Externally Managed REITs Don’t Have To Be Avoided At All Costs
Co-Produced with The Belgian Dentist
Internal versus external management
A REIT is externally managed when its management team is employed by a separate business on a fee-for-service. Often an external manager will provide services to a series of different entities. RMR (RMR) for example is the external manager of 4 REITS: Hospitality Properties Trust (HPT), Senior Housing Properties Trust (SNH), Office Properties Income Trust (OPI) and Industrial Logistics Properties Trust (ILPT).
A REIT which employs its own management team is “internally managed.”
The earliest REITs were externally managed in every respect – by law they had no employees. The 1960s through 1980s-era REITs were essentially mutual funds of commercial real estate properties, run by external advisors who were paid fees. These external advisors hired property management firms to run the physical assets and handle tenant interactions. Commencing with the 1986 tax act and the modern REIT era, REITs became “real” companies with internal employees, and the externally advised REIT model fell out of favor. The best REIT management teams behaved as operating entities that created value – they were no longer passive property owners.
Currently, many private real estate entities operate as a series of limited liability companies or LLCs, with an external management company overseeing each of them in exchange for an asset management fee and a carried interest participation in the ultimate profits of each entity. Many of today’s noteworthy publicly traded REITs were formed as a result of so-called roll-up transactions in which a series of these finite-life funds were reorganized into a newly formed REIT at the closing of the IPO.
Since there are conflicts of interest with external managers, it can be very difficult to generate sufficient investor interest to go public if an equity REIT continues to use an external manager. Therefore, REITs might consider internalizing their management company prior to, or concurrent with, its IPO.
REIT investors are generally very focused on making sure their interests are fully aligned with management’s interest when it comes to buying stock and pricing an IPO,” says Jeff Horowitz, Global Head of Real Estate, Gaming & Lodging Investment Banking for Bank of America Merrill Lynch.
“To achieve maximum investor demand and optimum pricing, we typically recommend REITs internalize management and be fully integrated, self-managed and self-advised.
The biggest problem with external management is the possibility of conflicts of interest between the management and the shareholders. Under most external management agreements, the managers are paid a base fee on assets under management. This means that the external managers may be incentivized to build larger portfolios, even at the expense of quality or profits. Furthermore, a number of managers hold board seats on multiple managed companies’ boards, resulting in further potential conflicts of interest.
As a result, even if an externally advised REIT is successful in completing its IPO, it will often trade at a discount to its internally managed peers.
The advantages of external management
A REIT, generally, will opt for an external manager for two reasons. First, an external manager will often have better scale than the individual REIT, bringing more advanced back-office and analytical capabilities than would otherwise be possible. Second, an external manager can allow the REIT to simplify its operations. Instead of having to manage a fully functional investment team with back-office support, the REIT can simply hire the third-party manager and rely on his or her existing infrastructure.
Also, with regard to management succession, externally managed REITs have a broader set of employees from which to select senior executives, thereby broadening the skills and experiences available to the REIT.
Which REITS are externally managed?
Below you can find a list of 19 US equity REITs that are externally managed. Most of them are indeed small caps. None of them is large cap and only two of them, Hospitality Properties Trust and Senior Housing Properties Trust are midcaps.
Exhibit 1: Externally managed REITs
Do externally managed REITs underperform?
The average annual total returns of externally managed REITs are claimed to lag those of the industry. But is this really true?
The Vanguard Real Estate ETF (VNQ) posted annualized total returns in the past three and five years of 7.2% and 9.0%, respectively.
The average annualized total returns of externally managed REITs was 4.8% and 4.1% in the same periods.
Exhibit 2: Total returns
Source: Seeking Alpha
In general external REITs have underperformed, but it might be presumptuous that the reason for underperformance is due to the structure. As previously mentioned, most externally managed REITs are small caps, while VNQ is made up primarily of large caps. The recent underperformance might have to do with market cap too.
Do externally managed REITs trade at a steeper discount?
Externally managed REITs are also claimed to trade at a steeper discount to NAV compared to internally managed REITs.
This claim is also in general true. Externally managed REITs trade at a discount of 17.1% to NAV, while REITs on average trade exactly in line with NAV. Internally managed REITs trade at a premium of 1.7% of NAV.
Exhibit 3: NAV Premium/Discount
What about the dividend safety of externally managed REITs. Does their weaker governance result in higher pay-out and debt ratios?
Exhibit 4: Dividend safety
As you can see in exhibit 4 externally managed REITs do indeed have weaker pay-out and debt ratios and hence a lower dividend safety. Nevertheless some externally managed REITs are able to grow their dividend while maintaining a pay-out ratio below 100%: Preferred Apartment Communities, NexPoint Residential Trust, Alexander’s (ALX), Universal Health Realty Income and Hospitality Properties Trust.
Finally let’s take a look at the valuation of externally managed REITs. In general they are a bit cheaper than internally managed REITs, as you can see in exhibit 5.
Exhibit 5: Valuation
The most significant problem with externally managed REITs is the potential conflict of interest between the external manager and the REIT’s shareholders. The external manager is incentivized to maximize his or her own benefit, which is not always in line with maximizing shareholder value. An external manager could, for example, prioritize growing the firm’s assets to maximize his base fee at the expense of picking profitable, high-return investments.
This problem doesn’t exist with an internal manager as in-house management is fully aligned with the company’s objectives. Internal managers have other advantages as well. An internal manager will have responsibility for only one portfolio, whereas an external manager may have responsibilities with several REITs that split his or her time and attention. The added focus of an internal manager can enhance capital allocation, ongoing portfolio management, and ultimately, shareholder returns.
But this doesn’t imply that all externally managed REITs have governance issues and should be avoided. As always, one has to be selective and do the necessary homework.
E.g. NexPoint Residential Trust scores very well on past performance, dividend growth and trades at a premium to NAV (which bodes well for expected growth). Unfortunately it’s not cheap.