What’s Behind Small Cap, Externally Advised REITs?

chart01.pngAmong the much-hyped apartments REITS, externally advised small caps have caught the attention of investors, thanks to their high yield and greater upside. For example, NexPoint Residential (NXRT) spiked by 29% last month, reaching a 51% year to date return. Independence Realty Trust (IRT), Bluerock Residential Growth REIT (BRG), and Preferred Apartment Communities (APTS) are averaging a 11% year to date return. However, if you are investing in these companies, you should be prepared for some distortions.

First, there is a reason that small caps are high risk, high return. The management is essentially fighting for survival or their place in the sun. Trading volume is thinner so stocks may not fluctuate in the smoothest manner. Moreover, they are often much less followed by the Street, meaning discussions over management moves and strategic planning tends to be little and less scrutinized by the market. Finally, they have fewer borrowing options and worse terms. Some strive for aggressive growth is an effort to be on better footing with bigger peers.

Second, externally managed REITs present a conflict of interest. Bluerock Residential went further and disclosed a long list of common situations where shareholders’ interest could be hurt when the REIT makes decisions. As a way to mitigate the conflicts, some external managers own a portion of the REIT. In Bluerock’s case, they own approximately 12% of the class A common stocks.

The following was extracted from their Risk Factors section in their last 10-k.

  • The external manager is under no obligation to dedicate specific personnel to the REIT. This means the REIT might not receive the same level of support it would if it were internally managed.
  • Some of the REIT’s officers work for the manager. This means that agreements between the REIT and the manager (for example, their management agreement) might not be favorable to the REIT and the REIT may choose not to enforce their rights.
  • As the result of conflicts of interests with their managers, the REIT could end up making decisions that are not in the best interest of their stockholders.
  • The incentive fee the REIT pays their manager may cause it to make riskier investments.
  • If they purchase properties from their manager, the price may be higher than it would have been had it been negotiated at arm’s length.
  • Regardless of the portfolio’s performance, the manager will receive a base management fee.

In a recent article, Hoya Real Estate questions the legality of Bluerock’s arrangements with external management and its private funds. Sounds like that this disclosure works as a blank check for the manager to do whatever they want without the fear of legal repercussions (click here). Nevertheless, other REITs also disclose potential conflicts of interest and whether they are disclosed or not, they are observable in all externally managed REITs. Bluerock simply had the courage to be thorough.

In conclusion, small caps were already high risk investments. The introduction of external management simply adds a new twist.

Source: Bluerock Residential Growth RE(AMEX:BRG), Preferred Apartment Communitie(NYSE:APTS),Independence Realty Trust, Inc(AMEX:IRT),NexPoint Residential Trust, In(NYSE:NXRT)

Disclaimer: This newsletter is not engaged in rendering tax, accounting, or other professional advice through this publication. No statement in this issue is to be construed as a recommendation to buy or sell any security or other investment. Please do your own due diligence before making any investment decision. Some information presented in this publication has been obtained from third-party sources considered to be reliable. Sources are not required to make representations as to the accuracy of the information, however, and consequently the publisher cannot guarantee accuracy.

Disclosure: The author has no positions in any shares mentioned, and no plans to initiate any positions within the next 72 hours.

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