As evidenced by the US, Japan and other economies around the globe, the introduction of real estate investment trusts (REITs) has a significant impact on a country's property markets. Not only do REITs provide a public investment vehicle for retail investors, they also bring additional transparency and liquidity to real estate markets, create a more efficient tax structure for property ownership and, for private equity real estate firms, provide additional exit routes – and potentially competitors – for their real estate assets.
As the pace of REIT introduction picks up speed around the world, eyes are now turning to the UK. Following a March 2004 Consultation Document, which sought views from the property industry, the UK government published a Discussion Paper about UK-REITs as part of its April 2005 Budget proposals.
While the Discussion Paper reiterated the Treasury's commitment to introduce a UK-REIT in 2006, the UK government has continued to play a cautious hand regarding the new real estate investment vehicle. Significantly, the government has not revealed how it proposes to deal with a number of challenging issues, the two most important of which involve taxation: how to tax overseas investors in UK-REITs and the charge property companies will have to pay in order to convert to REIT status.
Despite this uncertainty, a number of industry commentators remain optimistic that the government will resolve all open issues and make a positive announcement in the Pre-Budget Report in November 2005 with a view to introducing legislation in the middle of 2006.
KEY FEATURES OF A UK-REIT
So what's planned for the UK? The Discussion Paper suggests that the government has been mindful of industry calls for as little regulation and as much flexibility as possible. The Paper therefore proposes that a UK-REIT is likely to:
TAX, DEVELOPMENT AND GEARING
One of the most attractive features of real estate investment trusts in general is, of course, an advantageous tax status. In the UK, no corporation tax would be charged on a REIT's property activities; instead tax would be levied at the investor level. The loss of the corporation tax is why the UK government is so keen to impose an appropriate conversion charge.
While the tentative proposals above suggest a good deal of flexibility for REIT operators, there are certain constraints that companies will have to satisfy in order to benefit from this favorable tax status. In addition to deriving at least 75 percent of its gross income from, and ensuring that at least 75 percent of its gross asset value relates to, a “property letting business,” a REIT must also distribute at least 95 percent of the net income from its property letting business to investors. Its non-property letting business will be subject to the normal UK tax rules.
There will also be some restrictions on the scope of the commercial activities of a UK-REIT. For instance, there will be limits on the ability of a UK-REIT to carry out development activity (probably limited to not more than 25 percent of its gross assets). These types of restrictions will determine how attractive it will be for UK companies which undertake substantial development activities, such as Brixton and Hammerson (which already operates a French REIT), to convert to a UK-REIT.
The government is also wary of potential tax loss through the use of gearing by UK-REITs and will likely limit their borrowing ability. In practice, REITs in Australia, France, Japan and the US had average gearing levels between 35 percent and 43 percent in 2004 according to the Consultation Document. These are relatively low levels and the result of market forces, rather than regulatory requirements. In the UK, there will be less incentive for a UK-REIT to borrow since, unlike normal UK companies, they will not be able to claim a tax deduction for interest expense. It is therefore not anticipated that restrictions on borrowing for UK-REITs will be troublesome.
OPEN ISSUE: OVERSEAS INVESTORS
While the government endorses the principle that a UK-REIT should be broadly tax transparent, the government remains concerned that some non-resident investors would be able to take advantage of the limited taxation of dividend income from UK-REITs (since the UK-REIT would be treated as a normal UK company for tax purposes).
As the French have found out, this concern is not entirely fanciful. Two Spanish companies, Metrovacesa and Colonial, own 68 percent and 85 percent respectively of two French REITs, Gecina and Société Foncière Lyonnaise, thereby profiting from the favorable double tax treaty between France and Spain.
Alongside the exempt company model, the government is also thought to be considering a “22 percent model”, whereby a UK REIT would withhold 22 percent of amounts distributable to investors, presumably leaving it to non-tax payers to reclaim the amount of any such withholding.
Industry commentators fear that if the government opts for the 22 percent model, investors will be put off by the apparent complexity and the fact that the UK-REIT will not “look and feel” like other REITs. They also point out that the government currently receives as little as £200 million from the entire UK listed property sector in corporation tax each year. Given the flurry of economic activity UK-REITs would generate, they argue the government will be more than compensated for any tax lost to foreign investors.
OPEN ISSUE: CONVERSION CHARGE
As noted above, the other key issue, which has yet to be addressed by the government, is the “conversion charge” to be levied on any property-owning entity wishing to convert to a UK-REIT.
There are a couple of approaches for the government to consider. In France the tax authorities imposed an “exit charge” on companies converting to SIIC status (the French equivalent of a REIT), equal to half the converting entity's unrealized capital gains tax liability, payable in installments. An alternative method would be to levy an “entry charge” based on a percentage of the entity's gross asset value (irrespective of whether this value includes unrealized gains).
The government must tread carefully. If the charge is set too low, it will lose out on much needed revenue. If the charge is set too high, nobody will convert.
OPEN ISSUE: LISTING
The government has also left open whether it will allow an unlisted version of the UK-REIT. The industry is hopeful that unlisted UK-REITs will be permitted, primarily because the unlisted sector would provide a “nursery” environment for companies that would allow for the development of an IPO pipeline.
PREPARATIONS IN THE UK MARKET
REITs in other markets have historically become specialized, typically investing in a single sector, such as industrial or office properties. It is clear that over the last couple of years a number of major UK property companies have rationalized their property portfolios to focus on specific sectors, presumably with one eye on converting to a UK-REIT sometime in the future. A case in point is British Land, which now has 99 percent of its assets in the UK and 95 percent of its property portfolio in two asset classes, retail property and office space.
There is speculation, however, that some major UK property companies, such as Land Securities, which have relatively mixed property portfolios, will buck the trend and choose to convert into a single “umbrella” UK-REIT, retaining a mixed property portfolio, rather than splitting into a number of single sector vehicles.
The stakes for the UK are arguably very high. Over the last few years, a large volume of funds has moved out of the UK to be managed by offshore vehicles. Proponents of UK-REITs insist the government must do more to stem the flow of investment funds offshore. In fact, when the government extended the stamp duty land tax regime to cover dealings in partnership interests in 2004, many unit trusts opened in Jersey.
A less conspicuous and more recent development has been the establishment of property companies in Guernsey by well known names such as Insight, ISIS, Standard Life and Invesco. This allows for a favorable tax treatment, the distribution of almost all income and a listing on the London Stock Exchange, providing liquidity and access to UK retail investors – exactly the same investors who would be targeted by UK-REITs.
WITHSTANDING THE TIDE
As is well documented, REITs have been a roaring success in other countries. For the last five years in the US, the National Association of Real Estate Investment Trusts (NAREIT) Composite Index has increased on average by over 23 percent per year. REITs were introduced in France at the end of 2002, and in two years, preliminary figures report returns of 18 percent in 2003 and 9 percent by mid-July 2004. Furthermore, Datamonitor Market Research predicts that by 2009, the global REIT sector will be worth $1.1 trillion, an increase of 163.5 percent over 2004, and a predicted annual growth rate of 21.4 percent.
Closer to home, the enthusiasm of other European nations to capitalize on investor appetite for REITs is evident – in July of this year Germany reiterated its commitment to introduce a REIT in 2006, and The Netherlands is considering easing the restrictions on its REIT in order to increase their competitiveness in the global market.
If the government does not introduce a UK-REIT soon it could be the only G7 nation without one and the movement of funds offshore could gather pace. This is unlikely to be a prospect which the government will relish, as it may well miss the opportunity to establish London as the center of the European REIT industry.
Andrew Wylie is a solicitor in the investment funds group at Macfarlanes, the London law firm.