Internalization Fee Horizon

To charge an internalization fee or not to charge an internalization fee, that is the question facing non-traded REIT sponsors.  Starting with Cole Credit Properties Trust II (CCPT II), which announced last summer that it was going to seek a liquidity event within twelve months, a number of non-traded REITs are, or should be, exploring a liquidity event for investors over the next several years.  A non-traded REIT’s liquidity event for shareholders can take various forms, including listing shares on a stock exchange, merging with another REIT, selling the REIT outright to another company, or selling properties individually or as portfolios.  Typically, as part of a REIT offering liquidity to its shareholders, the non-traded REIT sponsor will internalize the REIT's advisor, the separate but affiliated company that serves a conduit for a non-traded REIT's sponsor's management services to the REIT.  (There is no law that says a REIT must internalize its advisor).  The amount paid for a REIT to acquire its advisor is called an internalization fee. *

The internalization fee is important because it is, potentially, the largest form of compensation a REIT sponsor will receive.  Asset management fees and property management fees are fine compensation, but internalization fees are the mother lode.  Past internalization fees have ranged from the tens of millions to the hundreds of millions of dollars.   Internalization fees are unique from other forms of compensation because 1) the fee is not directly based on assets or performance, and 2) a REIT’s sponsor typically sets the price at which the non-traded REIT will acquire its management company.  A third party company will then affirm this valuation through a fairness opinion, but the sponsor typically determines who writes this opinion, and then allows the REIT to pay for it.  It’s no surprise that the third party firm magically confirms the sponsor’s value, but this process is a topic for another post.

Cole’s decision on whether or not to charge an internalization fee for CCPT II's advisor will influence other non-traded REITs that will seek liquidity options in the near future.  This is because CCPT II raised and invested its capital before the credit crisis.  CCPT II is a big REIT, having over $3.4 billion in assets at September 30, 2011, and its size will factor into its sponsor's decision-making process on what it does with CCPT II's advisor.  Other large, non-traded REITs that recently closed their equity offering periods, and that raised capital before, during and after the credit crisis, such as the first two KBS REITs, Wells REIT II, Inland American REIT, and CNL Lifestyle REIT will face the same decision as CCPT II.  How CCPT II deals with its external advisor will provide a clue to how the other non-traded REIT sponsors deal with their REITs' advisors.

I have no idea what CCPT II or the other non-traded REITs will do, but I would be surprised if the REITs pay significant internalization fees for their advisor.  Internalization fees, due the past size of the fees, have a stigma, and broker / dealers, analysts, and attorneys will scrutinize any internalization fees.   For sponsors that are raising capital for new REITs, an internalization fee for an old REIT has sales implications for the new REIT.  I suspect some of the non-traded REIT sponsors won’t charge internalization fees, but look to compensate management in other ways, such as stock grants (see my prior posts on Healthcare Trust of America, which internalized its management company without a fee, but has been granting stock to its executives with abandon (and impunity) ever since), or through lucrative, post-liquidity management compensation.  Some non-traded REIT sponsors may just decide to delay a liquidity event and keep earning their asset and property management fees.

I believe sponsors need to think long and hard before taking an internalization fee.  The financial temptation to take an internalization fee in some form or another will be great.  The REITs' boards of directors need to weigh the pros and cons of taking an internalization fee, including the negative connotation surrounding this fee that could impact the sponsors' current offerings and the cost of potential legal action by unhappy investors and aggressive attorneys.   I don’t want sponsors working for free, they do deserve fair compensation, but the compensation needs to be aligned with investors' financial interests, not at the expense of investors.  The decision to take an internalization fee doesn’t need to become a Shakespearean Tragedy. 

  *Internalization fee is the cost a non-traded REIT pays to acquire its management company from its sponsor.  Most non-traded REITs are structured as externally advised entities, where the REIT pays for management services from its sponsor.  Typically, a REIT “internalizes” its management as a process to separate itself from its sponsor.  The REIT typically pays the internalization fee to its sponsor in the form of REIT stock.  After an internalization fee the REIT will no longer pay asset management fees or property management fees, but pay directly for the management services.