An external REIT manager is a third-party professional responsible for managing a REIT's portfolio of assets. The REIT contracts with these external managers in a structure similar to private equity arrangements, where the external manager is compensated with a flat fee and incentive fees for managing the assets on behalf of the REIT.
The advantages of hiring an external manager at a REIT
There are two primary reasons a REIT elects to hire an external manager. First, smaller REITs may not be able to afford to hire a full investment and asset-management team. Hiring an external manager gives the REIT access to a complete team of professionals, potentially at a fraction of the cost. For these smaller REITs, the drawback is that the external manager may also have other clients, limiting the time available to focus on each separate REIT.
Second, some REITs elect to hire an external manager to simplify their infrastructure. Instead of having to maintain an entire office of support staff, in addition to the investment team, the REIT can simply hire an external manager who will handle all necessary operational support and investment management.
A 2014 study by Fitch Ratings also found that externally managed REITs are better at controlling administrative expenses than internally managed REITs. In their review, costs at externally managed REITs were 20 basis points lower than their internally managed counterparts, relative to market value.
REITs with external managers present corporate governance challenges
The externally managed REIT structure is common around the world, but remains somewhat controversial in the U.S. Critics point to the corporate-governance risk of having an external individual with so much control over the decisions that drive the REIT's results.
Without a strong governance program, it's possible for the external manager to act in his own interest first, creating value for himself at the expense of the REIT and its shareholders. The problem is compounded if the external manager also has significant representation on the REIT's board of directors, creating a conflict of interest that could compromise the board's ability to effectively oversee the company.
To mitigate these risks, REITs can implement certain policies and practices to better align the REIT and the external manager. Incentive-based pay is the most obvious, ensuring that the external manager makes money only when shareholder objectives are met. The REIT can also require a certain number of independent directors be appointed to the board, further limiting the influence of the external manager.
Another common practice is to require the external manager to hold a significant equity position in the company, minimizing the potential conflict of interest by making the external manager itself a shareholder.
What fees do external managers receive?
Generally, external managers receive a flat fee plus an incentive fee. The flat fee can vary from REIT to REIT; however, it's almost always a flat percentage of the total assets under management at the company.
The incentive fee is more variable. Generally, the incentive fee is paid based on management's ability to achieve specific performance metrics that are both appropriate for the REIT's niche and objectives, and usually tied to an industry benchmark, as well. In this way, the incentive fee grows only when management is effective in its stewardship of the company's assets.
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