The REIT Run by a Manager Paid to Make It Bigger

Two Ways to Run a REIT

A REIT can be managed in two ways. An internally managed REIT employs its own management and staff, who work for the REIT and its shareholders directly. An externally managed REIT hires a separate management company to run it, paying that company fees for its services.

The distinction sounds administrative and it has real consequences, because the external manager is a separate business with its own interests, and the way it is paid can put those interests in conflict with the shareholders it manages for.

The Fee Conflict

The heart of the issue is how external managers are typically paid. Many charge a base management fee calculated as a percentage of assets, or of equity, under management. Some also charge acquisition fees when the REIT buys properties.

This creates a direct incentive to grow the REIT, because the manager fee rises with the size of the assets it manages, regardless of whether that growth benefits shareholders. A manager paid on assets is rewarded for acquiring more properties, issuing more shares to fund them, and expanding the REIT, even if the acquisitions are mediocre and the share issuance dilutes existing shareholders.

The problem is that the interests diverge exactly where it matters. Shareholders want returns per share, which depends on buying good assets at good prices and not diluting themselves. A manager paid on asset size wants a larger REIT, which can be achieved by buying almost anything with almost any financing.

The Documented Damage

This is not a theoretical concern. Externally managed REITs have, on average and with exceptions, tended to underperform internally managed ones, and the pattern is consistent with the incentive.

The specific behaviours that harm shareholders are identifiable: issuing shares at prices below the value of the assets to fund fee generating acquisitions, buying properties of questionable quality to grow the asset base, and expanding aggressively in ways that benefit the manager fee more than the shareholder return. When a REIT repeatedly issues shares to buy assets while the share price languishes, the external management structure is often part of the explanation.

Why the Structure Exists Anyway

Despite the conflict, external management persists and has legitimate uses. It is common for new or small REITs that cannot yet justify a full internal staff, and for REITs sponsored by a larger asset management firm that provides the expertise. The external manager can bring scale, systems and experience that a small REIT could not build on its own.

The structure is also common in the non traded REIT space, where the sponsor manages the vehicle and the conflicts are correspondingly sharper because the shares do not trade and the market cannot discipline the manager through the share price.

For a small growing REIT with a well aligned manager, external management can be sensible. The danger is that the alignment depends entirely on the fee structure, and a fee based on size rather than returns embeds the conflict permanently.

What Reduces the Conflict

Better external management arrangements align the fees with shareholder returns. Performance fees tied to total return, rather than fees based on asset size, reward the manager for the thing shareholders care about. Caps on fees, and provisions that let shareholders terminate the manager, provide discipline.

The strongest alignment, and the reason many REITs have converted, is internalisation: bringing management in house so the people running the REIT work directly for shareholders. Many externally managed REITs have internalised over time, often under pressure from investors who identified the conflict, and internalisation is frequently treated as a positive corporate governance event.

The Bottom Line

An externally managed REIT is run by a separate company, and when that company is paid on the size of the assets rather than the returns, it is rewarded for growing the REIT whether or not growth helps shareholders. The result has been identifiable harm: dilutive share issuance and mediocre acquisitions that raise fees while lowering returns per share. The structure has legitimate uses for small or sponsored REITs, but the alignment depends entirely on how the manager is paid, which is why performance based fees and outright internalisation are the fixes that matter.