Real Estate Investment Trusts (REITs) are increasingly popular in Singapore. Besides providing exposure to real estate at a low starting capital outlay, REITs also offer portfolio diversification, enjoy tax incentives, and offer relatively high yields.
But REITs are by no accounts perfect.
One flaw is that some REITs’ managers may not be specifically incentivised to increase their REITs’ distribution per unit- the metric that is most important to unitholders.
Because of this misalignment in interest, REIT managers may be tempted to pursue goals that end up harming unitholders. I did a quick review of some REITs in Singapore to compare how their managers are incentivised.
Misaligned interests?
For instance, Frasers Logistics and Industrial Trust’s manager is paid a performance fee that is 5% percent of the REIT’s annual distributable income. Mapletree Industrial Trust and Keppel REIT’s managers are paid a performance fee of 3.6% and 3% of the net property income, respectively.
At first glance, investors may think this is a fair practice, since it encourages the managers to grow their respective REITs’ distributable income and net property income. But the reality is that an increase in either of these may not actually result in an increase in distribution per unit (DPU).
In some cases, the net property income and distributable income may rise because of the issuance of new units to buy new properties, without actually increasing DPU.
Keppel REIT is a prime example of a REIT whose unitholders have suffered declining DPU in the past while its manager enjoyed high fees.
Performance fees aligned with unitholders
That said, there are REITs that have good performance fee structures.
For instance, Sasseur REIT and EC World REIT’s managers are paid a performance fee based on 25% of the difference in the DPU in a financial year with the DPU in the preceding year. In this way, they are only paid a performance fee if the DPU increases.
ESR-REIT has an even more favourable performance fee structure. They are paid 25% of the difference between this year’s DPU and the highest DPU ever achieved.
Base fees
We should also discuss base fee incentives. Besides performance fees, REIT managers are also typically paid a base fee.
The base fee may be pegged to asset value, distributable income, or net property income. The base fee helps the manager cover the cost of its operation. A base fee pegged to the size of the assets makes sense since a larger portfolio requires more manpower and overheads to maintain.
In my opinion, the base fee should be there to help cover the cost of managing the REIT, while the performance fee should be the main incentives for the REIT managers.
Based on a quick study of base fees, ESR-REIT and Mapletree Industrial Trust are two REITs that pay their managers a relatively high base fee of 0.5% of the deposited asset value. Sasseur and EC World REIT’s managers are paid a base fee structure based on 10% of distributable income.
Typically, investors should look for REITs that pay their manager a low base fee, which in turn incentivises the manager to strive to achieve its performance fees.
Conflicts of interests
As you can see, managers and minority unitholders of REITs may end up with conflicts of interests simply because of the way REIT managers are remunerated. If a manager is incentivised based solely on net property income, it may be tempted to pursue growth at all costs, even though the all-important DPU may decline.
On top of that, REIT managers’ are also often owned by the REIT’s sponsor. This might result in an additional conflict of interests between sponsors and REIT minority holders.
But having said all that, conflicts of interests may not always end up being bad for investors. Even if remuneration structures and interests are not aligned, an honest and fair sponsor might still feel obliged to treat minority unitholders fairly.
The Good Investors’ Conclusion
As retail investors, we have little power over the decision-making processes in a REIT. We depend almost entirely on the REIT manager. It is, therefore, essential that we invest in REITs who have managers that we trust will do what is right for us. So how do we do that?
The first step is to study the REIT’s manager’s remuneration package. Ideally, the REIT manager should be remunerated based on DPU growth. If the manager has poorly-aligned interests, you then need to assess if it has a track record of making honest decisions. Look at the REIT’s DPU history. Has it allocated capital efficiently and in a way that maximises DPU?
Too often investors overlook how important it is to have a manager that has the interests of minority unitholders at heart. Hopefully, this article brings to light the importance of having a good and honest sponsor and manager.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.