Globe and Mail reporter Tim Kiladze.The Globe and Mail
It's tough to take pleasure from a downturn, but something about this rough patch for real estate investment trusts should make investors smile. Fingers crossed, it will be the end of external management contracts.
REITs once covered their expenses in a unique way. At corporations, costs such as machinery and salaries are subtracted from revenues to calculate profit. Real estate trusts tweaked this formula; instead of accounting for such outlays in-house, they covered them by paying a flat fee to an external manager.
The simplest way to think of this structure is to imagine extracting a trust's management team and human resources group and outsourcing it to a small company that is paid a percentage of the REIT's total assets – say 0.25 per cent, annually. The argument in favour of this model: efficiency. If a single outside group managed a few different REITs, each trust wouldn't need its own team, meaning that some costs could be cut.
That made sense in theory, and when industry veterans such as RioCan REIT started trading in the early nineties, it was the dominant structure. But it eventually became clear this model had some serious problems.
External managers weren't solely paid flat annual fees. They also made money every time their REIT issued equity. And they earned fees every time the REIT bought a new property. The knock against these contracts, then, was they rewarded bad behaviour. No matter how good or bad an acquisition was, the manager made money off it.
And it just so happened that external managers were usually run by the trust CEOs – meaning that the chief executive officer got paid fees up front, no matter how investors fared in the long run.
This became a big problem around 2003 as REIT unit prices took off during the income trust mania. Cha-ching. Things turned even more ludicrous in 2010. Postfinancial crisis, few investments were thought to be as stable as real estate trusts. Even better, they paid lofty yields.
Canadian investors couldn't get enough. From 2010 to 2013, the S&P/TSX Capped REIT Index skyrocketed 20 per cent each year, after including distributions. Property acquisitions were rampant during this era.
The good news: By the time the commercial real estate market caught fire in 2010, most REITs had quietly scrapped their external contracts. Few had said much about their decisions to exit them, but RioCan chief executive officer Edward Sonshine always called it like he saw it. "Everybody here at RioCan stands or falls with the success of RioCan," he told The Globe and Mail in 2012. "When you're externally managed, it's not quite the same."
The bad news: Two REITs that kept their external managers were some of Canada's largest.
Historically, H&R REIT was known for a management contract that was especially egregious, paying 3 per cent of gross rental revenue and 1 per cent of acquisition and development costs to H&R Property Management, an external manager owned by members of the Hofstedter and Rubinstein families (hence the "H" and "R" in the name; Tom Hofstedter is H&R's CEO). These fees were cut to 2 per cent and 0.66 per cent, respectively, around 2005, but the contract still paid big money for developments such as the Bow Tower in Calgary.
Dundee REIT – since renamed Dream Office REIT – had a similar arrangement. The external manager, run by CEO Michael Cooper, was paid a base management fee of 0.25 per cent of the REIT's asset value annually, 0.25 per cent of the value of any equity raise and a percentage of every building purchased. The acquisition fees particularly added up: From 2007, when Dundee installed its external manager, to 2014, the REIT's assets soared from $1-billion to $7-billion. In 2012 alone, Dundee's external manager made $30-million.
Funny enough, Dundee and H&R teamed up to buy Scotia Plaza in 2012 for $1.3-billion, paying the most for any office tower in Canadian history. H&R's external manager made $3-million off that deal alone.
Both REITs found religion by 2015, coming up with plans to unwind their external management contracts by persuading trust investors to pay hundreds of millions of dollar to buy them back. But by then the damage was already done. The external managers had been paid big money during the bull market, yet now some of the properties they were paid to acquire are being sold by the REITs to shore up cash.
Last week, Dream Office announced a divestiture plan to unload at least $1.2-billion worth of assets, and there are rumours swirling that both Dream and H&R could sell stakes in Scotia Plaza.
It's a classic market story. It took the tide to go out for the real problems to show. Once again, investors are the ones left saddled with the woes.
Tim Kiladze