Western real estate advisors case study: REIT roll-up

Real Estate Issues, Dec 1997 by McMahan, John

PENSION INVESTORS

Poor Performance: Although Western had faced problems, they paled in comparison with those experienced by older, larger investment advisory firms. And not without reason-pension investors were upset with real estate returns consistently lower than their securities portfolio, largely as a result of losses of up to 40 percent in real estate portfolio value. Also a concern, was the incredible amount of staff time that real estate investing seemed to require.

"Agency" Problem: Many investors believed that a large part of the poor performance record was an inevitable result of the investment advisory delivery system, in which the advisor not only initiated the investment, but managed it as well. Investors perceived a conflict of interest in this arrangement, as no one knew who the investment advisor really worked for. The fact that most advisors did not invest in the properties meant that advisory firms could be making money while their clients, the pension investors, were losing theirs.

Search for Solutions: In order to resolve these concerns, pension investors began exploring alternatives. About 30 percent, mostly smaller plans, decided to get out of real estate altogether. Not wishing to leave real estate, other plans sold their private market assets and invested the proceeds in securitized real estate, primarily REITs. Some of the larger public plans attempted to modify the private market investment process by requiring changes in their investment advisory contracts. They believed that by making certain requirements of their advisors (e.g. dedicated advisor staffs, dedicated reporting, advisor co-investment, etc.), they could capture the major benefits of securitized investing and still enjoy the greater portfolio diversification benefits provided by private market assets.

REAL ESTATE INVESTMENT TRUSTS

Legislation: The REIT Act of 1960 envisioned a conservative investment vehicle with certain tax avoidance features that would encourage longterm investment in real estate by individual, taxable investors.

Although regulations have loosened considerably over the years, REITs still must meet fairly stringent rules if they are to annually maintain their REIT status:

Have at least 100 shareholders. Five individuals cannot not own more than 50 percent of the stock (5/50 rule);

Seventy-five percent of assets must be in real estate equity, mortgages, REIT shares, or cash;

Seventy-five percent of income must come from rents or mortgage interest;

No more than 30 percent of operating income can come from properties held less than four years;2

Ninety-five percent of taxable income must be paid out annually.

In terms of organization, all REITs must be a corporation or a trust and be managed by a board of directors or trustees. The majority of trustees must be independent of REIT management.

Early History: Less than half of the REITs operating in the 1960s were self-advised (internally managed, no external advisor) and, even in these cases, management did not participate extensively in stock ownership. There was little market activity and not much coverage from the financial community.