REIT honorable vehicles

Long a staple in Japan and the US, real estate investment trusts are gaining ground throughout Europe—with varying results. By Aaron Lovell

In March, England's Chancellor of the Exchequer Gordon Brown presented his tenth consecutive budget, joking about how he was the first chancellor since 1822 to do so.

But the 2006 finance bill was historic for another reason. It included plans for a UK real estate investment trust (REIT) vehicle beginning at the start of next year. It was a move real estate professionals in the UK were expecting—and the latest development in the ever-evolving European real estate market.

Industry players expect the development of taxefficient REIT vehicles in the United Kingdom—and possibly in Germany—to bring more transparency, discipline and liquidity to the European property sector.

“Once the United Kingdom and Germany get on board, the three major economies of Europe will have REIT structures in place,” notes Fraser Hughes, the director of research for the European Public Real Estate Association in Amsterdam (EPRA).“Once they have the REIT structure, Spain and Italy will follow suit.”

Some European markets already offer REIT vehicles. The Netherlands was early on the scene with its own REIT structure, the Fiscale Beleggingsinstelling (FBI), which was first introduced in 1969. Currently, there are seven companies operating under the structure with a market cap of approximately $17 billion (€14 billion). The government is currently mulling an overhaul to make the country more competitive in the international markets.

France's Sociétés d'Investissements Immobiliers Cotées (SIIC) is the Gallic answer to the REIT structure and has attracted investors in a relatively short period of time (see sidebar). Since being enacted in 2003, the total market capitalization of the sector has increased from €10.4 billion to €25.1 billion in 2006, according to EPRA.

Understandably, these sorts of healthy numbers have other countries looking to enact their own REIT legislation.

Largely seen as the frontrunner to replace Prime Minister Tony Blair as the leader of the Labour Party, Brown's budget was viewed by many as a window into what the former rugby player's government policies might look like. Alongside money for Olympic-athlete training and a higher tax on sport-utility vehicles was the much-heralded, long-anticipated REIT legislation, allowing property companies in the UK to list on an exchange and enjoy a more efficient tax structure.

Once the United Kingdom and Germany get on board, the three major economies of Europe will have REIT structures in place. Spain and Italy will follow suit.”

Much like their US and Japanese cousins, the UK REITs will be exempt from taxes on income and capital gains and will pass its profits back to shareholders in a dividend. The REIT provision includes a one-time “conversion charge” for existing real estate companies to establish themselves as trusts—the levy would be 2 percent of the gross market value of the company's portfolios. It also cut down the percentage of profits that need to be returned to investors to 90 percent—figures as high as 95 percent were bandied around before the March announcement.

William Hill, the head of property at London-based Schroder Property Investment Management, says the traditional listed property company might be the first group to take advantage of the new vehicles, leading to a company with the same shareholders and a different tax structure. Following that, Hill suggests that investors who have been doing well in the property markets over the past few years will launch IPOs.

While most UK market players are happy with the government's decisions regarding the REIT legislation, some point out that previous REIT legislation in the US and Japan was introduced during a dearth in liquidity.

Hill says one worst-case scenario would be if the REIT rollout in the UK came at the top of the market. And as property investors avoid the vehicles, mass-market investors could quickly get disillusioned. “It's great launching the thing at the bottom of the cycle,” Hill says. “It's all recovery.”

While the debate in the UK may center around what sort of investors the REIT will attract, in Germany there are far more serious questions surrounding the future of the German REIT structure.

“It may actually open up the playing fields. But that may just be wishful thinking.”

This month, government officials in Germany will be meeting with people in the real estate industry to discuss the viability of REIT legislation in the world's third largest economy. But the legislation, more than two years in the making, is being questioned by members of the center-left Social Democratic Party, which has also voiced concerns about private equity in the past.

In April, the SDP said that the structure could be detrimental to the rights of tenants and could lead to more companies leaving Germany. The politicians registered their concerns in a report titled “Locusts on the Doorstep?,” calling to mind last spring's famous “locust” comment about leveraged buyout firms. The new report carried on the pest motif, suggesting that private equity real estate funds could swarm over German property like “locusts and cockroaches.”

The SPD position on REITs suggests a split between the leftcenter party and its center-right collation partner, the Christian Democrats. Chancellor Angela Merkel has come out in favor of the structure and her fellow party members have said the country needs the new vehicle and the foreign capital it could bring to the country's soft real estate market. Duetsche Bank AG has said that, if enacted, German REITs could attract more than €130 billion by 2010.

REITs could have a profound effect in a market like Germany, where cash-flush investors are eyeing large portfolio deals, particularly in the residential sector. Many participants feel the new tax-friendly vehicles would benefit the market with more liquidity and more options for exits.

