Reit unitholders should not assume that an internal manager will automatically leave them better off

IN THEORY, internalising the function of a real estate investment trust’s (Reit’s) manager looks appealing. There are cost savings in fees paid to an external manager, there is a closer alignment of goals (on paper, at least) between the manager and unitholders in terms of maximising distributions per unit, and having an internal manager would appear to minimise conflicts of interest that could arise if the existing external manager is a subsidiary of the sponsor.

Furthermore, the majority of Reits listed in the US – the world’s largest Reit market – are internally managed, so why shouldn’t Singapore-listed Reits, or S-Reits, follow suit?

No doubt these are compelling arguments. Certainly, they were sufficient for unitholders of Sabana Industrial Reit to accept when they voted at an extraordinary general meeting (EGM) on Aug 7 last year to internalise the Reit’s manager after lobbying by activist unitholder Quarz Capital.

So much so that there have been rumblings in the market that unitholders of other Reits should consider doing the same. Or should they?

For one, the internalisation process pioneered by Quarz has dragged on for almost a year now as there were legal hurdles to overcome, particularly the key issue of whether the trust deed has to be amended to effect the change.

In May, this was resolved when the High Court ruled that the answer is “yes”, while also ruling that Sabana’s sponsor, ESR Group, and its entities have to abstain from voting on the amendments. Although these rulings have been hailed as a victory for unitholders, questions still remain.

Apart from being in limbo for 11 months and counting, the process thus far has been quite costly – as at Mar 31, S$1.84 million of expenses have been incurred in connection with (and up to) the requisition of the Aug 7, 2023, and Mar 8, 2024, EGMs. And S$5.4 million was incurred in respect of implementation of the resolutions passed at those meetings.

For the sake of Sabana unitholders, one can only hope that the final bill after the completion of internalisation is eventually outweighed by the claimed benefits – however long this takes.

For other Reit unitholders, the danger lies in assuming a “one-size-fits-all” approach to Reit management, which may not necessarily be valid. Each case has to be assessed on its own, based on the characteristics of the Reit.

For instance, focusing on potential conflicts of interest between sponsors and sponsor-owned managers doesn’t take into account the importance of having a strong sponsor behind the Reit. This is in terms of helping secure advantageous financing terms, a pipeline of decent properties to inject into the Reit possibly at a discount, income support, and provision of tenant contacts.

In Sabana’s case, it is unclear what effect a change in manager to a non-ESR entity would have on its financing costs. In this connection, ESR has claimed that a 100-basis-point increase in funding costs would amount up to S$8.3 million in interest each year, far outweighing any savings from the new manager. However, whether or not this will indeed be the case remains to be seen.

Moreover, it is unlikely that sponsor-backed Reit managers would undertake value-diminishing transactions, given the reputational risks that might ensue and considering that sponsors typically retain stakes in the Reits in the first place.

All told, it would be best for Reit unitholders not to assume that an internal manager is automatically better. Instead, they should carefully consider all pros and cons if called upon to decide.