A sophisticated retail investor will have their own due diligence process when selecting real estate investment trusts (REITs) for their portfolio or ISA. REITs can prove excellent investments for income-seekers, as they tend to offer good yields that exceed those from bonds and other equities. Yet this investment universe – there are 118 REITs listed in the UK alone – comes with its own research challenges and nuances.
It is not just the outlook for a given sub-sector that is important, but how a particular REIT’s strategy, asset allocation and leverage levels will reflect that opportunity via performance. An important factor that could be overlooked during due diligence is the structure of a REIT’s management team and, even more specifically, how its managers are remunerated. Ultimately, this is about the alignment of interest between shareholders and the person or people running the money.
REIT management structures: internal or external
REITs can be managed internally or externally. The latter arrangement involves the contracting of third-party managers to make investment decisions.
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In the UK, just over half (52%) of REITs, by number, are managed in this fashion – though these tend to be below average, in size, and among the youngest in the REIT cohort. External management became the norm for new UK REITs in the period following the financial crisis when quantitative easing and the move to near-zero interest rates created fertile ground for new REITs to raise money.
Yet externally managed vehicles have a mixed reputation due to their potential for conflicts of interest and a lack of alignment between the managers’ fee and the best interests of shareholders.
Management fees are usually based on a percentage of AUM (assets under management). This means managers can be reluctant to sell assets, even when such sales would benefit shareholders, because in doing so they also reduce their own fee. Furthermore, in a bear market, share prices collapse much more quickly than asset values – meaning managers are essentially earning fees based on historic numbers.
Getting external management right
While internal management structures have traditionally been seen as best practice, many externally managed vehicles are evolving and addressing issues around alignment of interest. Phoenix Spree Deutschland (PSDL) – a small, UK-listed specialist owner of prime residential units in Berlin – supplies an interesting case study in this respect. When REIT asset owners have share prices that are languishing way below net asset value (NAV), disposals can become an important part of the strategy, as they demonstrate properties’ true, realisable values and generate cash to pay investor dividends or buy back shares at a discount.
Recognising this, in June PSDL’s board announced they had renegotiated with the company’s external manager, QSix, to pay it a 1 per cent disposal fee as an incentive to sell assets. The board also capped QSix’s management fee and ongoing costs at a much lower rate than the previous year. With the shares trading at more than a 50% discount to asset value, the board decided that it was no longer appropriate for the manager to be paid based on an asset valuation which was artificially high. The good news is that the solution is a virtuous circle – sell assets, which proves the asset value, which sees the share price rise. Smaller companies like PSDL – portfolio value €714 million (30 June 2023) – benefit disproportionately as a small number of sales can make a big difference in a difficult market.
The greatest form of alignment is for the manager to be remunerated on market capitalisation rather than asset value. This is the case with LXI REIT, a £1.6 billion long income-focused REIT, where the manager has shared in the pain of the share price correcting much faster than the asset value.
Fees as a barrier to M&A
It is no secret that the last 18 months have been torrid for the listed real estate universe, with shares continuing to trade at large discounts to NAV, even as we inch towards peak interest rates. Companies with the greatest leverage have suffered the greatest volatility – with generalist investors shunning the property sector and ignoring the fundamentals that underpin it. This means there are many REITs with strong fundamentals and yields that now look extremely cheap, making them attractive acquisition targets.
Merger and acquisition (M&A) activity is often an excellent way for shareholders to realise value. In May, CT Property Trust (CTPT), a £200 million market cap diversified REIT, announced it would be acquired by fellow REIT LondonMetric, at a 34.3 per cent premium on the former’s share price. We owned about 10 per cent of CTPT and so benefited from this deal. In fact, one of the many reasons we liked this REIT was that its management contract was a rolling six-month agreement, which offered an intriguing advantage from an investor's perspective. The contract can be terminated in mere months, meaning the acquirer pays a relatively modest fee to the outgoing manager. This flexibility provided a significant advantage for CTPT as a target, as it minimised the financial burden and will facilitate a smoother transition of management control.
At the other end of the spectrum, Urban Logistics REIT has negotiated a three-year fixed fee management contract with their board. Arrangements of this kind raise a number of concerns and contradict the steady evolution of ensuring alignment between owners and managers – where contracts have evolved to rolling one-year (or less) notice periods.
One obvious concern of such a long, fixed contract is the creation of a ‘poison pill’. Should Urban Logistics REIT be trading at a substantial discount to its asset value and become an acquisition target, any interested party would be obligated to pay the manager for the remaining years of the contract, which would amount to tens of millions of pounds. This would have to be deducted from any value paid to shareholders.
In conclusion, sophisticated retail investors should incorporate an evaluation of the management structure and remuneration arrangements of REITs in their due diligence process.
There is nothing wrong with an external management structure, in principle, but alignment of interest must be rigorously imposed by any board. Key features such as fees based on market cap, a manager who puts their own money in (eats their own cooking) and one-year rolling management contracts seem to be straightforward alignment controls. There is no need to revert to the dark arts of previous decades.
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