Discussing the need for a German REIT structure, EPRA's Hughes points out that roughly one third of the DAX's capitalization is being held on corporate balance sheets—representing a huge potential for businesses to divest their real estate assets. As recent high-profile deals involving Terra Firma and Fortress Investment Group have illustrated, German companies and municipalities are looking for ways to liquidate large residential portfolios, another part of the market that could eventually become fodder for a trust vehicle.

Still, some feel the vehicles being established across the continent are more limiting than their overseas REIT cousins.

“As these [vehicles] roll out across Europe, it is a bit more restrictive,” says Mark Eagan, real estate partner and chairman of law firm Paul Hastings' London branch. “What they really have in mind are listed vehicles. There aren't as many potential applications for the vehicles.”

Andrew Wood, chief operating officer of Macquarie Global Property Advisors, says that the excess liquidity in the European market could mean that additional national REIT vehicles might take a while to get off the ground. “The question is, ‘How long will it take?’” he says.

And once the proper legislation is passed, it doesn't necessarily mean an immediate groundswell in interest. The effects of the new structures can be slow to impact the marketplace, something seen after the rollout of the SIIC in France according to Hughes. “It does take a bit of time,” he says. “Companies have got to reorganize and get on the radar screen of investors.”

But most are quick to point out the many benefits of REIT legislation in the European property markets. The structure would certainly help private equity real estate funds plot their exit strategy throughout Europe—and could encourage investing as more exit options become available.

In the UK, Hill points out that opportunity funds investing in property companies that are saddled with a large capital gains tax bill could be helped by the REIT vehicles. The firm could wipe out its tax via the one-time, 2 percent conversion charge.

“It could be a good way to turn water into wine,” Hill says. In addition to exits, Macquarie's Wood says that more REITs throughout Europe will also increase the options for institutional investors as well. “It also gives institutional investors the opportunity to invest in an efficient publicly quoted vehicle, which gives them the chance to invest in real estate without owning it,” he says, adding that the tax-efficient structure plays to the concerns of the taxexempt institutions.

Eagan notes that prices could be affected by an increase in REITs, something that would be both a positive and a negative for private equity real estate funds. “You can expect prices to get driven up, but exit prices get driven up as well,” he says. As for the specter of increased competition in the European real estate markets, Hughes says it's almost a nice problem to have.

While the REITs could mean more capital flooding into the markets, Hill predicts that the more traditional property companies, once organized as REITs, could largely be chasing steady cash flows, rather than opportunity fund-like transactions.

“It may actually open up the playing fields,” he says. “But that may just be wishful thinking.”

Leading the most recent wave of publicly listed European real estate investment vehicles was the French structure, Sociétés d'Investissements Immobiliers Cotées (SIIC), enacted by the French government in 2003.

Since the introduction of the SIIC in 2003, the EPRA/NAREIT France index has generated a return of 130 percent. Over the same time period, the sector's market capitalization has jumped from €10 million to €25 million.

Under the French arrangement, the SIICs must distribute 85 percent of their income and 50 percent of their capital gains back to shareholders. The SIICs also pay a one-time, 16.5-percent exit tax on unrealized capital gains over four years, which was advertised as a way to help reduce the country's budget deficit.

Fraser Hughes, research director at EPRA, says that, at the outset, the SIIC rules helped rejuvenate a few existing French property companies. “The SIIC breathed life into those sleeping companies,” he says.

He believes the vehicle will now increasingly be used for IPOs. French supermarket group Casino Guichard-Perrachon et Cie recently spun off its Mercialys shopping center unit into a publicly listed SIIC. The company, which holds 147 properties adjacent to Casino supermarkets, was listed last fall.

According to a report from EPRA, however, there have been some negative repercussions. A number of listed companies have been taken off the open market or seen their market capitalizations reduced because of takeover bids since the loss of SIIC status could have a detrimental impact on valuation. It is something the new generation of SIIC laws hopes to fix by allowing sellers to exchange assets with a SIIC in return for an equity stake.

“The benefit of this ‘kiss of life’ by an opportunity fund is that a small SIIC can grow substantially and the free float of this company rises over time when the opportunity funds sells it stake,” writes Max Berkelder of property analyst Kempen & Company in the report. “This can all take place in a relatively short period of time and is probably quicker than an IPO process.”

But a variety of different investors have looked at the vehicle as a way to access French real estate—and reorganize their own Gallic portfolios. Spanish investors have been particularly active in the SIIC market; in March 2005, Spanish developer Metrovacesa acquired a majority stake in the €6-billion Gecina vehicle, one of the largest SIICs in France.

Dutch and British property companies with extensive French holdings have also been taking advantage of the new structure. When the £1.1 billion French portfolio of London-based property company Hammerson was converted to a SIIC in March 2004, the company estimated its savings at £45 million over four years; its share price hit a 10-year high.