Green Building, Cost of Equity Capital and Corporate Governance: Evidence from US Real Estate Investment Trusts Hui-Ching Hsieh; Viona Claresta; Thi Bui Sustainability · 2020-05-02 CC BY 4.0 · https://creativecommons.org/licenses/by/4.0/ Source: https://www.mdpi.com/2071-1050/12/9/3680 Abstract Distinct from the existing literature, which mainly focuses on the impacts of green building practices on the owners’ benefits, this paper examines capital market participants’ perceptions of green building, specifically, the cost of equity capital. The study uses data regarding the United States Real Estate Investment Trusts (US REITs) from 2000 to 2016, employing a panel regression analysis and adopting a Price Earnings Growth (PEG) ratio model for the cost of equity capital estimation. We find a negative relationship between green building certification and the cost of equity capital. Our results encourage REITs to participate in green building certification and aim for higher green building rankings. In addition, we examine whether corporate governance could affect the intensity of green building practices in REITs. It is found that corporate governance practices implemented to align shareholders’ and managers’ interests, such as higher institutional holdings and a less dispersed ownership structure, positively impact firms’ resource allocation for green initiatives. The results suggest there could be mutual benefits for both economic profits and sustainable buildings. 1. Introduction The pursuit of rapid economic growth has made people focus merely on economic profits, and neglect what may have thereby been sacrificed, for decades or even centuries. This has led to several severe consequences, such as environmental pollution, climate change, biodiversity loss, etc. The continually worsening situation has raised people’s awareness of how their activities can affect their surroundings and urged us to find innovative practices that could mutually benefit economic growth and environmental sustainability. This social phenomenon has led to the popularity of corporate social responsibility (CSR) in recent years. The concept of CSR is based on the assumption that social, environmental and economic perspectives should all be considered in the business operation process by stakeholders when coming up with investment decisions [ 1 , 2 ]. Thus, it can simply be defined as strategies that firms use to conduct their business in an ethical and society-friendly way. The sustainability revolution is also occurring in the real estate sector. This paper specifically focuses on “green building” as the application of CSR in the environmental dimension. In fact, the CSR practices in real estate may play the most critical role in sustainable transformation, because building and construction comprise the world’s largest consumer of energy and producer of carbon dioxide (CO 2 ) emissions (accounting for 36% of global final energy use and 39% of energy-related CO 2 emissions) [ 3 ]. Hence, progress towards green buildings and construction is essential to sustainable transformation and has grown significantly and rapidly over the past 10 years, with the aim of supporting public health and well-being, as well as the economy and the environment [ 4 ]. As a result, it is believed that there will be a new wave of investment in the real estate sector in which sustainable building will be set as a top priority. The increased environmental awareness in the real estate industry has created a demand for the growth of voluntary certification systems such as Leadership in Energy and Environmental Design (LEED), Energy Stars, etc. These rating agencies have been initiated by government organizations, aiming to assess the degree of environmental friendliness and energy efficiency of construction, so as to quantify the standard of building sustainability. This study focuses on LEED green certification because it is considered the most widely used green building rating system in the world. LEED was developed by the US Green Building Council (USGBC), and its certification has been evaluated as an internationally recognized symbol of sustainability achievements. Besides the several major contributions green building makes to the environment, there is a growing concern about whether or not these certified buildings affect financial performance positively. Most of the previous studies have focused on how greenness affects the properties’ values. Green buildings have been found to generate higher premium rental rates and higher occupancy rates [ 5 , 6 ], longer economic lives [ 7 ], and higher profits for investors and developers [ 8 ]. Moreover, previous studies have found that real estate firms and Real Estate Investment Trusts (REITs) with green certification have higher stock returns [ 9 ] and lower operating expenditure [ 10 ]. Despite extensive research on this topic, the previous studies have mainly focused on the profits of the green building owners, e.g., on the accounting and market-based financial performance. So far, there is an absence of research examining capital market participants’ perceptions of green building, e.g., the cost of equity capital. The cost of equity capital is defined as the return a company requires, in order to determine that an investment meets its capital return requirements, representing