Encouraging Boards to champion governance practices that safeguard the interests of shareholders
This article was originally published by Green Street News here
By Marcus Phayre-Mudge, fund manager, TR Property Investment Trust
For real estate investment trust (REIT) investors, examining the remuneration of managers is rarely a waste of time. It is not necessarily the amount managers are paid that matters most, but how this is calculated, given that compensation metrics drive behaviour.
TR Property owns stakes in more than 50 pan-European property companies, and we have no problem if the people managing the companies successfully are well remunerated. However, this sentiment is entirely contingent on us – and our fellow shareholders – also reaping the financial rewards through the payment of dividends and the share price performance.
External management: the devil’s in the detail
This article is not going to delve into the nuances of C-suite executive remuneration – there are multiple consultants available to advise boards on appropriate metrics for their CEOs and CFOs. Instead, this piece will focus on an important issue in REIT Land: that of external management.
While the vast majority of listed companies have internal leadership structures with a CEO and CFO hired directly by the board, many REITs use external management contracts, under which boards appoint third-party contractors to manage the REIT’s assets and make investment decisions. In the UK, 51 per cent of listed property companies, by number, are externally managed[1]. These vehicles tend to be smaller and younger than their internally managed peers – the most well-known exception being Tritax Big Box. The relative youth of these companies comes from the fact that external management became the norm when establishing a REIT in the period following the financial crisis, when quantitative easing and the move to historically low interest rates created ideal conditions for new trusts to raise money.
Unfortunately, some contracts may misalign the objectives of the external manager with those of shareholders. Managers can lose sight of their primary objective, which is to generate real returns for the company’s owners. Certain management contracts, I believe, lead to financially incontinent ‘investment’ decisions.
Share buybacks: when managers get in the way
Poor external management practices include paying fees based on net asset value (NAV), rather than fees based on market capitalisation. Given shareholders cannot benefit from NAV returns directly, readers will soon see the problem here. The recent enthusiasm for share buybacks provides a backdrop for examining how some external managers prioritise a large asset base ahead of the company’s share price.
Winterflood reported that 118 investment trusts repurchased their shares in April 2024, the highest monthly total since the analyst’s records began in 1996[2]. Even casual observers of the REIT sector know that these companies continue to trade at among the largest discounts to asset value on a sector basis, often making share buybacks a good option. By repurchasing shares at a discount to NAV, a company effectively buys its own assets at a lower price than they are worth. This increases the NAV per remaining share. Yet buybacks also reduce a company’s cash holdings and therefore its asset base. For the manager whose pay is based on asset value, it is easy to see why such a move would be unappealing, even when it would benefit the shareholders who patiently await a healthier capital return.
Warehouse REIT[3] (LSE: WHR) owns an £810 million portfolio increasingly focused on multi-let industrial, one of our favoured sub-sectors. Since the beginning of this financial year, the company has raised £61.6 million via the sale of single-let industrial assets, no longer its area of focus. With the share price languishing at a 30 per cent discount to NAV, the use of these sale proceeds was a clear focus for shareholders: Would they buy their own, existing, handpicked portfolio at a sizeable discount? Or would management resist the reduction in the size of the portfolio? The answer – unfortunately in my view – is that Warehouse REIT spent £38.6 million buying a Tamworth retail warehouse park at current market value, plus 7 per cent transaction costs. Buying its own stock – which incurs stamp duty of just 0.5 per cent – would have provided guaranteed value accretion per share that buying assets at market value, plus costs, simply cannot match. In addition, the improvement to earnings per share would have been baked in. Call me cynical, but I do not believe it is a coincidence that its external manager’s fees are based on a percentage of NAV, not on market capitalisation.
Multi-year contracts: A poison pill for M&A
Another property company that has been busy buying assets at market value while its own shares trade on a heavy discount is single-let warehouse specialist Urban Logistics REIT (LSE: SHED) – though here we have the added issue of an over-long management contract.
In 2023, the board of Urban Logistics REIT agreed to appoint Logistics Asset Management as its investment adviser on a three-year contract which commenced in May 2024. One obvious concern of such a long, fixed contract is the creation of a ‘poison pill’. I have written many times about the virtues of M&A activity as a value underpin for shareholders dealing with stubborn discounts. But should Urban Logistics REIT become an acquisition target, any interested party would be obligated to compensate the manager for the remaining years of the contract, a sum amounting to tens of millions of pounds (during the most recent financial year, Urban Logistics REIT paid its investment advisers £6.8 million). This payout would have to be deducted from any value paid to shareholders. Consider the benefits for Logistics Asset Management, as what was essentially its revenue turns into pure profit, given its lack of ongoing operating costs.
Strengthening REIT governance practices
As we can see, misaligned incentives can lead to financially incontinent decisions that prioritise manager compensation over shareholder value. But it is possible to get external management right, with good controls including fees based on market cap, a lead manager that eats their own cooking, and one-year – maximum – rolling management contracts.
We do have a poster child for good governance: one where board and management have worked together to re-engineer the incentivisation and contract costs. The stock is Phoenix Spree Deutschland (LSE: PSDL), a small cap portfolio of prime Berlin residential properties, where the strategy has evolved to one of de-gearing and asset sales given the gulf between share price and asset values. The absolute fee paid to its external manager, QSix, has reduced twice in the last 18 months, with management given an additional incentive to sell assets – in line with the board’s strategy. It is also worth noting that the manager is keen to impress shareholders as its contract has a continuation vote in July 2025. It is time for all REIT boards to take this type of decisive action and champion governance practices that safeguard the interests of shareholders.
Capital at risk. Approved by Columbia Threadneedle Management Limited on 09/09/2024
[1] 20 out of the 39 UK names in the EPRA index are externally managed, as of 9 August 2024
[2] Winterflood Monthly Investment Trust Review: April 2024, released 8 May 2024
[3] The mention of any specific shares should not be taken as a recommendation to deal.
