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Executive Summary.
Research has shown that externally-advised equity real estate investment trusts (REITs) underperformed internally-advised REITs prior to 1993. We contend that an increase in monitoring by institutional investors beginning in 1993 would drive externally-advised REITs to mitigate problems associated with the external advisor relationship and improve performance. We confirm that externally-advised REITs performed poorly before 1993 and show that this underperformance does not persist in 1993 and later years. This performance improvement coincides with increases in institutional ownership of REIT stocks. We present evidence that supports the notion that monitoring by institutional investors helped equalize the performance of externallyand internally-advised REITs after 1993.
Over the past several decades, there have been a number of modifications in the laws and regulations governing the structure of real estate investment trusts (REITs). Among these modifications is a change in the flexibility that REITs have in their management structure. Prior to 1986, the codes required REITs to retain an outside organization (or organizations) to manage their investment portfolios (the external advisor) and to manage the properties in their portfolios (the external manager). The original concept was that REITs would serve as passive entities investing in real estate similar to the way that mutual funds invest in securities. Mutual funds pay an investment advisory firm to make investment decisions, and the funds do not involve themselves in the operation of the companies whose securities they hold.
While this original design for REIT management seemed to be a good idea, experience began to show that there were problems with the structure. Agency problems, self-dealing, and conflicts of interest when advisors had multiple clients appear to lead to REITs making decisions that are not in the best interests of the REIT investors.
After the passage of the Tax Reform Act of 1986, the Internal Revenue Service (1RS) relaxed this restriction through several private-letter rulings and allowed REITs the option of making their own investment decisions and of managing the operations of their investment properties. Following this change, REITs no longer had to hire outside advisors and managers, although many continued to do so. However, internal management appears to have become the structure of choice within a relatively few years. Ambrose and Linneman (2001) reported that by 1996, internally-advised REITs dominated...