the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. As a result, this indicator performs an important role in affecting corporate investment and financing decisions and is one of the substantial determinants of film value. Shleifer and Vishny [ 11 ] suggested that a lower cost of equity capital means that the savings can be retained or used in other investments. Accordingly, firms prefer a lower cost of equity. This research aims to provide an overview of how financial performance reacts to green building practices through the channel of the cost of equity capital. Another question that we intend to answer in this research is whether there is a relation between corporate governance and the green building intensity of REITs. At present, there is still little understanding of the circumstances under which firms are more likely to invest resources in sustainable goals [ 12 ]. Since outside shareholders have difficulty evaluating the profitability of green infrastructure projects, managerial discretion is more likely to be responsible for such investment decisions. Managerial discretion is an important element of the corporate governance mechanism, and it has been suggested that better corporate governance results in higher firm valuation and performance [ 13 , 14 , 15 ], stock returns [ 16 ], and stock market liquidity [ 17 ]. Therefore, it is likely that the corporate governance mechanism could affect the green building practice intensity of REITs. The ownership structure is one of the most important elements of the governance mechanism, as it can have an enormous impact on the incentives of managers, thereby affecting the efficiency of the firm [ 18 ]. It is assumed that firms’ strategies are conducted based on the motivations and benefits of the parties involved in formulating and making decisions in the firms. Meanwhile, the ownership structure is defined by the distribution of equity with regard to votes and capital, but also by the identity of the equity owners. Therefore, it would be interesting and significant to examine whether the ownership structure is the driving force behind the green building practice intensity of REITs. This research will focus on two proxies for ownership structure, namely, institutional holdings, and ownership concentration. In short, through analyzing the United States Real Estate Investment Trusts (US REITs) in the period between 2000 and 2016, we conduct empirical studies to determine, firstly, whether or not green building practices can help improve the financial performance of REITs in terms of cost of equity, and secondly the relationship between corporate governance and green building implementation intensity. Our results do not merely fill the research gap in identifying the attributes that characterize green building in REITs, and their financial performance from the perspectives of capital market participants, providing beneficial implications for REIT investors, but also, and more importantly, should encourage green building practices due to the finding of mutual benefits in terms of economic profits. The remainder of this research is organized as follows. Section 2 provides a review of the theory and literature in relation to green building implementation, cost of equity, and corporate governance. Section 3 discusses the methodology, including the selection of the sample, calculation of the variables, and formation of the regression equations. Section 4 presents the research results, and Section 5 concludes. 2.1. Green Building Implementation and Cost of Equity Capital Green buildings are considered a part of the CSR strategy. Research into the impacts of green practices on financial performance can also be based on prior studies of the causal relationship between CSR and financial performance in terms of direct relationships, CSR is assumed to increase the expenditure of firms, while the benefits cannot be seen clearly in the financial statements. Despite the ongoing debate on CSR engagement, most studies have agreed that it has a positive relationship with financial performance [ 19 , 20 ], meaning that the more actively firms are involved in CSR activities, the better financial returns they can achieve. According to Renneboog et al. [ 21 ] and Chiang et al. [ 22 ], CSR activities could bring positive growth in long-term stock performance and other investment opportunities. Much of the literature provides evidence that analysts and investors consider environmental performance when making investment decisions or analyses [ 23 , 24 , 25 ]. Firms with superior environmental performance can easily draw attention from consumers who take social outcomes into consideration, resulting in better support, and thus, better financial performance [ 19 ]. In financial literature, the definition of the cost of equity capital is the return that a firm pays its equity investors to compensate them for the risk they undertake by investing in the firm. Hence, the relationship between environmental performance and the cost of equity capital is affected, to some extent, by the risk perceived by the investors. In the context of the current market, under which consumers have a high level of social awareness, any social or environmental activities committed by firms enhance their public image [ 26 ], influencing the perceived