As structures are refined and markets improve, UK, Italian and German REIT prospects look brighter, say Paul van der Vaart and Luke Powell
After several years of hard work by the property industry and regulators, the introduction of real estate investment trusts (REITs) in Germany and the UK (in 2007) and in Italy (in 2008) has been something of a disappointment. Share prices in the sector have been hit hard, while few companies have taken the opportunity to get a listing - just two in total in Germany and only two new REIT listings in the UK since the beginning of January 2007.
There are several reasons for this. The current turbulence in the property and equity markets has undoubtedly played a part, as has the way in which REITs have been structured and introduced. Nevertheless, we still believe that REITs in Europe have a bright future. The market will revert to a level of pricing that makes a public listing attractive again, and there are promising initiatives underway, such as the potential for an EU REIT.
When REITs were introduced to the UK and Germany, many felt that the property sector would see REITs establish themselves as a dominant form of ownership for property assets. In the UK, we have indeed seen a whole raft of existing listed property companies, including such luminaries of the sector as Land Securities and British Land, convert into REITs. Since the first wave of conversions however, the flow of new REITs to the market has slowed to a trickle. Only two more REITs have sought a listing in the UK, while Germany has just two REITs in total.
Why has the REIT sector been so slow to take off? Much of the blame lies at the door of the credit crunch. The US sub-prime crisis - and the resulting pressure that it has put on credit markets across the world - has put property values under pressure. The listed property market is able to anticipate falling property values more quickly than the direct market, which leads to listed property trading at an effective discount to property in the direct market. In short, this has closed the IPO window, as there is little incentive to list if higher sales prices can be achieved in the direct market. At Morley, a few prospective REIT IPOs have been run past us over the last year, but nothing has materialised.
The existing REIT structures are also far from optimal. Firstly, European countries do not have the UP-REIT model, which is a key feature of the successful US market. This model allows a property partnership to be gradually converted into a REIT. The German market has also been adversely affected by the uncertainty surrounding the treatment of partnerships and subsidiaries, as well as by the effective exclusion of REITs with a residential focus. This decision by the German government has made it impossible to set up residential REITs in an effort to protect tenants' rights. Ironically, this leaves many residential portfolios in the hands of unregulated, leveraged private equity funds. German companies have also generally delayed conversion to REIT status, since corporation tax is being cut this year, which will also reduce the conversion tax payable when converting to a REIT.
There are problems with the REIT regime in other countries. In the UK, there are investors who would like to see AIM-listed property companies convert into REITs, but current legislation makes this impossible. In Italy, regulators have not done enough to make the REIT tax regime attractive. Capital gains generated by REITs are taxed twice - at both the company level and at the shareholder level on distribution. This will hold the sector back.
Despite 2007 being a difficult year for European REITs, their future is still bright. As markets stabilise, valuations in the direct and listed property markets will converge, re-opening the IPO window. However, the most interesting prospect in view is the potential for the creation of a single European REIT market. The diversity of REIT structures across Europe has been an obstacle to the emergence of a genuine pan-European REIT market, distorting competition and encouraging a lack of transparency. Evidence from Australia suggests that an effective structure can facilitate the creation of a REIT market accounting for over 40% of the total real estate market.
Professor Piet Eichholtz of Maastricht University has boosted the case for a European REIT structure in his paper ‘The EU REIT and the Internal Market for Real Estate'. He has set out a preferred structure for an EU REIT without the need for invasive tax harmonisation. Several property industry representative groups are currently discussing the feasibility of such a structure with the European Commission. An EU REIT would discourage companies from looking for tax loopholes and facilitate a single internal market with increased levels of cross-border investment, enhancing liquidity and market transparency through the provision of greater certainty.
Although an EU REIT is still likely to take some time to come to fruition, its advantages are clear.
Luke Powell (left) is property sales and marketing specialist and Paul van der Vaart is real estate securities fund manager, Morley Fund Management