The UK Treasury has committed itself “in principle” to introducing legislation for a tax-exempt Real Estate Investment Trust (REIT) in 2006. However, some in the UK real estate market doubt the vehicles will be an immediate success with investors.
And Germany, which had also been slated to introduce REITs as early as 2006, could become bogged down in taxation problems (see below).
In its March budget, the UK Treasury published a further discussion paper outlining its preferences on a number of points and seeking further comment from the real estate industry on others.
REITs, which were pioneered in the US, offer investors a liquid securitised exposure to real estate. Property rental income is also tax-exempt, eliminating the double taxation that investors in UK quoted real estate companies suffer, where rental income has already been taxed at the company level.
The tax exemption and liquidity of a REIT would benefit pension funds, which have been keen to increase real estate exposure or invest in the asset class for the first time. Smaller pension funds tend to be excluded from directly holding properties due to the large lot sizes – a single shopping centre can cost more than €150m.
The discussion paper suggests REITs will divide their business into two parts, a ‘ring-fenced’ tax-exempt business, which collects rents from properties and an unfenced business which will cover ancillary services – management fees, for example. Dividends from the ring-fenced business will be tax-exempt, as will capital gains which are distributed to investors.
REITs will be required to derive at least 75% of gross income from ring-fenced activities and to distribute at least 95% of its net ring-fenced income to investors. The Treasury has not decided whether REITs must be listed, or what the tax rate is to be
(or how it will be calculated) for assets transferred into a REIT.
The Treasury has not yet come to a conclusion about the best way to treat non-UK investors and is looking for feedback on this matter. Neither has it decided on the level of any conversion charge.
A conversion charge could limit the number of existing UK real estate investment vehicles converting to REIT status. Qualifying quoted real estate companies would convert, but offshore private funds or listed offshore investment trusts, which already pay no tax at the company level, are unlikely to bother.
William Hill, head of property at Schroders, which runs a number of offshore funds, says: “Our investors already get everything they need in terms of tax-transparency so why would they want to incur the cost of changing status?”
Other real estate professional have suggested that pension fund investors will not be interested in REITs as they will suffer equity market volatility and not provide real estate returns.
However, studies suggest that, over five years and above, REIT returns follow those generated by the underlying real estate (although day-to-day volatility remains). And US institutions account for 50-60% of investment in US REITs.
However, Andrew Baum, of Oxford Property Consultants, points out that the UK real estate market is not short of capital at the moment, making a vast surge of immediate demand for REITS unlikely.
The UK Treasury’s proposed model has received a generally favourable reception from the real estate industry. UBS global real estate strategist Scott Crowe says: “The good news is that the UK Government has gone a long way in this announcement to diminish the risk that the REIT structure would be too inflexible.
“The model that the Government have outlined is flexible and progressive in our view. However, the not so good news is that there has been comparatively little information on the conversion charge, which makes the issue of pricing the impact of the introduction of REITs difficult. “
UBS also questions the proposed imposition of a “withholding tax” of 22% (the minimum tax for rental income) to be levied on the rental income of a REIT (ie. at the entity level), which, although common practice in Europe (for example, Dutch and French REITs), is not consistent with Australian and US REITs, where all of the tax on this type of income is paid at the investor level. The UK Treasury claims this imposition will “simplify” the tax position of retail investors.
The Government has stated that a UK REIT would be required to distribute at least 95% of its “net ring-fenced income to investors”, which is high compared with other REIT jurisdictions, suggests Crowe, especially as the UK does not allow depreciation on real estate, unlike other markets such as the US and Australia.
How onerous this will be depends, according to Crowe, on how the definition of allowable deductions and capital allowances, which ought to allow for sufficient surpluses for re-investment into the upkeep of the portfolio.

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