After more than 30 years of active representations by the property industry, REITs are here in the UK. During last year, the prospect of their success was weighed up as the government made some fundamental legislative changes to make the regime work. But among all the excitement, one pundit was heard to comment that REITs were ‘no more than the quoted sector with a tax break with little prospect of growth'. Cynic or realist?
Some may argue that this view doesn't matter because REITs have been introduced in the UK. This is an interesting point. Getting to REIT status is not the measure of success for the listed property sector. Instead, for UK REITs to be truly successful, the market must expand, develop and deliver competitive returns.
By mid-2007, most listed property companies that are going to convert will have converted. That may be less than 20 companies but this will provide a platform for expansion and is sufficient to create a market in those shares. Such REITs cannot stand still - they will have to grow. But how will they achieve this?
Some may have pipelines of development or supply that can feed their growth, at least initially. The quoted sector (this does include some traders as well) has a value of around
£50bn (€75bn) but according to the Royal Institute of Chartered Surveyors, there is around £300bn of owner-occupied property and a further £250bn of property held by offshore investors and institutions. Interestingly, in the US the focus is beginning to be on development with the benefits of increasing value from a site. REITs are demonstrating their skills in restructuring leases, site assembly, redevelopment and extensions of buildings which have added value.
Alternatively, the answer could be a merger of interests to form a larger player in the market. The first of these was seen as early as last October. Currently, apart from the senior listed market there are companies listed on the AIM (alternative investment market) and family companies that would be appropriate targets. Corporate acquisitions offer a number of benefits. The tax costs will be lower than for an asset acquisition. There are two main tax costs when a target is acquired. There is a transfer tax cost of 0.5% on the consideration given for the shares which will be lower than gross asset value where the target has gearing.
To this must be added the entry charge of 2% of the gross property assets of the target. The total of these two charges will be less than the stamp duty land tax cost of 4% of gross asset value which would be paid on an asset acquisition. While there are transaction costs to bear such as due diligence, mergers are also likely to deliver more property than piecemeal acquisitions.
Retailers, leisure and other property rich businesses cannot become REITs because they are owner-occupiers and are therefore precluded. But REITs can provide a useful source of finance either through a sale-and-lease-back arrangement or as an exit route for those who have separated their operations from their property ownership (the ‘Opco/Propco structure'). Clearly this depends on the business model and the cost of finance. It won't be suitable for every business but it provides an alternative to a securitisation. REITs could also be an attractive exit route for private equity houses seeking to realise value from their investment portfolios.
Where does residential property feature in the UK REIT regime? Currently it doesn't. Universities and other public institutions with residential property, such as housing associations, are currently looking at the model. If new housing stock can be delivered to the market then this would help the government meet some of its housing needs but the numbers have to work.
Funds could play a significant role in developing the REIT market, given their track record of managing and creating wealth from property. While they cannot convert without significant restructuring, they could use their skills to raise money in the market and create new REITs. There would need to be relaxation of some of the REIT rules in the early stages of such a REIT - for example, the balance of business test. This requires that 75% of profits have to be derived from rental income and 75% of the assets have to be rental generating assets. At inception, such a REIT is unlikely to have sufficient qualifying assets or income to meet these tests.
Also, the real benefits of a REIT are currently focused on UK property with tax potentially payable on investment in non-UK real estate. To give the UK REIT a further boost, the tax regime would need to be adapted to remove tax charges at the REIT level on income from non-UK real estate.
For example, dividends from say a German real estate owning subsidiary received by a UK REIT could be exempt from tax at the REIT level with a system for tracking and taxing income flowing through to investors in the REIT. While a REIT provides exemption from tax, this is only at the vehicle level (investors suffer tax through assessment in the UK or through the 22% withholding tax for offshore investors). So there should be no loss of tax to the Exchequer. And if further amendments are required, it would make sense to exempt REITs from tax on distributions from other REITs (with some safeguards for investors which would limit such investments to prevent the whole market investing in each other) and let them invest in property related assets, eg derivatives, commercial mortgage backed securities, etc, as has occurred in the US. Derivatives could be helpful to spread risk without incurring the physical costs (eg registration of title) and related tax costs (stamp duty land tax and possibly VAT).
Is this too much to ask for in early 2007? Perhaps, but the UK government needs to take active measures in response to developments in this sector world-wide to ensure the UK REIT remains competitive.
Rosalind Rowe is real estate tax partner at PricewaterhouseCoopers LLP
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