By John J. Kriz

With REITs gaining in numbers, scope and size around the world, governance is fast becoming a key topic for investors—debt and equity alike. Good governance not only helps speed the resolution of personnel, strategic or operating problems, but more important, it helps to stop them from arising in the first place.

Moody's Investors Service evaluates REIT governance on two levels: the quality of governance practices, and the degree to which the board and management team have shown that they are able to effectively balance shareholder and creditor interests.

Moody's believes that significant strides have been made in the corporate governance of REITs and other companies over the last three years, most notably:

• Directors are bringing a renewed level of commitment.

• Boards are reaching beyond their traditional networks and utilizing search firms to recruit a growing number of "independent" directors.

• Executive and director compensation has begun to shift from stock options to restricted stock, which Moody's believes fosters a greater focus on long-term growth and minimizes the downside potential of risky short-term strategies. For REITs, executive pay is often heavily weighted toward restricted stock.

• Transparency around governance policies has improved significantly through utilization of the Internet as a communications medium.

In some cases, improvements to REIT governance may be attributed in part to the generational shift in management that has been taking place across the real estate universe, often with the appointment of younger family members or professional managers to the CEO or other leadership positions. Some observers believe this new generation of management is more focused on building the necessary control structures and management systems than their predecessors who founded the firms and operated them as privately-held entities.

Family ownership remains a distinct feature of the REIT sector. Many REITs are still controlled by the founding family, with founders or founders' descendants running the business. In Moody's view, family ownership brings both strengths and concerns from a governance perspective. On one hand, founding families are able to make long-term decisions based on their commitment to the business. This commitment provides an important level of continuity and stability. On the other hand, Moody's believes that the role of the board is often more limited than is the case in a widely held company. Often family-controlled REITs also have relatively low levels of board independence, which could constrain the objectivity of the board in evaluating management's actions.

Nonetheless, the manner in which many real estate firms were founded—typically by entrepreneurs consolidating sometimes-disparate real estate holdings—creates a backdrop in which some clear governance challenges remain that appear more specific to REITs. Related-party transactions among directors, executives and the real estate firm are common and management teams are given significant discretion to make major investments.

Finally, the U.S. UPREIT structure creates potential conflicts among the REIT, shareholders and operating-unitholders.

Moody's expects REITs to develop their governance practices further as the industry continues to mature. Board independence will, over time, improve as affiliated directors retire and new board members join, which will expand boards' skill-sets. Talent development efforts across the REIT space will improve boards' ability to influence succession planning, even in family controlled firms. Control procedures will strengthen. The challenge for REITs will be making all of these improvements at a pace that allows them to keep up with governance advances taking place in U.S. corporations more generally.