Executive Summary
The primary arguments against externally managed REITs are that the fees are too large, conflicts of interest too great, and transparency too low.
There are two main advantages associated with externally managing a REIT. The first is that externally managed REITs generally scale better and allow for more advanced back-office and analytical capabilities sooner in the REIT’s lifecycle.
The FIBRA industry has made impressive strides in internalizing management structures in order to satisfy its investors’ preferences and requirements.
Of the six FIBRA IPOs since 2018, only one (i.e., FIBRA Storage) has launched with external management structures. As of March 2023, 53% of the seventeen listed FIBRAs are managed internally, up from 20% in 2015 and 47% in 2019.
An analysis of NAV discounts of externally and internally managed FIBRAs, indicates that externally managed FIBRAs are trading at a significant discount compared to their internally managed counterparts.
Introduction
The externalization of FIBRA (i.e., REIT in Mexico) management teams has been a contentious issue with some investors in the asset category in Mexico. In 2019, Sam Zell blasted the practice of managing FIBRAs through external structures deeming FIBRAs uninvestable. This mattered because Zell is one of the pioneers of the American REIT industry, and introduced the first Brazilian and the first Mexican focused real estate companies on the New York Stock Exchange. Afore Sura, one of the largest pension fund administrator companies in Mexico, made similar comments in 2018 when it strongly urged the industry to internalize management structures or risk losing investor support.
The primary arguments against externally managed REITs are that the fees are too large, conflicts of interest too great, and transparency too low. In a typical externalized management arrangement, the outside management team collects annual asset management fees based on the NAV (i.e., assets – liabilities) of the properties. The financial incentive (i.e., conflict of interest) to overstate asset valuations, and raise more capital to purchase more properties, is a material concern for most serious investors. The external management companies often make additional fees for services such as leasing, tenant coordination, marketing, and brokerage services. In contrast, internal management teams are usually rewarded through delayed compensation linked to share performance and other metrics aligned with the interests of investors.
There are two main advantages associated with externally managing a REIT. The first is that externally managed REITs generally scale better and allow for more advanced back-office and analytical capabilities sooner in the REIT’s lifecycle. This is especially the case with smaller REITs (i.e., less than $2 billion market cap) which don’t have the asset base to support and recruit robust management teams. The second benefit is that the structures are simpler and cleaner which permit the REIT leadership to focus on core activities and less on personnel, and building and managing its own back-office operations.
In 2017, Ernst & Young compared the financial performance of international REITs managed by internal and external management structures. The general findings were that externally managed REITs did quite well and even better than their internally managed counterparts in the developed REIT markets of Canada, Australia and the UK. This indicates that the strong investor preference for internalized management teams is not materially driven by returns. What’s more likely at play is a general aversion to investing in companies with unaligned management structures. There is something quite different between the company cultures of a brokerage and development team, compared to a team dedicated to managing a large real estate portfolio on behalf of institutional investors.
Figure 1: International REIT Performance By Position of Management Team (E&Y Chart)
Mexican FIBRA Progress Towards Internalization
The FIBRA industry has made impressive strides in internalizing management structures in order to satisfy its investors’ preferences and requirements. Of the six FIBRA IPOs since 2018, only one (i.e., FIBRA Storage) has launched with external management structures. As of March 2023, 53% of the seventeen listed FIBRAs are managed internally, up from 20% in 2015 and 47% in 2019.
Figure 2: FIBRA Rate of Internalization
The 53% of FIBRAs that are internally managed today control around 43% of the total FIBRA market cap on the Mexican stock exchange. This spread can largely be explained by FIBRA Uno, an externally managed FIBRA, which has the largest market cap by a significant margin.
Figure 3: FIBRA Market Cap by Position of Management Team
Only one FIBRA, FIBRA Inn, has transitioned from an external to an internal management structure. Shortly after the restructuring, the general and administrative fees represented .8% of the total asset value, a decrease from 1.1%. These hard savings are in addition to the more intangible benefits of satisfying investors and increasing the likelihood of successfully tapping into capital markets in the future. Recently, a private group of investors has taken control of FIBRA Inn’s assets calling into question whether it remains in the internally managed category.
NAV Discounts/Premiums as a Measuring Tool
Internalization of management structures will continue to be driven by investor demands in every REIT market, including Mexico. When the NAV of a REIT is higher than its market cap, this discount is evidence that something beyond fundamentals is driving investor sentiment. In these cases, the opposite of a discount is a premium.
American REITs emerged in the 1960s as mostly externally managed entities. It wasn’t until the 1990s, when an investor-led movement began demanding management structures be internalized, that real change began. This pressure resulted in significant discounts to Net Asset Value (“NAV”) for the American REITs which refused to cooperate. Correlated to REITs internalizing their management structures, is the explosive growth the industry experienced as shown in the below chart. Today, American REITs account for about 70% of the global REIT market cap.
Figure 4: Explosive REIT Growth in America
An analysis of NAV discounts of externally and internally managed FIBRAs, indicates that externally managed FIBRAs are trading at a significant discount compared to their internally managed counterparts. This effect is likely primarily driven from investors exerting pressure through withholding investment. The spreads are potentially exacerbated by a desire of the externally managed FIBRAs to push up NAVs in order to collect larger fees for themselves.
Figure 5: FIBRA NAV Discounts and Premiums
Contributor to this paper: Antonio Alejandro Gonzalez Castillo, the cofounder of fibraspy.com and the author of a book investing in Mexican REITs.
Comments