risk profile of the firms in the capital markets [ 27 ] and thereby leading to a lower expected return and lower cost of equity capital accordingly. Another analytical study came up with the same result, supporting the idea that investors would presume there to be a lower risk, and therefore, accept a lower return on their investment in firms with better environmental performance [ 28 ]. Moreover, Reverte [ 29 ], El Ghoul et al. [ 30 ], and Goss and Roberts [ 23 ], focusing on the impact of CSR on the cost of equity capital, provided evidence that firms’ environmental performance could enhance firm value by reducing the cost of capital. In recent years, an increasing number of studies on green building have been carried out. It has been found that green building certification leads to better financial performance and a higher future value of the property [ 9 ]. This is based on a positive relationship between green building certification and the occupancy rate of the building, rental prices, revenue values [ 31 , 32 , 33 , 34 , 35 ]. Given their lower energy consumption compared to ordinary buildings, green buildings will incur lower operational expenditure. Therefore, the REITs operating them should also incur lower operational expenditure [ 8 ]. An and Pivo [ 34 ] showed that loans on green buildings have slightly better terms than loans on non-green buildings and, more importantly, loans on sustainable buildings also carry less default risk. Moreover, it has been proven that there is, on average, a 6.6% higher return on investment (ROI) on LEED-certified buildings than on non-certified buildings [ 35 ]. In addition, it has been suggested that green portfolios are capable of generating higher returns than non-green portfolios and even did so in the crisis period between 2007 and 2009 [ 7 ]. This study specifically focuses on instrumental stakeholder theory, which implies that achieving stakeholder expectations may result in several competitive advantages, such as a good reputation, long-term relationships, or higher market value [ 36 ]. In this case, green building certification is a confirmation of REITs’ environmental performance, which has become a stakeholder demand under the current circumstances. Therefore, green building certification may result in long-term financial benefits for REITs. Given the prior research and theory, this study puts forward the following research hypotheses for testing: LEED green building certification has a significant negative effect on REITs’ cost of equity capital. 2.2. Corporate Governance and Green Building Practice Intensity Several theoretical academic works have found evidence that corporate governance could affect firms’ decision to go green. According to stakeholder theory, it shows that sustainable properties follow a “win–win” model, as green infrastructure not only provides value to the property’s owners but also makes a huge contribution to the community [ 37 ]. As a result, if green buildings can bring considerable benefits to firms, shareholders should promote corporate governance practices that strongly encourage managers to invest in them. In addition, the over-investment hypothesis, based on the agency theory of Jensen and Meckling [ 18 ], argues that an effective firm governance mechanism helps reduce the probability of over-investment by managers via the channel of CSR activities. Moreover, Cespa and Ceston [ 38 ] proposed a theoretical model regarding conflict of interest, claiming that firms engaging in CSR activities are not only able to increase profits but also be ethical and socially supportive. Consequently, if CSR can help increase a firm’s value, corporate governance should guide firms to get involved in CSR activities. In other words, it is expected that there should be a positive relation between corporate governance and CSR intensity. In order to provide a better understanding of how the corporate governance mechanism can be linked to green building implementation intensity, this study empirically tests two previously examined proxies representing the corporate governance system, institutional ownership, and ownership concentration. The ownership structure is considered a key element of the governance system, as it can affect how managers exhibit their control rights over the firm’s strategic decisions and, hence, impact on a firm’s operating efficiency. For example, the “convergence of interests” hypothesis of Jensen [ 39 ] suggests that managerial ownership helps align the interests of shareholders and managers. Accordingly, managers will have more motivation to make good decisions to improve firm value. Furthermore, it is argued that, when firms’ outstanding shares are overly dispersed across many individuals, minor shareholders, and institutions, and none of them hold substantial portions, they will have less motivation to put time and effort into controlling and evaluating managerial decisions [ 40 ]. The situation could change when ownership is more concentrated. Investors with large holdings, such as institutions, can manage to exercise control over the managers. Such shareholders have the potential to force managers to do what they want through two typical channels, namely trading their shares and voicing their disapproval. As a result, the ownership structure can be used to capture