19 March 2007
The long-awaited introduction of UK real estate investment trust (Reit) legislation on 1 January was universally welcomed by investors, property companies, funds, banks and professionals.
Prior to the introduction there was an enormous amount of speculation over how the introduction of UK Reits would impact on the UK property industry and its position in the developing global real estate market. For the majority of companies that have taken the plunge to convert, it has been largely business as usual.
However, speculation remains on how the introduction of UK Reits will impact on the market going forward and what effect this will have on the type of UK legal services required.
Only seven listed property companies and two specialist property companies converted to Reit status on 1 January. But those that have converted or have publicly announced that they intend to convert make up 50 per cent of the quoted property sector by market capitalisation.
Common themes for those companies that have converted are:
•nearly all have converted their existing listed real estate operating company into a UK Reit, without demerger or creation of specialist sector sub-Reits;
•they all had significant imbedded historical capital gains tax liabilities that were eradicated by the 2 per cent Reit entry charge;
•the removal of double taxation (a by-product of UK Reit conversion) has led to the erosion of the traditional real estate operating company's share price discount to actual underlying net asset value; and
•each of the seven listed companies had diversified portfolios and appropriate business models which satisfied the Reit conditions with little or no reorganisation.
The companies have converted with the minimum amount of restructuring so that internal reorganisation costs are kept to a minimum, while the obvious tax benefits and, in theory, the obvious benefits of increased access to the capital markets and equity funding are obtained.
Some trends are already emerging from the converted companies. Possible outcomes could also be anticipated based on the experiences of more mature Reit markets around the world.
•M&A. In the run-up to 1 January and thereafter there have been a number of UK real estate transactions in which converted companies have effectively utilised tax arbitrage by acquiring private property companies or funds with imbedded capital gains. The UK Reit, unlike other investors, does not need to discount the price by more than the 2 per cent gross asset charge to reflect the amount of the imbedded capital gain in the target company, meaning that it can pay more and outbid non-Reit investors. If this trend continues it could lead to increased demand for complex corporate real estate, tax and finance expertise from lawyers.
•Consolidation/specialisation. The best performing Reits in Australia and the US are utilising the fact that their shares are trading off higher premiums to net asset value than their competitors, and are swallowing them up. The benefits of sector specialisation are well publicised - there is a perception that sector-specialised Reits are more focused on their underlying specialist asset class and benefit from a reduction in management expense ratios, and these benefits should be passed on to investors by way of increased shareholder value.
•The changing nature of the property investment market. There are clear signs that yield compression is now slowing and there is increased uncertainty around interest rates. In this environment, the UK Reit has two advantages over debt buyers: access to cheaper capital through equity raising and no need to discount for imbedded capital gains. In comparison with the US and Australia, where more than 50 per cent of investors in the established Reits are individuals, direct investment in UK commercial property has historically been regarded as a complex asset class. This has resulted in UK-listed real estate operating companies having only a small number of individual shareholders.
What can Reits be used for?
The big question is whether Reits will prove useful beyond conversions of existing property companies. There are two obvious areas of potential activity: using the Reit as a property fund vehicle and using a Reit as a tax-efficient exit strategy for companies or other property owners to realise value from their property interests.
Reits as a property fund vehicle
There has been a huge amount of activity in the property fund world in recent years. The holy grail of fund structuring has been to develop a structure that mirrors as closely as possible the tax position on a direct investment.
Existing property investment vehicles achieve this to some extent, but each has their limitations, for example: limited partnerships are suitable only for sophisticated investors and not retail; the small numbers of authorised unit trusts that invest directly in property - such as the New Star Property Unit Trust - suffer from some tax inefficiency and from the lack of ability to gear up; and tax efficient offshore unit trusts - such as the Standard Life Shopping Centre & Retail Park Trust - and offshore company structures both incur additional costs of overseas administration and management.
The Reit certainly has the potential to be an alternative fund vehicle. It is suitable as a retail fund and will be perceived to be a well-regulated and marketable vehicle through its listed status.
There are two situations in which Reits may not necessarily be optimum: funds looking to invest significantly in non-UK land or where investors will to a significant extent be non-resident; and new funds raising money to acquire properties that will not be able to satisfy all the Reit conditions before any properties are acquired, unless rule changes are made or structures developed to avoid any entry charges.
Reits as an exit strategy
As a Reit does not incur tax on capital gains it may be an attractive tool for the disposal of property. There are three obvious examples of this.
First, investors who hold a suitable portfolio of properties through a corporate structure could convert to Reit status and then exit the investment by selling shares in the company at a price which need not reflect a discount for any taxable latent gains. This is likely to be attractive only when there is sufficient market interest in buying shares in the portfolio.
Second, and perhaps more common, is the scope for selling shares in a property holding company to a Reit. On joining the acquiring Reit group, the acquired company will become entitled to make future disposals of its land assets free of capital gains tax. In other words, an investor should be able to get a better price for their shares from a Reit buyer as opposed to other buyers. There are already indications in the UK market that Reits can and do offer higher prices on share acquisitions.
The third is using a Reit as an alternative to existing Opco/Propco structures that are used to split trading companies with large property portfolios in order to realise value from the portfolio.
•Don Rowlands, Bradley Phillips and Isaac Zailer are partners at Herbert Smith