The recent trend toward management and fee structures that better mirror global best practice in the real estate funds’ world will likely make externally managed REITs a more competitive alternative than they have been in the past.
Pros and cons of externally managed REIT vehicles
Externally managed REIT vehicles have historically faced challenges around fee structures, conflicts of interest and liquidity issues, but well-structured externally managed vehicles do exist. High-quality management teams, back-loaded fee structures and strong corporate governance are features of good externally managed vehicles. Consider the pros and cons.
Pros:
- Due to its scale, external management can — from the first day — offer unrivaled resources, talent (personnel) and influence. And, it can draft additional skills and resources from across the parent platform when needed. For an industry built around individual transactions and assets, access to best-in-class talent is critical. For new or smaller REIT vehicle, this can be a differentiating feature that enables a new REIT to establish itself more rapidly.
- Capitalizing on market opportunity — with an existing platform in place — managers can launch REIT products in response to evolving market trends.
Cons:
- Externally managed REITs have often been high-load products. While annual overhead for internal is typically less than 50 basis points (bps) of total assets, fees on externally managed vehicles are typically in excess of 100bps of net asset value. Fee structures may include sales commissions and dealers manager fees, as well as acquisition and investment fees.
- Fee incentives often challenge manager and shareholder alignment to receive higher management fees, but at the expense of performance or shareholder dilution.
- Performance hurdles may encourage managers to use excessive leverage and take undue risks.
Performance of internally versus externally managed REITs
We studied the performance and capital-raising activities of REITs by comparing those with internal versus external management structures. Our analysis suggests there may be some merit to the arguments made against externally managed REITs, but it is far from conclusive and less valid for smaller entities.
From a performance perspective, in the US, internally managed REITs have outperformed their externally managed peers by around 240bps per annum over the last five years. The differential is, however, reversed (externals outperformed by 145bps) for smaller entities (market cap under US$2b).
Outside the US, externally managed vehicles have performed well of late and even outperformed internally managed peers in established REIT markets, such as Canada and the UK.
The perception that externally managed REITs are particularly prone to raising equity capital also appears to have merit. Externally managed vehicles in the US have raised 30% of their current market cap through subsequent equity raises (primarily follow-on offerings) in the last five years, whereas internally managed vehicles have raised 13% of their current market cap.
Performance and capital raising
Externally managed REITs have performed well over the last three years, with particularly strong returns in Canada, the UK and Hong Kong. In the US — the most mature REIT market in the world — the performance differential heavily favors internally managed vehicles.
The US is the only market with a significant number of both internally and externally managed REIT vehicles with five-year track records. Internally managed REITs have outperformed externally managed vehicles by 240bps per annum on a total return basis. Externally managed vehicles with market caps under US$2b today have, however, marginally outperformed their internal peers.
For smaller and potentially less established REITs, investors appear to benefit from an external platform.
Capital raising — equity
Externally managed REITs listed in the US have raised relatively more capital in the last five years than their internally managed peers. With about 30% of their current market cap raised through equity offerings in the last five years, raising equity in an accretive manner and allocating capital prudently — both core functions of any REIT — become exceptionally important.
For externally managed REITs (not all of which have been listed for five years), the primary method of raising equity has been follow-on common equity offerings and, to a lesser extent, preferred equity.
Externally managed REITs in 2017 — better structures, better alignment and stronger governance
New, externally managed listed entities — in both the US and worldwide — are becoming increasingly prevalent as a result of structures better mitigating many of the historic alignment, fee and governance issues. Listed REIT products are now providing retail and institutional investors of all sizes with access to best-in-class fund platforms.
One of the main challenges for externally managed REITs is messaging and specifically allaying concerns — however unfounded — that corporate actions are being taken without shareholders’ interests in mind. Management teams should approach affiliated transactions with an expectation that the manager will receive scrutiny from the company’s array of stakeholders.
Critical, therefore, to the success of an externally managed vehicle is addressing even the most detailed structuring issues during the formation of the management relationship. Avoiding the need to undertake affiliated events is essential, as anything perceived to benefit the manager will be viewed with skepticism. The amount of detail in the initial contract describing the key terms is critical and will set the tone for the REIT’s success.
Investors, however, need to be sure that the REIT will deliver the strategy outlined at inception. Holding a board accountable through re-election is, therefore, a powerful tool. A compromise may be launching with a classified structure or plurality voting but committing to declassifying — which, as a process, can take a number of years — as part of the initial corporate governance strategy. This could give manager-appointed directors a set term (three to five years) to deliver the initial strategy before being subject to re-election and potential replacement.
A better approach is once again specifying up front which costs are reimbursable and which should be externally sourced.
Conclusion
Greater acceptance of external structures is an important step in promoting further growth of the REIT concept globally as more managers sponsor products. Externally managed REITs have a long way to go to rival their internally managed peer group in market cap terms. But, the recent trend toward management and fee structures that better mirror global best practice in the real estate funds’ world will likely make it a more competitive alternative than it has been in the past.
Getting the structure of an externally managed REIT right remains challenging, when, even in the simplest form, the relationship between management fees and promote can create an environment that influences, or is perceived to influence, subsequent management decisions.
Summary
Externally managed real estate investment trusts (REITs) have a long way to go to rival their internally managed peer group in market cap terms. But, the trend toward management and fee structures that better mirror global best practice in the real estate funds’ world will likely make it a more competitive alternative than in the past.