corporate governance effectively. Increased institutional holdings and the concentration of institutional ownership reflects the growing dominance of this group in the capital market. Given their significant number of shares, they are capable of taking aggressive action, either directly or indirectly, to influence managerial discretion. Thus, they have more incentive to exert their monitoring ability in the governance mechanism. In addition, institutions are believed to be prudent investors due to their information-seeking ability. Thus, their direction of firm management can be thought to make sense. Earlier research has suggested a positive association between institutional ownership and firms’ corporate governance quality [ 41 , 42 , 43 , 44 ], meaning that higher institutional holdings imply a better corporate governance mechanism. Consequently, this study supports the idea that high institutional holdings are positively associated with a firm’s green building practice intensity. Ownership concentration refers to the amount of stocks held by individual or large block shareholders who own at least 5% of the equity of a firm. A concentrated ownership structure implies a “convergence of interests” or “alignment effect”. Hence, a more concentrated ownership structure is supposed to align the incentives of owners and firms well, reducing management inefficiency and representing a better governance quality [ 45 ]. Following the alignment effect, less dispersed ownership leads to higher congruities in stakeholders’ interests, thus resulting in a more efficient governance mechanism. Thus, ownership concentration might comply with the alignment effect, representing better governance quality for REITs. In a nutshell, regarding the relationship between the governance mechanism and green building implementation intensity, the levels of institutional ownership and ownership concentration can express the quality of corporate governance practices in terms of interest alignment. Therefore, this study posits the following hypothesis: Corporate governance practice is significantly associated with REITs’ green building implementation intensity. 3.1. Data Green building certification data are obtained from the LEED official website, which provides the name of the building, type of building, and the score for its greenness level. For each building, we classify the REITs to which that building belongs. We first collect the list of buildings from each REIT annual report and match those buildings with the buildings from the LEED website to classify the buildings’ greenness levels. Finally, these data are used to calculate greenness scores at the REIT level. All financial data, such as return on assets, total assets, market-to-book ratio, leverage, and others, were obtained through Datastream, along with the forecasted earnings per share and stock price needed to compute the cost of equity capital. Institutional ownership and the concentration ownership Herfindahl–Hirschman Index (HHI) were collected from Thomson Reuters institutional data. While the LEED program was initiated in 1998, the sample from its early stages is very limited, and thus, most of the existing literature starts the analysis from the 2000s. We follow Eichholtz et al. [ 10 ] who started their sample in 2000 and study the period from 2000 to 2016 in the US. The final sample consists of 107 US REITs with 1011 firm-year observations. 3.3. Empirical Model Specification The paper is constructed of two main parts. First, we will examine the effect of LEED green building certification ownership on the cost of equity capital. The first model is as follows: C C i t = α + β 1 G r e e n n e s s s c o r e s i t + β 2 R O A i t + β 3 S I Z E i t + β 4 L E V i t + β 5 M B R i t + β 6 B E T A i t + β 7 R E T V A R i t + β 8 I N T i t + ε i t (7) The second model investigates the relationship between ownership structure (as a proxy for corporate governance) and green building implementation intensity: G r e e n n e s s s c o r e s i t = α + β 1 I O i t + β 2 H H I i t + β 3 R O A i t + β 4 S I Z E i t + β 5 L E V i t + β 6 M B R i t + β 7 B E T A i t + β 8 R E T V A R i t + β 9 I N T i t + ε i t (8) where CC is the cost of equity capital, Greenness scores stands for G1, G2, G3, and GB, IO is the institutional ownership, HHI stands for ownership concentration, ROA represents return on assets Size measures the REIT ’s size, LEV stands for leverage, MBR is the market-to-book ratio, BETA represents the firm beta, RETVAR measures the return variability, and INT is interest coverage. 