Mortgage REITs could help resolve the debt problem in the UK real estate market and lead to the next wave of growth in UK REITs, says Ros Rowe

The real estate industry in the UK began 2012 with the major challenge of there being too little debt available, and it looks like we are in a worse position than we were at the beginning of 2011. Back then, the main threat was cold weather, but the economy soon recovered with the arrival of a warm spring. It seemed that the country was emerging from the nightmare of 2007-08. The market looked favourably on real estate investment trusts (REITs), which were able to build up their cash reserves through share placings, rights issues and some innovative bond issues, not only in the UK but also overseas. Indeed some bonds were significantly oversubscribed.

However, by autumn 2011 there was a mood change. The euro-zone was fragile at a time when growth in the UK economy was falling. For example, the forecast growth in GDP in August 2011 for 2011 was 1.3% compared with 1% by November (source: HM Treasury Independent Forecasts). Added to this, there were certain banks with credit-rating problems, while all were faced with greater capital adequacy requirements, given Basel III.

The result today is that there is still no clear resolution to the ongoing problem of banks retrenching from the lending markets and, as a result, there is not enough new debt available for borrowers seeking new loans or for those looking to refinance existing loans.

According to De Montfort University in its annual UK Commercial Property Lending Market report, the aggregate value of outstanding debt recorded in loan books, and secured by UK commercial property, was £206.9bn (€246bn), of which £31.9bn matures in 2012. This is a significant amount and with the introduction of higher capital adequacy ratios under Basel III, will put pressure on banks to prioritise refinancing their existing loans rather than originating new ones. The report identified that new lending has decreased significantly since 2007 and only £19.9bn in new loans, including refinancing, were originated in 2010. This situation makes is more difficult to obtain new loans, which is further exacerbated by the fact that banks will have to take write-downs on much of this debt, as often the debt and associated swap is greater than the value of the property.

As ever, the market has responded to the demand for debt. New alternative lenders have emerged to take more market share. For example, insurance companies have established lending teams and raised equity for new real estate debt funds. Furthermore, developers are substituting debt with equity on a co-investment basis with pension funds and sovereign wealth funds. However, this equity is only available for the ‘right' opportunity and is predicated on location, with London and the South East being the preferred investment markets. Borrowings of loans secured against secondary property in regional cities and towns are facing the greatest challenges.

Given the size of the market and its current inadequacies, it is clear there is no single solution, but mortgage REITs could prove to be part of the answer by supplying some debt. While the UK government has confirmed there will be major changes to the UK REIT regime and has issued draft legislation for consultation, there are currently no stated intentions to introduce mortgage REITs, unlike in the US where they are prevalent.

In the US, a mortgage REIT is a tax-transparent listed fund which provides debt funding, typically in the form of medium-term fixed rate loans, secured against commercial property. Were mortgage REITs to be introduced in the UK then we would expect them to benefit from the REIT regime. Shares in a mortgage REIT could be traded on the London stock exchange, AIM, PLUS or similar. The loans would be qualifying assets and income from those loans would be exempt from UK tax. We would expect the government to require the mortgage REIT to distribute such income as part of its property income distribution (currently 90% of taxable profits) and that the shareholders would be taxed on the receipt.

The mortgage REITs would raise their funding from the markets based on a model where there was a closer link between the debt and the asset providing the security. Given recent experience, there is likely to be greater prudence in assessing a reasonable loan-to-value ratio. Mortgage REITs could provide refinancing or buy-in second-hand debt where the underlying security is an interest in properties - but only at the right price. However, it may be easier to use mortgage REITs for new deals where there are clean companies and there are new borrowers that would make the diligence process easier.
Approaches in operating mortgage REITs differ across the world. For example:

• Australia does not have a specific REIT regime. Trusts are taxed on a flow-through basis provided they only hold passive investments (for example, debt instruments, rental properties);
• As mentioned above, mortgage loans are qualifying assets for US REITs. In fact, REITs started as mortgage REITs. It was only in the 1990s that they began holding properties following a change in the tax law. Today, 83% of the 134 publicly traded US REITs are ‘equity REITs' (source: NAREIT, Dec 2011). There is a well-developed and long-standing market in the public space for these types of companies and, in fact, the sector surged coming out of the debt crisis. Often they are a pure income-play vehicle, although there are property-owning REITs that have a portion of their capital invested in mortgage debt;
• Some countries, such as Japan and Singapore, do not have mortgage REITs, or they are not permitted, as in Germany;
• The National Asset Management Agency (NAMA) in Ireland has been reported as suggesting that the Irish tax authorities introduce mortgage REITs.

Clearly any tax provisions for mortgage REITs need to be properly assessed with a reasonable time for consultation with the property industry. There are issues to be worked through. For example, at the strategic level, would there be any appetite for existing REITs to have a portfolio of property-backed loans or would mortgage REITs be the only new lenders? Turning to the taxation treatment, how much, if any, of the interest receipt should be distributed to investors and how would that income be treated? Given that the taxation treatment of an item is driven by its accounting treatment there will be a need to work through how to deal with bad debts.

Consideration will need to be given to the degree of regulation, as mortgage REITs would provide loans in a similar manner to banks; the hope is that this would be on a ‘light touch' basis where the government would have power to act only in cases of fraud or negligence. For such a regime to succeed it has to be simple (easily understood) and cost-effective to operate without a swathe of red tape, which reduces margins.

While there was no reference to mortgage REITs in the draft Finance Bill provisions, it is not too late for the government to start the consultation process on the introduction of mortgage REITs, which could bridge part of the funding gap and expand the REIT regime in 2012.

Ros Rowe is a partner in the real estate practice at PwC