The government’s reform of the REIT regime is a work in progress, but the US experience provides encouraging signs for its future, writes Rosalind Rowe
In 1913 there was an innovation that led to a near riot, but which has, over time, been accepted as influential in its field: The Rites of Spring, a ballet composed by Stravinsky.
The government’s changes to the Finance Act of 2012, which shook up the real estate investment trust (REIT) landscape and led to a resurgence of the REIT regime in the spring of 2013, were equally surprising. But will the REIT innovation be maintained and what does the future hold?
In 2007, the REIT regime came into play following talks between the property industry, investors and the government. REITs are designed to attract investment in property through creating liquidity in the market, as the shares have to be listed on a stock market and widely held. There is a favourable tax regime where the tax liability on rents and gains is displaced from the REIT to its investors. The REIT is required to distribute 90% of its rental income, known as property income distribution (PID), to its investors. This means a REIT can provide a return similar to direct investment in real estate, which enables investors with diverse tax attributes (pension funds, individuals, sovereign wealth funds, and so on) to invest alongside each other.
While it was initially ground breaking, the REIT regime lost momentum as the number of joiners tailed off in response to the challenges of the recession in late 2007. There were changes to the regime in last year’s Finance Act, which intended to attract new REITs, particularly those investing in the residential sector.
When REITs were introduced there was an entry fee to join the regime of 2% of the gross value of investment property. Last year’s alterations included the removal of the entry charge, relaxation of the listing requirements (admission to listing on the Alternative Investment Market and similar markets). The reform also permitted a certain type of investor (institutional investors) to take larger stakes without causing a group to become ‘close’ and leave the REIT regime (close company status is a complex area where shares are held by a small group of influential investors). Permitting institutional investors to take larger stakes recognises that certain types of investors – for example, pension funds – actually represent a large body of investors so their stake is already widely held.
These alterations were heralded by some as the start of a new generation of REITs. Unfortunately, problems in Europe, with the crashing of a number of economies and a lack of easily accessible debt, did not immediately deliver the expected renaissance. Better news from the euro-zone, as well as the saving in the entry charge, have been sufficient, recently, to attract new REITs in the self-storage, healthcare and commercial offices sectors, which have all emerged this spring.
But that is not all. The exciting news is that the first student accommodation REIT has been launched. The government is seeking greater investment and other providers of student accommodation are thought to be considering entry to the REIT regime. With acceptances of around 400,000 new student places at UK higher education (UK and EU students) for 2012-13, the hope is that such REITs can meet some of the housing demand.
Furthermore, there are more residential REITs in the pipeline, following the recent announcement that a social housing organisation expects to launch a REIT shortly. While it intends to start on Alternative Investment Market, its growth plan indicates large-scale investment over the longer term – the step-change that the government is seeking if it is to bridge the supply-demand housing gap. In 2012, annual housing starts totalled 98,280, down by 11% compared with 2011; annual housing completions in England totalled 115,620 in 2012, 1% higher than in 2011 (DCLG statistics, February 2013). The annual demand for new houses is at least 200,000.
So has the government done enough to encourage growth in the regime?
It is a good start but the regime needs to evolve further to ensure it performs effectively. There is legislation in this year’s Finance Bill that will enable a REIT to invest in another REIT.
Previously, when one REIT invested in another, the rental distribution (PID) was
taxable, which inhibited REITs from taking a stake in another REIT. Once the legislation is enacted (due to take place this summer 2013) there will be no tax on the rental distribution from one REIT to another if the PID is passed in full to the investing REIT’s shareholders.
This will benefit smaller REITs which may synthesise a ‘REIT-like’ return where cash has been raised but has not yet been invested in property.
However, investing REITs have not been designated institutional investors. At a time when debt is not easily accessible, REITs have responded by accessing debt from other sources, including insurance companies and sovereign wealth funds. There is a fetter on their commercial activity unless they are designated institutional investors. If that change were to be made, then when a REIT wants to spin off a particular part of its portfolio it could form a new REIT (Exit-REIT) and sell off the shares. Alternatively if it has a co-investment structure and at some point a co-investor wants to exit, then an Exit-REIT could provide a commercially viable route where the exiting investor could sell all or a proportion of their shares.
The UK differs in size from the US. There are around 30 REITs with a value of around £30bn in the UK, compared with the US total of around 180 REITs valued at $600bn. But that market has grown from around 30 REITs valued at approximately $1.5bn in 1972.
The world has changed since 2007 and the government has responded to the economic challenges by reshaping the regime. It is clearly a work in progress but the US experience is encouraging – create an attractive regime for investors and growth will follow.
Rosalind Rowe is a tax partner at PwC