4.1. Descriptive Statistics Analysis In Table 1 , the greenness scores G1, G2, and G3 have mean values of 1.31%, 1.96%, and 0.79%, respectively. This means that only 1.31% of US REITs’ properties are green-certified infrastructures, and only 1.96% of the total building area is certified by LEED assessment. The average “greenness” score given by LEED across all properties of US REITs is 0.79%. The average value of the cost of equity capital (CC) is 11.79%. The independent variables for ownership have mean values of 0.77 and 0.07, for institutional ownership and ownership concentration, respectively. These imply that, on average, 77% of US REITs’ shares are held by institutions, while their ownership concentration is 7%. The latter value is relatively low, which is consistent with previous findings of an inverse association between ownership concentration and quality of legislation. ROA is the ratio of net income to total assets, and the average value of this variable is 1.85%. This number is low because REITs consist of properties and other tangible assets, making their total asset value very high. In terms of leverage, the mean value of this variable is 53.09%. Since leverage is the ratio of total liabilities to total assets, it implies that the capital sources of REITs are well balanced between debt and equity. The mean value of the market-to-book ratio is 2.3, which implies that, in general, REITs are overvalued, or stocks are traded at a premium. The average beta value is 1.03, which indicates that these US REITs’ risk is similar to those of the market. In terms of return variability, the maximum value is 69.32%, which means that some REITs’ returns are very volatile. The minimum is only 2.23%, and the average only 7.58%, which can be considered less volatile. The interest coverage ratio has a mean value of 2.66. 4.2. Correlation Analysis Table 2 shows the results of the correlation analysis. It can be seen that cost of equity capital has a negative correlation with the greenness variables. Thus, as the greenness of the REITs increases, that is, G1, G2, and G3 are higher, this leads to a decreased cost of equity capital. It can also be seen that the greenness scores are positively correlated with institutional holdings but negatively with ownership concentration. In terms of the control variables, no high correlation can be detected among the variables, implying there is no multicollinearity problem. 5. Conclusions The growing awareness of environmental issues has led to the booming interest in green buildings. Thus, trying to understand whether or not, and if so how, green building practices could benefit both the economy and environment is important. Although numerous research works have been carried out, they have mainly focused on the profits of sustainable building owners, e.g., through accounting and market-based financial performance. It is still unclear whether green building practices can benefit capital market participants. The empirical results of this study provide insights into the effect of green building certification on REITs’ financial condition, as well as the role corporate governance, specifically ownership structure, may play in promoting greenness. The first model of this study aims to unveil the effect of green building certification on the cost of equity capital. We find significantly negative relationships between the greenness of the REITs and the cost of equity capital, indicating that the participation of REITs in the LEED green building certification scheme significantly reduces REITs’ cost of equity capital. Apparently, this motivates REIT managers to join the LEED green building certification scheme. Although prior studies have suggested that green building involves higher costs during the development period [ 63 ], the savings obtained from the lower cost of equity capital for REITs would bring benefits from the development of green buildings. Another conclusion from the empirical results is that REITs will experience a lower cost of equity capital as they become “greener”. This should encourage managers not just to participate in LEED green building certification, but also to seek higher rankings in the green building rating system. The second model emphasizes the effect of ownership structure, as an element of corporate governance, on green infrastructure implementation. We find evidence that corporate governance practices, measured by both institutional ownership and ownership concentration, have positive impacts on the amount of resources firms devote to green building. That is, with an increase in institutional holdings and a higher level of ownership concentration, REITs tend to own more green infrastructure. In other words, corporate governance practices implemented to align the interests of shareholders and managers positively affect green building adoption. This suggests that good corporate governance encourages green building as a way to build good public relations and thereby enhance firm performance. In this sense, an effective control mechanism might provide the foundation for green building implementation. Author Contributions Conceptualization, H.-C.H., V.C. and T.M.N.B.; methodology, H.-C.H., V.C. and T.M.N.B.; software, H.-C.H., V.C. and T.M.N.B.; validation, H.-C.H., V.C. and T.M.N.B.; formal analysis, H.-C.H., V.C. and T.M.N.B.; investigation, V.C. and T.M.N.B.; data curation, V.C. and T.M.N.B.; writing—original draft preparation, V.C., T.M.N.B. and H.-C.H.; writing—review and editing, H.-C.H.; visualization, H.-C.H.; supervision, H.-C.H.; project administration, H.-C.H.; funding acquisition, H.-C.H. All authors have read and agreed to the published version of the manuscript. Funding This research received no external funding. Conflicts of Interest The authors declare no conflict of interest. Rights: © 2020 by the authors. Article-specific publisher copyright text distributes this version under the Creative Commons Attribution (CC BY) license and links CC BY 4.0. Edition changes: Licensed narrative text edition. 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