“Management changes, like marital changes, are painful, time‐consuming, and chancy.”

—Warren Buffett

I'm sure you've heard the phrase, “Bet the jockey, not the horse.” It refers to the idea that investors should focus more on the management team than the business model.

I consider the adage to be quite true, especially in REIT‐dom, where management teams are responsible for all the obligations of being a landlord – from finding a tenant to collecting the rent, taking care of repairs, and maintaining the balance sheet – and, of course, sending distributions (i.e., dividends) to investors. Stated bluntly, bad management can destroy value in a portfolio of real estate properties. Good management can add value.

I often tell people that, when you invest in a REIT, you're not only placing your “bet” on the underlying real estate. You're also putting your hard‐earned money toward paying the “jockey” that's running it for you.

That's why I spend a lot of time meeting with C‐suite executives, always looking for information to help me form a deeper understanding of the underlying investment strategy – and whether it allows my goals to be aligned with theirs. By that, I mean there's no conflict of interest between management and shareholders. Also, there's an independent board of directors involved and hopefully some insider ownership going on as well.

When leadership has some obvious skin in the game, you'd better believe it makes a difference in how things are run.

Remember that, as a shareholder in any company, you're helping to pay its CEO's, CFO's, and CIO's salaries. This means they owe you complete transparency regarding past earnings, acquisitions, or other pertinent information.

While there's no way they can effectively communicate with every single shareholder one‐on‐one, there are events where you can better interact with many of them. This includes Nareit's annual REITweek and The MoneyShow, where I'm a regular host for CEO roundtable events. I also frequently interview members of management on my podcast, The Ground Up. That's its whole purpose: to connect you with insider information.

In 1994, during a Berkshire Hathaway annual shareholder meeting, Warren Buffett explained how important it is to see how a manager performed. “Look at what they have accomplished,” he advised, “considering what the hand was that they were dealt when they took over compared to what is going on in the industry.” Those are wise words to follow.

Buffett always considers management to be a key factor on whether to buy into a stock or not. He said during the same meeting that, to learn more about a company's governance, read “about both what they've accomplished and what their competitors have accomplished,” then see “how they have allocated capital over time.”

In addition, review “how well they treat their owners” by reading their proxy statements. “See how they treat themselves versus how they treat [their] shareholders… . The poor managers also turn out to be the ones that really don't think that much about the shareholders.”

As a real estate developer for over three decades, I can attest to the fact that good managers can make or break a deal. In fact, as I reflect on my experience in the private sector, it makes me realize how important management is to the success (or failure) of operating a portfolio of real estate properties.

For example, one of my tough lessons in life had to do with being a multi‐unit franchisee for a global pizza chain. In addition to attempting to manage a portfolio of shopping centers and net lease buildings, I also took on the oversight of eight pizza stores in two states. If that sounds easy, let me assure you it wasn't. Not even close. And after losing close to a million dollars, I graduated with an honorary degree of hard knocks and a much clearer understanding of my “circle of competence,” as Buffett calls it. I meant well, of course. But that didn't mean it ended well.

In his 1996 shareholder letter, Buffett said, “What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected.’ You don't have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”

Thanks to that advice, and I'm sure due to my past missteps, I pay close attention to REIT management teams, always making sure they adhere to that mantra. That's why it's important to note the “pureplay” designation. REITs labeled that way are telegraphic investors that stick to their specialties. Whenever one begins to drift outside of its lane, I become skeptical, recognizing that there could be elevated risks to consider.

Personally, I tend to stay away from residential mortgage REITs for this reason. They're all externally managed, which means they have contracts with third‐party businesses to perform all material operations. This includes determining the optimal use of leverage and selecting assets, which means a very good chance of picking and grabbing whatever's available. The REITs themselves are almost always large asset managers that exist to manage fee revenue, a focus that too easily leads to trouble.

Speaking of externally managed landlords, they also have to pay base management and incentive/performance fees. So it's critically important to review the terms of their contracts with these third parties. When my team and I study them, we compare all aspects of the agreement to their externally managed peers in order to try uncovering any potential conflicts of interest. This includes understanding any total return provisions and performance fee hurdles.

And for any REIT whatsoever, I pay very close attention to each one's competitive advantage, with an emphasis on two critical defensive characteristics. Quoting Buffet yet again (now from the 1995 Berkshire Hathaway annual meeting), “We're trying to find a business with a wide and long‐lasting moat around it” that protects “a terrific economic castle with an honest lord in charge… .”

