Question: A major bank has established a Real Estate Investment Trust (REIT) that issues trust units (which are essentially equivalent to ordinary shares) to investors, raises debt capital, and uses the proceeds to purchase mortgages. The REIT pays no corporate tax and distributes all its net income in dividends to the investors. Assume that the REIT currently holds $20,000,000 in mortgages yielding 13 percent. The company's capital structure consists of 500,000 trust units with a total book value of $5,000,000 and $15,000,000 of debt yielding 11 percent. The trust units have a market price of $ 1 2.50 per unit.
(a) What dividend yield do investors obtain on the trust units?
(b) Mr. Smith has $200,000 available to invest in mortgages, which may currently be purchased to yield 13 percent to maturity. He may also borrow at 11 percent, and his bank is prepared to lend him up to $600,000 if he invests the whole $800,000 in mortgages. Mr. Smith is considering either purchasing units in the REIT or borrowing from the bank and purchasing mortgages himself. Based on the theory of capital structure, as developed by Modigliani and Miller, determine what Mr. Smith should do. Carefully explain your arguments and support them with numerical illustrations showing that your recommendations will maximize Mr. Smith's wealth.
(c) How would your answer to (b) change if Mr. Smith could only borrow from the bank at 13 percent?
(d) What, if any, other factors should Mr. Smith take into account in his decision?