Is it time to give up on a pan-European REIT? Shayla Walmsley considers the arguments
In the pre-credit crunch years, the debt financing market had become highly aggressive, as lenders competed with each other to offer the highest loan-to-value (LTV) ratios and the smallest margins.
This was fuelled by the burgeoning commercial mortgage-backed securities (CMBS) industry which, since the onset of the sub-prime crisis, has shrunk into relative insignificance.
This time last year, investors frustrated by a patchy continental listed market could look forward to the mooted introduction of a pan-European real estate investment trust (REIT).
When a consortium led by the European Property Federation mooted the idea to the European Commission in November 2007, the idea was that such a REIT would remove obstacles to cross-border property investment.
Research conducted by a Maastricht University team - cited extensively in the consortium's case - pointed to "distortions" created by national REITs regimes and the need to ensure "a properly functioning internal market for real estate investment". An EU REIT, claimed the research, would boost specialisation in European-scale property.
Best of all, if withholding tax were removed, only entry and exit tax would need harmonising - and governments would be easy to convince if reassured that they would not lose their cut. The result would be the creation of "the largest and likely most efficient property market in the world".
Even if its introduction wasn't imminently likely, the hype around it promised to accelerate the introduction of a national REITs regime in, for instance, Denmark and Spain.
So what happened? The market, is what. In the past few months, EPRA has challenged the EU REIT agenda with the suggestion that lobbying for an EU REIT merely diverts industry energy away from potentially more productive lobbying for the removal of restrictions to cross-border investment.
These restrictions include artificially imposed thresholds for cross-border participation aimed at guaranteeing tax revenues. "The benefits of a single EU REIT do not outweigh the complexity of its design and implementation," EPRA CEO Philip Charls told his organisation's annual conference. The damage done by lobbyists for an EU REIT could extend beyond waste of lobbying hours.
In fact, suggested Charls, it could increase uncertainty for existing REIT regimes. Rather, in a recent position paper, EPRA urged investors to focus on practical solutions", such as resolution of tax issues, instead. REIT-style legislation in Finland in 2006, for instance, failed to lift double-taxation provisions.
"When you have a number of different states trying to decide on REITs regulations, it depends on the extent to which they want to encourage overseas investment, their policy on capital inflows, and factors such as whether they want to encourage investment in residential," says EPRA head of finance and investment Gareth Lewis. "They're starting from different tax bases. Their attitudes are just different. Governments just want to be sure they collect tax somewhere."
Start local, move outwards EU REIT champions claim it need not be created from scratch; rather, the experience of national REITs regimes will provide direction towards an optimal pan-EU structure.
The problem is, they haven't. Lewis acknowledges lingering inefficiencies in the market - including variable degrees of transparency. "Currently you have the same international code but different interpretations. If you're investing from outside Europe, you want to be sure you're comparing on a like-for-like basis," he says.
Though not an advocate, Leonard Geiger, Cohen & Steers director of research in Europe, believes market competition will likely generate a pan-European REIT - he's just in no hurry. "Markets already have their own and they'll leapfrog each other to perfect their own," he says.
He points out that the UK looked at the US example in drawing up its own REITs regulation, that France took a few goes to make its legislation work, and that the Netherlands is currently modifying its REITs legislation to take into account new property development. In other words, this is not a one-step process.
"With Swedish and Finnish REITs in the offing", says Geiger, "it will get to a point when most European markets have a REIT. The French and UK models are not far off the US model," says Geiger. "I don't know why the EU should have one so different from the US."
This requires REITs-investing pension schemes to shop around for the best regime. "Some REIT regimes are more favourable than others though when it comes to investment and non-investment-related requirements.
The fiscal treatment [dividend withholding tax] also makes certain REIT regimes more attractive than others," says Thijs Steger, a spokesman for APG, the asset management company wholly owned by ABP, the €230bn Dutch public sector pension fund.
The problem with the ‘market' thesis is that it works slowly, if at all. The introduction of REITs in some European markets has been less than totally successful - at least in its initial drafts - and vested interests of national government, excessive caution and inadequate drafting initially hampered the replication of earlier, successful regimes.
In Germany, the exclusion of residential from the REIT structure contributed to the poor take-up. Stringent German rules on leverage contrast with liberal ones in, say, the French regime. To date, only two German property companies have become REITs.
Although their advocates claim they perform more like direct investment in property than equities, REITs are listed companies, and they suffer when equities do. Nor are they somehow immunised by their REIT status - as Macquarie Prime REIT found out in September when Moody's downgraded it.
Without an improvement in the market - that is, an increase in the number of IPOs - the number of conversions is unlikely to increase significantly. "People read too much into the lack of take-up of REITs. If we had a normal market, we'd see more of them. It's more about the drop in the number of IPOs than it is about the REIT structure," says Geiger.
The case for REITs
Advocates for the REITs structure have been vociferous in their defence, among them (German REIT) Alstria CEO Olivier Elamine, who recently suggested that the REIT structure was taking the flak for a weak market.
Steffan Wollnik, an equities analyst at HSH Nordbank, who covers Alstria, agrees. "You hear a lot of complaints about the structure but it's positive that it became a REIT," he says.
