The Impact of Underpricing of the Default Risk on Investment: Evidence from Real Estate Investment Trusts (REITs)

Underpricing of the default risk of borrowers is theoretically proved to be immanent in a market with many lenders, given sufficient time, because of a race to the bottom for lending interest rates. This study examines the impact of underpriced default risk on investment in the real estate investment trust (REIT) sector, where firms’ investment is highly sensitive to changes in credit market conditions. The findings reveal that REITs exploiting underpriced default risk have a higher level of investment than their peers since the former can obtain access to loans having low rates of interest. In addition, we also find that default probability is negatively related to investment.