The REIT path

REITs are not a magic bullet, but the markets in the US and Australia, where REITs have been around the longest, are notably more dynamic than in the UK

Under starter’s orders
When Gordon Brown announced last November that he was minded to introduce a UK real estate investment trust (REIT), some assumed there would be an early bonanza for property advisers setting up the first UK REITs during 2004. However, in truth, this is a marathon and we were only just past the starting line. Some seven months later, how much further along the track are we?

In March the Treasury issued its consultation document, requesting responses by 16 July. The British Property Federation (BPF), the Investment Property Forum (IPF) and the Royal Institution of Chartered Surveyors (RICS), whose coordinated lobbying during 2003 led to the Chancellor’s announcement, have continued to work together, fostering a wide debate. Seminars and conferences have been held; informal discussions have taken place between advisers and their clients; research has been carried out into the wider international picture. There has been a real sense of the property sector working with the Government to achieve major reform.

There will no doubt be a brief pause in the level of activity (at least outside the Treasury) over the summer. We can then expect a response from the Government later in the year, probably leading to enabling legislation in next year’s Finance Act. The flood of REITs work some may have hoped for during 2004 looks more likely to occur in late 2005 (assuming that events, such as general elections, do not get in the way).

Tax hurdles
So why all the fuss? Why is the property sector and the Government investing so much resource into a new property-owning entity?

Most people involved in the sector will now be familiar with the basic characteristics of a REIT (the US term has proved more enduring than the Treasury’s suggestion of ‘property investment fund’). In essence, a REIT is a vehicle (usually a company) that owns property and benefits from a special tax regime which gives tax transparency.
Although investors are investing indirectly through the REIT, they are taxed broadly as if they directly own the underlying properties – there is no tax within the REIT itself. To qualify for this treatment, the REIT will have to meet various conditions. Key to these is a requirement to distribute all, or nearly all, of the REIT’s profits.

This tax regime compares favourably with the normal tax treatment of a company: the company is taxed on its profits before they are distributed to investors to be taxed again. This double taxation is one of the causes for property company shares trading at a discount to net asset value. Previous attempts to provide widely owned vehicles, such as property investment trusts, have not been successful.
Unquoted vehicles, such as offshore unit trusts and limited partnerships, offer tax transparency, but cannot be widely marketed.

When debating the merits of REITs, it is important to remember that the property investment market is not a homogenous whole. There is a wide range of investors, each with their own objectives. The individual with a single highly-geared, buy-to-let property is in a very different position to the institutional investor. What is clear is that, thanks in part to the poor performance of stock markets in recent years, there is an appetite for investment in property. Income returns have been attractive and stable; the potential for capital gains from the residential market apparently unlimited. The Government also has its own objectives, as outlined in the Treasury document: improving liquidity; ensuring investment security; raising quality; promoting housing development; and encouraging regeneration.

Proponents of REITs point to their success in other countries where they have been established, in particular the US, Australia and most recently France. Of course, REITs are not a magic bullet, but the markets in the US and Australia, where REITs have been around the longest, are notably more dynamic than in the UK. Other countries are going down the same path – there is even talk of a pan-European REIT.

Key issues
The consultation document invites views on fundamental issues relating to how a UK REIT might be structured. These include:

  • Quoted or not – the debate has tended to focus on REITs providing a marketable vehicle that is regulated by the Stock Exchange in which individuals can invest. However, to enhance liquidity you need a successful unquoted sector that is able to make the transition to quoted status.
  • Gearing – a ‘safe’ investment would be ungeared, simply generating an income from rents. However, gearing allows a business to develop and maximise future returns. Most non-UK REIT regimes allow borrowing, although gearing is often at lower levels than the rules permit.
  • Activities – REITs are predominantly a vehicle for investment in property. But some development activity is carried on in most property companies to provide new stock. Ancillary services may be provided to tenants. An unduly restrictive approach to the activities that can be undertaken by a REIT could limit their potential use. One solution is to allow REITs to run non-qualifying activities through taxable subsidiaries.
  • Tax – a key objective of the Treasury is to ensure no loss of revenue arising from the introduction of REITs. This will be extremely difficult to measure. It is a basic feature of REITs that a high proportion of net income is distributed to investors and taxed in their hands – the REIT then suffers no tax itself, except on non-qualifying activities and, possibly, on capital gains that are not reinvested.
  • Conversion – companies that switch to REIT status are likely to suffer some form of conversion tax charge by reference to the accrued capital gain on their portfolio. The consultation process has not so far identified a level for this charge that would be acceptable to either the Treasury or the sector.

Sector response
The IPF, BPF and RICS have submitted a comprehensive response to the Treasury – the full response and a summary are available on their websites. They have looked at the wider picture and are arguing strongly (and in our view rightly) for maximum commercial flexibility and minimum regulation. There should be a basic framework of requirements that a REIT must satisfy, but the UK should take the lessons learnt in other jurisdictions and not limit the potential for using REITs in a wide range of situations.

The response recognises that further work is needed to refine some key issues – in particular the tax treatment of REITs and their investors. Decisions taken on these issues will have a major impact on the attractiveness of REITs compared with existing real estate structures. But the point to stress is that the aim is not to win significant tax breaks; rather it is to remove some of the tax inefficiencies that force property investors to adopt ownership structures that may be less than ideal from a commercial point of view.

Final straight?
The formal deadline for responses to the consultation document has now passed, although it seems unlikely that the Treasury will reject late comments. Discussions will, we hope, continue with industry representatives on some of the thornier issues. There is much work to be done to ensure a successful launch of UK REITs and all involved in the property sector are encouraged to participate in the ongoing debate. What we cannot say (yet) is when the first REIT will arrive at the finishing line. As noted at the outset, this is a marathon and there are plenty of obstacles still to overcome. But provided we stay on course, this is a race worth winning.

Anne O’Meara is head of real estate and Mark Simpson is head of real estate tax at Hammonds