He then went on to explain ways a company can build and maintain a moat. It can happen if a business is “the low‐cost producer in some area. It can be because it has a natural franchise because of surface capabilities. It could be because of its position in the consumers' mind. It can be because of a technological advantage or any kind of reason at all… .”

As I referenced in Chapter 10, “To create value from external growth initiatives, a REIT must earn a return on any new investment that exceeds the cost of the capital deployed.” Some of the most successful ones over the last 10‐ and 20‐year periods have been able to generate superior returns consistently because of their disciplined capital markets practices. Their management teams recognize that, in order to generate predictable profit margins, they must be low‐cost providers just like Wal‐Mart and Coca‐Cola in their respective spaces.

Directly correlated to cost of capital advantage is scale advantage: How much bigger can they get, and what can they do with that size? In my opinion, this is one of the most important “moat metric” factors to know about when analyzing real estate investment trusts.

Remember that most of the industry's growth occurred in just the past 30 years, driven by the IPO boom of 1993 and 1994, the huge wave of secondary offerings in 1997 and 1998, and the increasing size of many REITs as time went on. Even so, the sector remains small in comparison to both the broader stock market and commercial properties. Equity REITs owned approximately $2 trillion in net real estate investments as of the end of 2020 – just 10–15% of the total value of all institutionally owned commercial real estate in the U.S.

This is all to say they have substantial growth prospects with a total market cap that could expand dramatically over the next decade. But will this actually happen? In order to hazard a guess, we need to consider two key questions: 1) Will a significant number of private real estate owners want either to become REITs or to sell their properties to them? 2) Will individual and institutional investors want to expand their REIT holdings or otherwise decide to own more commercial real estate in securitized form?

To be sure, REITs are perfectly positioned to gain market share as private property owners liquidate their holdings or utilize the upREIT tool as discussed in Chapter 3. And the highly fragmented marketplace should provide them with powerful opportunities to use their scale advantages over the next several decades. But remember their management teams must utilize costs of capital and economies of scale in the process to create shareholder value. Without those all‐important additions, REITs are likely to underperform, and their investors will be disappointed.

During the Covid‐19 pandemic, investors found that scale advantage especially was critical, allowing certain large, intelligently diversified REITs to grow their dividends anyway during those darkest hours. Those that weren't as expansive or well‐placed, meanwhile, were forced to cut their payouts.

Smaller companies are also often unable to develop the type of extensive organizations and levels of expertise found in major corporations. So we have to ask ourselves whether a REIT might be at a competitive disadvantage if it can't afford to hire the highest‐caliber employees or obtain the very best market information concerning supply and demand for properties in its market area. That lacking could affect its acquisitions, property management, financial reporting, budgeting, and forecasting.

Bigger isn't always better. And smaller isn't always riskier. But there are certain efficiencies that come more easily with substantial size, including greater bargaining power with suppliers and even tenants. Again, cost of capital is the name of the game, and better‐paid leadership is often better prepared to capture that potential.

On the other hand, larger companies can find themselves relying too heavily on the superstars they hire (e.g., Warren Buffett at Berkshire Hathaway or Steve Jobs at Apple). In those cases, shareholders are at risk of any sudden departures from these outstanding individuals. It's never good for any organization to be excessively dependent on a single individual, no matter how talented.

This brings up an important side note. Management succession is a sensitive issue that is, for obvious reasons, difficult for both investors and REIT management teams to discuss. Yet it's of vital concern. Genius is tough to replace in any organization, but it's particularly tough to replace in small‐ and mid‐cap companies like most REITs are. So REIT investors need to assess the capabilities of those who will likely be replacing them and what tools they will have at their disposal when that time comes.

Buffett put it this way (another of his 1995 meeting statements): “But we are trying to figure out … why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, ten, twenty years from now? What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?”

I haven't met Warren Buffett – yet – but when my co‐author and I published the initial Intelligent REIT Investor in 2016, I sent him a copy. I'm not sure if he read it, but I do know that Berkshire Hathaway has since become modestly active in the REIT sector, taking an equity position in Store Capital and a debt position in Seritage Realty.

Going forward, it will be interesting to see if other large institutions follow suit in a sector that was designed for smaller investors and still serves them well. Certainly, as we addressed early on in the book, institutional investors have become more active over the last two decades. According to John Sullivan, U.S. chair and global co‐chair of DLA Piper's real estate practice, there's approximately $400 billion in institutional capital ready to be invested in commercial real estate.

To me, this reiterates how important REITs continue to be as part of an asset allocation strategy – when chosen wisely. Whether you're Berkshire Hathaway or an Average Joe, investors must always insist on buying high‐quality stocks. Buffett said in a 1999 Fortune interview that, “The key to investing is … determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

Benjamin Graham, his friend and mentor, also insisted on quality, saying that “one of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years.” That quote is one of the many reasons I'm convinced he would have approved of REITs today.

