When REITs forgot about RE

When I first comprehended the benefits of the funds management model, I thought it was the closest thing to financial alchemy. All you need to do is put up 5-20% of a fund (assuming you can raise the rest off other people) and the manager gets to keep a stable stream of management fees. To put this in perspective, in commercial real estate, the typical unlisted fee structures are

1. Management fees of 40-70bps of gross asset value (i.e. including debt)

2. Transaction fees (acquisition or disposal of c.1%)

3. Development fees of 3-5% of development spend

4. Performance fees of 10-20% above a hurdle

Of course, the fees differ based on the size, structure (e.g. internal vs. external) and nature of the fund, however, you can begin to get a sense that the fee-income can become quite meaningful if you attract a meaningful fund size.

So how do REITs/Funds continue to charge these levels of fees? The short answer is; the net returns of wholesale property funds are generally still strong (NCREIF returns are shown below)

Moreover, it costs significant amount of money to set-up a REIT including a tech platform, finance, property management, leasing, asset management, development, transactions and finance.

That being the case, once you have the funds and the platform; this funds management income stream is very appealing. Generally, this leads to REITs to develop habits which typical private developers would never adopt. These include:

• Imperative to act: deploying funds into overpriced assets to justify transactions transactions fees

• Avoiding smaller profitable projects: as the size of a fund grows there is a justifiable lack of interest in smaller projects (despite these offering strong property-level returns)

• In-housing functions to "demonstrate" the platform: the increasing number of funds that in-house IT and property management often do so to improve the income stream

• Underpricing development risk: with most Development fees sitting at 5%, this can motivate funds to chose greenfield development (more risky) when a simple refurbishment can get a better return

Whilst each firm is run differently, and I won't comment on which managers fall victim to these pitfalls, it is worth the average investor being aware of how the funds management model can impact the way in which REITs operate and the culture within them.