The Effects of Gross vs. Net Asset Value-Based Managers’ Compensation on REIT Capital Structure and Performance. Evidence from the Italian REIT Market

Abstract. Investors should always argue about management fees because of their impact on net performance that can be substantially. This especially for investments, like real estate, that require intensive management. However, differently from traditional mutual funds that are usually related to the gross value of the assets under management, but similarly to other financial industry sectors (e.g. hedge funds and private equity funds), REIT managers’ compensation structure typically provides a basically fixed payment based alternatively on gross asset value (GAV) or net asset value (NAV). In addition, managers usually also gain a performance fee. The paper analyses how the two alternative compensation schemes influence REITs’ investment decisions and capital structure and, consequently, REITs’ share value and performance. The final issue addressed is whether – and under which conditions – one compensation scheme is superior to the other. Due to the (usual) market price discount on NAVs, both fee structures incentive managers to leverage – even in a tax-free environment – in order to maximize the management fees. However, the leverage motivation is stronger for GAV-based than for NAV-based REITs, which are also expected to be more selective in investment decisions. Overall, considering initial fee percentage, GAV-based REITs are expected to execute higher management fees than NAV-based REITs due to the relevant leverage effect. Moreover, debt recourse produces different effects on share value if measured upon market price or net asset value. The empirical analysis focuses on public Italian REITs (2002-2012). The results seem to support the theoretical expectations. GAV-based REITs experience higher debt trends and levels than NAV-based REITs. At the same time, GAV-based REITs register lower real estate asset returns gross and net of management fees for both current and growth yields. Differences in the returns lead to permanent higher performances over total return indexes of NAV-based REITs compared to GAV-based REITs.