Bottom line: Today, more than ever, owning and operating commercial real estate successfully requires a proper business and a proper business mindset, no matter the subsector. Competition is fierce everywhere, but well‐run organizations can often operate at lower costs and frequently enjoy more bargaining power because of their costs of capital and scale advantages, as I referenced earlier. It can't be overstated that these elements give them significant competitive edges more often than not. REITs that have both will almost assuredly attract and retain the strongest tenants because they can provide best‐in‐class services to them.

Although private companies can certainly build solid organizations and motivate employees and management, share liquidity makes it easier for their public counterparts to accomplish these objectives. Plus, stock options, bonuses, and purchase plans are flexible, provide liquidity, and act as effective motivational tools for employees – from the most recently hired all the way to top management. Likewise, disciplined decision making, adequate financial controls, and incisive forecasts are becoming increasingly important to publicly traded management teams as they seek to get ahead of the competition.

More recently earnings, social, and governance (ESG) issues have become items of intense interest for investors, making it increasingly important for REITs to thoroughly disclose how they're performing in each of those categories. Fortunately, this isn't an entirely new concept for them.

According to Stephen Hester, CFA and senior analyst at Wide Moat Research, several elements of ESG were already included in their regular reviews by higher‐quality due‐diligence officers and researchers. Admittedly, other aspects are less familiar, especially since the larger guidelines involved can and do change with society's expectations and capabilities. Its application in the REIT sector is no exception.

Leadership in Energy and Environmental Design (LEED) standards set the benchmark in sustainable building operation and design back in 1994. And by 2006, it had grown to six comprehensive systems encompassing all aspects of construction. Today, it's nine, and the challenges presented in 2020 could impact it again considering how sharply demand for improved air quality, touchless door systems, and other building enhancements have increased. Employee health and success are influenced by the buildings they work and live in, and companies will want to properly provide for their workers in this regard.

Alongside creating better buildings, companies in general are focused on building more accountable management teams. Everyone has a different vision of exactly what that entails, but the prevailing view is that more diverse viewpoints and backgrounds are necessary. As one example, the number of female CEOs at the top of Fortune 500 companies grew by 37.5% in 2019, an impressive amount, though the final figure does remain below 10%. On the other hand, 44% of non‐executive director appointments to those same businesses' boards were women.

As a final point on this matter, an annual survey conducted throughout 2020 polled large institutional investors about their interest in ESG factors. It found that a full third that weren't yet using it expected to do so in the near term – with overall interest climbing three times year over year. A solid 42% already incorporate them into their portfolio construction, another record‐high number. Stated simply, capital flows matter and money is flowing into ESG.

Along those lines is Jonathan Litt, CEO of Land and Buildings. A well‐known REIT activist, he's pushed hard to turn around troubled REITs like Taubman Centers and Apartment Investment and Management. Litt is best known for his sometimes forceful opinion that REITs should have boards with several independent outside directors who answer to shareholders’ concerns about such things as allocation of capital, expense control, and compensation programs.

These experts should also be savvy at implementing strong financial systems and controls. The stronger the organization and its financial discipline, the more efficient it will be as an owner and manager of real estate … and the more it should be able to increase market share relative to smaller, less well‐capitalized, and less disciplined competitors.

Litt says, “The job of a REIT CEO is capital allocation: sell assets when at a discount and sell equity when at a premium. If only all CEOs and boards followed that principal, we would have a more successful industry.” In the end, he's right. Many companies find that the corporate governance requirements imposed on them after they go public, while often nettlesome and costly, actually strengthen their organizations in the long run.

Others have resisted the call to move to the markets because of that burden, though, which might turn out to be the wrong choice. The way I see it, if these large private companies continue along their present path, the continuing expansion of the REIT industry will be driven by many smaller IPOs, by property acquisitions and developments (including joint ventures with institutional real estate owners), by existing REITs, and by a gradual increase in the values of REIT‐held properties over time.

Considering how that should be expansive, their private counterparts could find themselves falling further and further behind.

I'll end with this thought from Graham's Intelligent Investor: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

While I'm more than willing to slap the “speculative” label on specific REITs when appropriate, the larger sector is filled with more than merely “adequate” returns. It offers the real chance of securing a worthwhile, enjoyable, sustainable retirement for you to enjoy, with something to pass on to your loved ones should you so choose.

That's the power of REITs … a power I'm proud to promote wherever I can.