Created in the USA during the Eisenhower era, REITs have dominated real estate investment capital and in the past have returned healthy yields. Unchanged, they were introduced to Canada in the early 90’s and have flourished in popularity. Their primary attractiveness being their monthly dividend. This series aims to examine REITs, their structure, environment in which they operate and their risk to returns.
The question being are they relevant in today’s marketplace?
Started as an investment vehicle for real estate to compete in mutual funds, its often sited that REITs are superior structures as they dividend almost 75 to 95% of all excess cash.
One of the main foundational documents of this thinking was written in the seminal 1986 paper entitled “Agency cost of free cash flow, corporate finance, and takovers”. Here, the author Michael Jensen explored the notion of principal-agent http://papers.ssrn.com/sol3/papers.cfm?abstract_id=99580
The thesis of principal agent, was tied into several sectors, principally oil pipelines. http://en.wikipedia.org/wiki/Principal%E2%80%93agent_problem
Summarized, both state that if left to their own devices managers will squander or pocket excess capital the company generates at any and every chance they get, regardless of ethics, the longevity of the company, and oversight by the board of directors. The old Scorpion and the frog problem.
That’s a pretty heavy accusation. Compounding this issue is that Jensen’s paper has been taken out of context, by thousands of portfolio managers and applied to real estate/REITs, which are never once mentioned in the paper. Regardless of academic papers or well-rehearsed ideas, fundamental in commerce is trust.
The REIT structure is about a lack of trust in mangers to do the right thing. Any notion of ethics in these REIT managers is therefore assumed incompetence and or frivolity. The shadow of guilt is also cast over the independent board of directors as equally incompetent and untrustworthy to work in the vested interest of the shareholder.
With its mandatory payout, this government mandated, self regulated structure, is taking cash out of the hands of capable, experienced executives. And makes management loose the opportunities for innovation & yield that non-REITS have. The REIT structure by essence, is saying, investors cannot and should not trust anyone at the REIT to even do the right thing. That they will not and cannot, innovate in anyway whatsoever, because managers will take all and any cash and squander it on unprofitable projects.
How can management operate under this flawed veil of assumed guilt in a model called ironically called an investment trust?
They try to make the best of a flawed and unwieldy structure, covered in the next article.