After a prolonged period of lobbying by the property industry, the Government recently announced that the Treasury will carry out a fact-finding investigation into real estate investment trusts (Reits) with a view to legislating for their introduction into the UK, possibly in the 2005 Budget. The move has been welcomed as one that may ultimately lead to the biggest revolution in property finance for 50 years.
In the last 10 years, UK commercial property has proved to be a high-performing and yet relatively low-risk asset class, consistently outperforming equities (both domestic and overseas), gilts and cash. However, pension and long-term insurance funds have in fact been steadily withdrawing from direct property investment for the last 20 years, and private investors remain relatively few and far between.
The reasons for this seeming paradox are not especially hard to find. Property continues to be regarded by fund managers, actuaries and private investors as a ‘lumpy’ asset. The size of the investment required, the significant entry costs (most notably stamp duty at 4 per cent) and the asset’s reputation for a lack of liquidity all act as deterrents to investment. Equities, on the other hand, can be bought and sold in smaller parcels in a matter of seconds, with little or no ongoing management costs.
In addition, corporate investment vehicles suffer from one fundamental drawback: they are not tax-transparent. Not only do they pay corporation tax on their profits and capital gains tax (CGT) on their disposals, but investors in them also pay corporation or income tax on any dividends they receive. Given this ‘double taxation’, it is hardly surprising that many of those who currently choose to invest in UK property do so via investment vehicles based in offshore jurisdictions with lower rates of tax; an estimated £14bn of UK property is currently held in overseas vehicles.
The property industry has long argued that what is required is a tax-transparent, tradable collective investment vehicle that replicates the benefits of direct investment in property. Enter the Reit, which is generally acknowledged to fulfil all these requirements.
Reits were first established in the US in 1960. They have since been adopted, in various guises, by all of the G7 industrial economies (except the UK), as well as Australia, the Netherlands and a number of other countries in Europe and elsewhere. The fundamental elements of a Reit-style vehicle are that:
- its assets are primarily comprised of property held for the long term.
- it derives its income primarily from that property.
- it distributes at least 90 per cent of its taxable income to its shareholders by way of dividend.
- those dividends constitute a deductible expense for the purpose of computing the Reit’s liability to corporation tax.
- its shares are freely tradable on the major stock exchanges.
- shareholders pay tax only on, shares traded in the Reit, and any dividends received.
- and as a public company, it is subject to appropriate stock exchange control and regulation.
Although US Reits performed relatively modestly until the early 1990s, they have since experienced unprecedented growth: in the 10 years to December 2002, their market capitalisation has increased tenfold.
Experience in Japan tells a similar story, where the market capitalisation of Reits has doubled since their introduction only three years ago. By contrast, the UK-quoted property market has shrunk by £5bn to £60bn over the same three-year period and may shrink even further if reports that Chelsfied and Canary Wharf are to follow other high-profile exits from the quoted sector should prove to be true. Indeed, such is the lack of enthusiasm for shares in UK-quoted property companies that they are currently traded at an average discount of 16 per cent to net asset value.
Thus far, the Treasury has always resisted the idea of Reits because it feared a significant loss of tax revenue. However, a joint research paper recently submitted to the Treasury by the British Property Federation, the Investment Property Forum and the Royal Institute of Chartered Surveyors argues that the converse might in fact prove to be the case. First, the Treasury could impose a one-off ‘entry’ tax on those seeking to adopt Reit status; it is anticipated that this could yield as much as £1.3bn. Second, analysts at Merrill Lynch and Goldman Sachs have stated that the introduction of Reits could double the size of the UK-quoted property sector to £120bn in 10 years. If that were indeed the case, then taxes on the dividends received by Reit investors would almost equal the amount of CGT lost on disposals by Reits, the research paper estimates. Third, investment funds currently held overseas and paying no UK tax might well be induced to come back within the Chancellor’s grasp. And finally, a flourishing Reit market would generate significantly increased levels of property and share transfers, and hence a substantially enhanced tax take via stamp duty.
It would appear that the Government now regards these arguments, coupled with increasingly dire warnings as to the future of the quoted property market without Reits, as being sufficiently sound to warrant further investigation into the benefits that Reits might bring. In the last six months, fact-finding visits have been made by Treasury officials to the Netherlands and the US. Property industry leaders have described these early steps as “encouraging”, while acknowledging that it is still far too early to draw any conclusions as to what the Government may ultimately decide to do.
One final incentive for introducing Reits into the UK would be to pre-empt the possibility of intervention from Strasbourg. Slowly but surely, EU member states are being driven to clear away any hurdles that stand in the way of the free flow of capital and investments within the EU. Domestic direct tax measures that discriminate against foreign investors by imposing a harsher tax regime than they might find elsewhere in Europe run the risk of being held to be incompatible with EU law.
Richard Quenby is a professional support lawyer in Addleshaw Goddard‘s commercial property group