REIT: In one study you and your co-authors investigated whether REITs with more shareholder-oriented governance gain higher valuations at their initial public offering and have stronger long-term performance. Why is governance so important?
Hartzell: I think of corporate governance as the set of mechanisms that align the incentives of managers with those of the shareholders, and to some extent, overcome human nature that would otherwise lead managers to pursue their own self interests. This is important because in a world with many dispersed shareholders, few shareholders have the incentive to spend personal time and money monitoring management, and few have the power to influence management even if they did do such monitoring.
Strong corporate governance, including oversight from a capable board, sets management’s objectives such that shareholders can trust that their interests are being taken into consideration.
REIT: Another of your papers seems to be especially relevant to the current market situation for REITs: you and your co-authors found that REITs with stronger corporate governance and increased ownership by institutional investors respond more positively to the available investment opportunities. Can you expand on the importance of transparency, monitoring, and discipline in producing stronger returns for investors?
Hartzell: Back to the human nature problem, investors have to be concerned that management will be tempted to invest aggressively even when they are faced with relatively weak investment opportunities. Management might be tempted to grow the organization or “empire build” even if market conditions suggest they do otherwise. But, strong corporate governance can help ameliorate these problems.
Due to the transparent structure, REIT investors have a better sense of management’s investment policies (compared to regular C corporations) and this transparency, combined with oversight by sophisticated and motivated investors, can ensure that management is responsive to market conditions rather than overconfident in their ability to add value in spite of the market.
REIT: You’ve compared the compensation of REIT executives with that of general partners in private equity real estate funds and found that GPs capture 10 times as much of the increase in share value as REIT executives do. Yet data from the NCREIF-Townsend Fund Indices suggest that fund investors have not done nearly as well as REIT investors, even during bull markets. Does your body of research suggest any likely reasons for this discrepancy?
Hartzell: Our study focused on the period just after the Tax Reform Act of 1986, when limited partnerships were sold as opportunities for individuals to invest in real estate, as direct competitors to REITs. Limited partnerships had lost most of their tax advantages over REITs, and with the advent of the UPREIT structure, the playing field was leveled further.
LPs’ lack of control over GPs implies that there is a need for much stronger pay-for-performance, or incentive compensation. But, this compensation is expensive and can benefit the GP at the expense of the LPs.
These differences in governance that are driven by the organizational form – to say nothing of the differences in liquidity or transparency – mean that the hurdle is high for privately-held limited partnerships to be able to add value for passive investors relative to the REIT structure. Your data suggests that from the LPs’ perspective, many funds have not overcome this hurdle.
REIT: In another study you looked at the conditions that result in IPO waves in the REIT industry. Do you expect that the IPOs we’ve seen recently are the first in a REIT IPO wave over the next few years?
Hartzell: Yes, I expect to see another wave of REIT IPOs. My sense is that there is a renewed focus on many of the attributes where public REITs have inherent advantages – the ability to access a wide variety of capital sources very quickly and at low cost, better liquidity for investors, greater transparency, and stronger corporate governance.
REIT: Are REITs part of your investment portfolio?
Hartzell: Yes. I have REITs in my personal portfolio, and we also have a student-managed investment fund that is dedicated to investing part of our Center’s resources in REITs. Unfortunately (or, maybe fortunately), our students have generated more alpha than I have.