Internal vs. external management structures

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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.

Two emerging trends will have important consequences for many REIT markets:

  • As the REIT concept has gained global traction, there are more markets where the external concept is either a requirement or considered the default structure — Japan, India (required), Singapore, Hong Kong (default).
  • Externally managed structures are evolving by addressing fee, conflicts of interest and, where appropriate, liquidity issues by mirroring successful fund models.

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.

Pros Cons
An external manager can offer resources, talent (personel) and influence that an internally managed REIT may not be able to rival due to the scale of the external advisor.

An external manager brings these benefits on day 1 and can draft additional skills and/or resources from across the parent platform as and when they are needed. For an industry built around individual transactions and assets, access to best-in-class talent is critical.

For new and/or smaller REIT vehicle, this can be a differentiating feature that enables a new REIT to establish itself more rapidly.
External managed REITs have often been high-load products, particularly in comparision with their internally managed peers, where annual overhead is typically less than 50 basis points (bps) of total assets. Management fees on externally managed vehicles are typically in excess of 100bps of net asset value, and fee structures may include sales commissions and dealers manager fees, as well as acquition and investment fees.
Fee incentives often challenge manager/shareholder alignment either through incentivizing transactions or by encouraging managers to raise capital and grow the size of the business in order to receive higher management fees at the expense of performance and/or shareholder dilution.
Capitalizing on market opportunity - with an existing platform in place, managers can launch REIT products in response to evolving market trends Performance hurdles may encourage managers to use excessive leverage and take undue risks.

Performance of internally vs. externally managed REITs

We studied the performance and capital-raising activity of REITs by comparing those with internal vs. external management structures. Our analysis that follows 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.

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.

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.