5% level (one-tailed test). The test statistic employed here is
I = CEfi//a^,fi, where N is the number of events in the sample and T is the number of one-day
periods over the interval under study. The null hypothesis is that the CE does not differ from zero.
 P.R. Allen and C. F. Swmans, Gaus IO acquinng firms shareholders 181

Table 3
Frequency of cumulative daily prediction errors (CE) for acquiring REITs based on the mean
adjusted returns model for the day before and the day of 38 acquisition announcements of oher
REITs. 1977-1983.

Range of cumulative No. of

prediction errors acquisition
(W announcements

-3.O<CE(-1.0)~ -2.0 1
- 2.0 < CE( - 1,O) < - 1.0 1
-l.O<CE(--l,O)<O.O 2
0.0 I CE( - 1,O) < 1.0 2
l.O<CE(-1,0)<2.0 0
2.0 I CE( - 1.0) < 3.0 6
3.0 5 CE( - 1.0) < 4.0 4
4.0<CE(-1,0)<5.0 8
5.0 _< CE( - 1,O) < 6.0 4
6.0 5 CE( - LO) < 7.0 3
7.0 5 CE( - 1.0) < 8.0 4
8.0 I CE( - 1,O) < 9.0 2
9.0 I CE( - 1.0) < 10.0 0
10.0 < CE( - 1.0) < 11.0 1
Total 38

Mean value of two-day abnormal return 5.78%

Median value of two-day abnormal return 4.34%
Standard deviation 2.90%
Minimum value - 2.37%
Maximum value 10.32%

descriptive statistics are displayed as well. The results in table 2 are derived
from the sample of acquiring REITs for the period from 40 trading days
before to 40 trading days after the first public announcement date.
With respect to the acquiring REITs, the results indicate that estimated
abnormal returns over the 40 days prior to the first announcement date deviate
only slightly from zero. The CE remains slightly negative (but statistically
insignificant) throughout much of the pre-event period but begins rising
around five trading days prior to the announcement date. The announcement
date is marked by positive, statistically significant abnormal returns of 3.82%.
The announcement effect of the acquisition may be diffused across more
than one trading day. For example, the announcement could have reached the
market on the publication date [day (0)] or the previous trading date [day
(-l)]. When aggregating across trusts in the portfolio, some of which made
their announcement at day (0) and others at day (- 1). the ability to detect
abnormal performance based on single-day returns is diminished. To alleviate
this problem, two-day returns are calculated for each trust in the portfolio
over day (0) and day (- 1). The results indicate a positive and significant
two-day return of 5.78%.
182 P.R. Allen und CF. Sirmans, Gums IO acquinngfirms shareholders

The distribution of two-day returns is presented in table 3, along with other

descriptive statistics. Table 3 also provides information as to the distributional
properties of the i?*. With a small sample, it is possible that the results could
be driven by outliers. However, the evidence indicates that the ,!?, are closely
distributed around the mean although slightly skewed. It does not appear that
the results are statistical artifacts.
In the post-announcement period, the i?t appear to be randomly distributed
around zero. The CE( -40,40) registers 8.71% as compared with the
CE( -40,O) of 8.00%.t As a result, the capital market seems to be efficient
with respect to processing information concerning the acquisition announce-
ment.
With respect to the gains to the target trusts, only three had data available
on the CRSP daily tapes. While the sample is too small to make any
generalizations, we did test for the merger effects. The announcement day
abnormal return was 1.46%. This was not significant. For the cumulative two
days [CE( - LO)], the abnormal return was 10.34% and also not significant.
For the three acquiring firms, the two day abnormal return was 3.22%.

