They’re like non-identical twins, opposite sides of the same coin – internal and external management of REITs seems to be very much a case of “what you lose on the swings you gain on the round-abouts.’
Generally, REITs are either internally managed, with management as employees of the REIT/operating partnership, or “externally managed” pursuant to a management contract with no direct employees. Usually, private REITs and registered-but-not-traded REITs are externally managed for a fee by a related party manager. The related party fees for these types of vehicles can be significant and will vary based on the underlying investment premise and effort involved (e.g., “core” investment portfolio strategies typically have lower fee arrangements than those of more “opportunistic” vehicles).
In a REIT with an internal management structure, the REIT’s own officers and employees manage the portfolio of assets. A REIT with an external management structure usually resembles a private equity style arrangement, in which the external manager receives a flat fee and an incentive fee for managing the REIT’s portfolio of assets. The debate over which management method is preferential is favouring the internal management model. The controversy has centred on which method of management produces higher returns for investors, with some arguing that conflicts of interest underpinning compensation arrangements for external managers create incentives not necessarily in the best interest of the shareholders. Internalising management has emerged as the conventional wisdom for removing any conflict of interest between management and investors.
An external manager will typically receive a flat fee and an incentive fee. Generally, the flat fee is based on the asset value under management, which gives the manager incentive to purchase assets, while the incentive fee is based on the returns from the sale of assets. Most incentive fees for external managers are structured with a high water mark. Therefore, external managers will receive incentive fees only when the net asset value of a REIT increases above its highest historical net asset value.
External structures can create governance risks (at least when compared to REITs that are internally managed) and these governance risks can translate into credit risks. The central governance risk is that the external manager uses its control to extract value from the REIT to the detriment of shareholders and bondholders.
Curiously, data is not supportive of the thesis that internally managed vehicles outperform externally managed vehicles, despite popular opinion to the contrary. The potential for conflicts of interest are still greatest in externally managed vehicles and thus will continue to be actively debated. Ensuring maximum alignment of interests between investors and managers seems to be the key to regaining investor trust and support for externally managed REITS.
Having said that the following benefits for external management have emerged:
- An external manager has larger scale than the individual REIT, so it can provide services at a more economical cost than managing the REIT internally.
- With regards 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.
- When external manager service agreements are specific and outline strict performance criteria, boards of REITs are better placed to oversee the manager’s performance. (Source: Moody’s)
On the other hand the external manager uses his/her influence over the REIT to further his/her own interests over those of the REIT’s shareholders or bondholders; external management representation on boards limits the board’s capacity to independently oversee the external manager and there are few, if any, independent control structures.
As South Africa is still feeling its way into the REITs market it may be worth our while examining what the trends are internationally: The US has typically internally managed, with a few externally managed REITs. External managers are often controlled by owner managers and may manage multiple and related REITs. In the United States, most REITs have now adopted the structure of internal management.
Australia seems to value both internally and externally managed REITs however a large portion of REITs have transitioned to internal management structures over the last few years.
Canada has some externally managed REITs but most are internal as are European, Hong Kong and Singapore.
Good governance is essential for the continuing success of the REIT, as the market places a premium on this attribute. The market needs to be made aware of the REIT’s commitment towards a strong corporate governance mandate.
Clearly the advantages and disadvantages speak for themselves and there’s no doubt that internal management is the favoured option around the world. South Africa is already following that trend it seems as emerging REITs are internally managed.