Journal of Real Estate Finance and Economics, 20:2, 91±116 (2000)
# 2000 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Debt, Agency, and Management Contracts in REITs:
The External Advisor Puzzle
DENNIS R. CAPOZZA
University of Michigan Business School, Ann Arbor, MI 48109-1234
PAUL J. SEGUIN
Carlson School of Management, Minneapolis, MN 55455-0430
This study investigates why externally advised real estate investment trusts (REITs) underperform their
internally managed counterparts. Consistent with previous studies, we ®nd that REITs managed by external
advisors underperform internally managed ones by over 7 percent per year. Property-level cash-¯ow yields are
similar between the two managerial forms, but corporate-level expenses and especially interest expenses are
responsible for lower levels of cash available to shareholders in externally advised REITs. We document that
the higher-interest expenses are due to both higher levels of debt and to higher debt yields for externally advised
REITs. We posit that compensating managers based on either assets under management or on property-level
cash ¯ows creates incentives for managers to increase the asset base by issuing debt even if the interest costs are
Key Words: agency costs, executive compensation, real estate investment trusts
Recent years have witnessed a rapid evolution in both the legal organization of claims to
real estate assets held by investors and in the compensation of managers of these assets.
The predominant real estate investment vehicle of the 1980s, the syndicated real estate
limited partnership (RELP), is now relatively rare. In its place, real estate investment trusts
(REITs) have burgeoned as the preferred real estate investment vehicle.
The compensation of real estate management has also evolved. Most RELPs were
managed by their sponsors, who typically held a 1 percent general partnership interest but
whose compensation derived primarily from asset-based or property-income-based
Many REITs have been managed by external advisors under contracts similar to those
found in the RELPs. Three types of fees are common among external advisor contracts.
First and most common are fees based on total assets under management (65 percent of
external advisor contracts). Other contracts specify fees as a percent of property-level
income (62 percent) (rental income minus property expenses) or as a percentage of
transactions volume (55 percent) (e.g., purchases and sales of properties, or issuance of