6. Analysis
The results in the previous section support the hypothesis that the an-
nouncement of an impending REIT acquisition increases the wealth of the
acquiring REITs owners. This finding contrasts with those of other merger
studies for standard corporations. For example, Dodd (1980) finds signifi-
cantly negative abnormal performance over the two-day announcement period
[CE( - 1,0) = -0.0109, t = - 2.981 for acquiring firms. Asquith (1983) finds
insignificant performance (0.0020, f = 0.78) as does Eckbo (1983) (0.0007,
t = 0.12).
As mentioned in section 2, some motives for corporate mergers are not valid
for REIT combinations due to their institutional environment. For example,
since 75% of REIT income is limited to passive sources such as rents and
mortgages, no production synergy or monopolistic power is likely to result in a
merger. Gains can still arise from REIT combinations if tax losses can be
utilized or if management of the acquired trust can be improved.
Prior to the Tax Reform Act of 1976, no operating loss deduction was
allowed for REITs. If the trust wanted to utilize an operating loss. it had to
disqualify itself as a REIT for at least three years and be taxed as a
corporation over that period. The Act altered the tax treatment of operating

loA slight positive trend in the post-announcement error terms would be expected given the
biased nature of the sample. The study is restricted to successful acquisitions only. As a result,
information arrives in the post-announcement period that increases the probability that the
merger will be a success. The issues concerning interpretation of abnormal returns in partially
anticipated events are addressed in Malatesta and Thompson (1985).
 P.R. Allen and C.F. Sirmans, Gains to acquiringjirms shareholders 183

losses for REITs, allowing the trusts to use the losses to offset capital gains tax
liabilities from the sale of trust properties without fear of disqualification.
Essentially, the 1976 Act granted REITs corporate status in this area, although
carry-back and carry-forward provisions are limited.
A search was made through The Wall Street Journal Index, Moodys Bank
and Finance Manual, and Compustat files for each REIT involved in an
acquisition. For the period beginning three years prior to the merger date
through the merger date, net operating income information was gathered for
both acquiring and acquired REITs. Of the 38 events in the study, 31 had
complete information for both trusts over the test period. Only six events
involved one or the other trust having experienced an operating loss in a
previous period. On the basis of this observation, tax motivations do not seem
to be an important motive in REIT combinations.
As an alternative test of the tax loss hypothesis, a differential means test was
conducted between the six operating loss events and the remaining 25 clean
events. As expected, the operating loss group had a larger CE( - LO) of 5.83%
as compared with the control groups CE( - 1,O) of 5.42%. The difference
between the two groups is statistically insignificant.2 On the basis of this
evidence, it appears that tax motivations alone do not systematically affect
shareholder wealth.
The possibility remains that the gains to acquiring shareholders come from
better management of the acquired trusts assets after the combination. There
are two types of REITs - mortgage trusts and equity trusts.13 Equity REITs
specialize in property ownership, and mortgage trusts concentrate in financial
instruments. Many REITs further specialize by investment in particular types
of property, specific geographic areas, or specific ownership or lending
arrangements. This specialization may allow the acquiring trust to identify a
mismanaged trust of a similar type at a lower cost than one comprised of other
assets. This implies, ceteris paribus, that the gains to acquiring shareholders
should be higher when the target trust is of the same type as the acquiring
trust. The sample of 38 is split fairly evenly between the two types of
mergers - 22 related mergers and 16 unrelated. As predicted, we find a larger
CE( - 1,0) for the related group of 6.63% as compared to 4.61% for the
unrelated group. A t-statistic of 2.24 indicates a statistically significant differ-
ence in the performance of the two groups. Thus, the alteration of the
management input seems to be the most likely source of shareholder gain.

I1 For a discussion, see Arthur Anderson and Co. (1978).

*A standard difference of means r-statistic is utilized to test the null hypothesis that the mean
portfolio return for the tax loss group is equal to that of the control group. The r-statistic for this
test is given in Masulis (1980).
I3 We define a trust as equity or mortgage if it has more than 60 percent of its assets in either
respective area.
 184 P.R. Ah and C.F. Sirmans. Gams IOacquiringjrms shareholders

7. Summary and conclusions

This paper has investigated the acquiring firms stock price reaction to
merger proposals when both buyer and seller are REITs. Employing standard
event study techniques, a statistically significant wealth increase was detected
for acquiring REITs which contrasts with those of other acquisition studies.
Given the unique institutional environment, two motivations for REIT
acquisitions were offered - utilization of tax losses and improved asset man-
agement. We found a significant relationship between the wealth gain and
whether the acquisition was of a similar type of trust. No relationship was
found between shareholder returns and utilization of tax losses.

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