"The main reason why Germany only has two is that market development on the stock exchange is very bad right now. When the market changes, that will change - but when that will be I don't know. The whole system is in quite a bad mood. When it normalises, the REITs ‘issue' will be resolved.
"There must be improvements in REITs law - especially the exclusion of residential and continuing double taxation. There was meant to be a parliamentary discussion on amendments in June but it got postponed. They have more important things to deal with at the moment."
From some REITs' point of view, the lifting of corporation tax alone justifies conversion. "It's very trite to say they haven't worked because they clearly have," says Dominic Smith, research manager at Land Securities, the UK REIT. "Before, corporate gains tax meant there were assets we couldn't sell. Now it's removed, we can so it's been effective from a portfolio manager's perspective. I know what the regulations were before and after, and I know which I prefer."
Smith speculates that the UK government could end up spinning off some of the property assets it bails out as a result of the financial services sector crisis as a REIT. He also argues that the introduction of REITs in the UK effectively created new sectors - such as storage via Big Yellow.
But there are potential gains for pension funds, too, says Smith. Schemes can view them as a long-term hold - because they perform like direct property - or as a short-term tactical play. "It's a property return versus a cash return. There's a lot of ways they can be used," he says.
APG has swallowed stakes in UK REITs, including Derwent London and British Land. "The advantages of investing in REITs versus other listed companies mainly boils down to the tax transparency of REITs and avoiding double taxation," says Steger. "Our investments are not so much determined by the specific REIT regime.
We first and foremost look where we want to invest based on risk-adjusted returns. Subsequently we investigate how we can best access these markets, with REITs being an alternative."
As APG has it, pension funds' appetite for investing in REITs comes as part of a trajectory away from direct investment and towards diversification. The fact that REITS are "an alternative" - as in, one of several - suggests that pension funds couldn't care less about the structure per se, as long as it doesn't entail tax losses. Some REITs regimes are more attractive than others, but none are either deal-makers or deal-breakers.
"The take-up has been low not just in Italy but in Germany and the UK - but that has nothing to do with the REIT structure. What Germany shows is that it isn't enough to be a REIT," says Geiger.
"With the exception of our Japanese clients [who may invest only in REITs for reasons of tax efficiency], investors aren't that sensitive to REIT versus non-REIT holdings," says Geiger. "In the long term, REITs will outperform because they have a better structure. But I can't see a fund not investing because it isn't a REIT."
REIT for pension funds?
In a position paper on investing in European REITs, APG backed the idea of REITs without necessarily opting for a pan-European version. For pension funds, it claimed, they simply offer a way out of direct property investment and the ability better "to diversify your real estate portfolio in other real estate classes and other countries, which in the end should result in a better risk adjusted investment performance." In addition, the tax transparency of REITs makes it easier to compare with private vehicle and direct real estate.
European pension schemes aren't alone in viewing the structure favourably. The CA$108.5bn (€68.3bn) Ontario Teachers' Pension Plan (OTPP) - an investor in Hammerson, the UK REIT - positions REITs as a discrete asset class within its inflation-sensitive alternatives portfolio, which also includes commodities, infrastructure and real-return bonds.
As of the end of 2007, the value of this portfolio was $39.3bn."These are investments that tend to correlate closely with changes in inflation, so act as a hedge against increases in the cost of future pension benefits," says Deborah Allan, communications director at the scheme.
Other North American pension funds have been more aggressive in their approach to investing in REITs. The Sacramento County Employees' Retirement System in September hired CBRE to manage a US$60m (€40.7m) mandate for non-US REITs, citing diversification benefits.
"REITs give us access to real estate outside the US in a way that can be well diversified," says chief investment officer Jeff States. "We're increasing our allocation to REITs because they provide long-term real estate exposure correlated to company performance.
We view it as an effective way to gain exposure - but with liquidity. "In fact, we're moving to exclude US REITs. Although there's some correlation across markets, it's a broader set. We're looking for new opportunities, and more opportunities for active management."
Which REIT is the right REIT?
A pan-European REIT might make real estate diversification easier for pension funds and their investment managers, but the fact that there isn't one is hardly holding up investment either in REITs or in European property markets.
In its absence, cross-border consolidation of existing REITs is likely where two regimes hold similar positions on tax, according to Andrew Baum, chair of Property Funds Research. He points to Unibail Rodamco, the Franco-Dutch retail REIT and Europe's largest property company.
Baum acknowledges that creating cross-border REIT mergers will be "a slow process" - a point echoed by Lewis's forecast that incremental improvement of cross-border flows across Europe "could take a very long time".
"There will be other areas of best practice, and the market is best placed to determine them," adds Lewis. "In terms of success in attracting international investment, over time they'll see which models work and which don't. I can't foresee the European Union saying, ‘This is what we want in a REIT'."Rather, he argues, "incremental improvement" will reflect best practice from the market perspective.
Wollnik is more optimistic - but only from a baseline of outright scepticism. "Harmonisation of the European tax structure would be useful for the whole EU -not just for REITs," he says. "An EU REIT isn't likely - but it's more likely than a harmonised tax structure across the EU for everything."