Real estate investments can offer you different opportunities. Depending on your investment preferences and goals, you may pick one type of REIT over another. Internally managed REITS have managers who make investment decisions for clients, while externally managed REITS hire third-party management. Let’s compare the advantages and disadvantages for your portfolio.
A financial advisor can help you create a financial plan for your real estate investment goals.
What Is A REIT?
A Real Estate Investment Trust (REIT) is a company that owns income-producing properties or the mortgages of income-producing properties. Most REITs specialize in a specific type of property. But some offer a mix of investments within the REIT.
As an investor, you can buy shares of a REIT. Investors can buy shares through the company or as an exchange-traded fund or mutual fund.
As a shareholder, you buy an interest in the REIT’s properties. When the property generates income, you’ll receive a share of the profits in the form of a dividend.
Essentially, REITs are attractive investment vehicles for investors who want to reap the rewards of real estate. But you might not have the time, energy, or risk tolerance to manage individual properties.
Internally Managed REIT
As stated earlier, internally-managed REITs have managers who make investment decisions. With an internal manager, the incentives between the manager and the shareholder can be more aligned.
How This Affects Investments
Internal managers often only have the responsibility of one REIT portfolio. With that, they can spend all of their time and attention optimizing the REIT for shareholders.
This laser focus can bring enhanced capital allocation and efficient portfolio management. Ultimately, shareholders could enjoy the rewards with potentially enhanced returns.
Pros and Cons of Internally Managed REIT
Before you invest, here’s a breakdown of the advantages:
- Potential conflicts of interest avoided
- Manager only responsible for one portfolio
- Added focus
Now, let’s take a look at some disadvantages:
- Potentially less experience
- Must create own infrastructure
While an internal manager’s incentives could align with shareholders, costs could eat into your returns as infrastructure is built out. Additionally, potential experience gaps could also pose a problem.
Externally Managed REIT
Externally managed REITs hire third-party managers to make investment decisions. They are the traditional option in the U.S. When REITs were first formed in the U.S., external management was selected as the model based on the example set by the private equity industry. Over time, the U.S. market transitioned to a largely internally managed model for REITs. But on a global level, externally managed REITs are still popular.
This style of management puts less pressure on the REIT to set up back-end operations. Instead, the REIT can rely on the systems put in place by the external manager.
How This Affects Investments
Many REITs still choose this option because external managers can bring more experience and analytical capabilities to the table. But the REIT will have to pay for the help of an external manager.
Typically, a fixed percentage of the assets under management represents the fee. Additionally, there is often an incentive fee that the manager can unlock by hitting pre-determined performance goals.
Pros and Cons of Externally Managed REIT
Before you invest, let’s take a look at the advantages of internally managed REITs:
- Potentially more experience
- External manager brings analytical capabilities
And now, let’s compare the disadvantages:
- Split time and attention
- Potential conflict of interest
Although an external manager may have more experience and resources, their incentives might not align with the shareholders. For example, an external manager might receive a commission or benefit for adding a particular security to an account. Also, an external manager could choose to prioritize growing the asset base over profitable long-term investments.
Bottom Line
When selecting between an internally managed and externally managed REIT, the choice may already be made for you. In the U.S., the vast majority of modern REITs are internally managed. Although it’s possible to find externally managed REITs in North America, it’s rare. However, other markets such as Japan and Australia have more of a mix of internally managed and externally managed REITs.
The difference between both styles of REITs boils down to the incentive alignment of the managers.
Tips for Real Estate Investing
- A financial advisor can help you determine which type of REIT best fits into your financial plan. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Real estate assets can provide meaningful income for your retirement. SmartAsset’s retirement calculator will help you estimate how much income you’ll need when you quit working.
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