REITs require long-term investment to succeed, but appeal more to private equity investors due to dividend policy, as Alec Emmott reports
To say anything (let alone to write it down) concerning price or value in the current circumstances is probably foolhardy or pretentious, and it's difficult to know for the moment where bravery ends and stupidity starts.
So while waiting for the world's investment professionals to sort through the succession of disparate spanners that securitisation and risk ‘management' have thrown into the works, it may be useful to check that the European REIT industry is properly dressed for the future.
The REIT debate has been rather hijacked by the tax specialists - sometimes at the expense of the economic and functional design brief. And yet the founding principals of the REIT movement in the US were not tax-based per se at all - but aimed at providing a tax-neutral vehicle which would enable a viable link between the retail savings and real estate markets.
The REITs concept, initiated in the US in 1960, whereby the ultimate stockholder rather than the corporation becomes the taxpayer, has revolutionised the real estate markets.
But the initial legislation had little impact until Congress introduced the up-REIT amendments after the chaos in the US real estate market in the late 1980s. The French experience has confirmed what a fundamentally important building block the tax-efficient contribution of assets for equity has been in growing both the size and appetite for REITs. Even though this essential step has been missed in many European schemes, the domino effect has nonetheless extended through most of those countries in which there is an organised real estate market and properly structured title to land and buildings. And while Europe lagged behind five years ago, it has now caught up.
As there is no tax differentiation between the treatment of capital gains and revenues, the move from asset collector to asset manager is facilitated. Sales are thus predicated by total return and real estate considerations rather than by tax planning, freeing up the rotation and trading of assets.
The European cut which has been given to the tax-jacket also favours the restriction to listed companies. This has obvious and significant advantages in terms of governance and regulatory control; but doesn't change the fundamental attraction of the model - its dividend.
Listing does however imply prudential borrowing limits. France assumes that markets are a better judge of what is acceptable than the tax authorities, and that the benchmark should be imposed by the capital markets. Others have chosen to cap it legislatively. Most importantly in this context, high leverage is a significant constraint on dividend policy.
The achievement of the US REIT industry has been to produce a product which appeals to the 401K saver. The NAREIT mission statement is ‘dividends and diversity'. This is based on dividend yields being significantly higher than other equities on average, and the creation of a steady cash-flow throughout the cycle. There's a real risk that the European REIT model is looking to appeal to the wrong audience - wearing the wrong trousers.
The European capital markets, through the professional and traditional sector managers and analysts, are telling the REIT sector to produce alpha: the traditional REIT model is aimed at producing beta. There's a real disconnect here which needs to be addressed, since the only current way to produce the required dividend yield is to value listed REITs at a discount to their net asset value - which is unsustainable.
An emphasis on sustainable and regular dividends implies an acquisition programme based on the higher end of the yield spectrum, and yield enhancement through regular but limited ‘capex' investment rather than a full development pipeline. Not surprising then that three of the largest US REITs are in the warehousing, distribution or self storage markets…. Not surprising then that a dividend yield only slightly above long-term interest rates has provided some sort of floor to pricing in the current storm….
Not surprising then that low gearing is seen as a positive.
Identifying and playing to the right shareholder is a key to success in the capital markets. And with the greatest respect to the alpha-seeking private equity and hedge fund managers, they are not the ‘sticky' capital which enables a REIT to plan and execute a long-term business plan. REITs need, in order to build their long-term operating platform, more of those shareholders who are not currently listening to them. It may be old fashioned but, as John Sunderland said when he was chairman of Cadbury: "I view a shareholder as a shareowner - someone whose interest in the success and the prospects of the company lasts more than three weeks."
There is no significant commission available for selling REIT shares directly to the retail saver - and this is one of the sector's real handicaps. If REIT shares can't be sold, the public will need to be convinced of the advantages of buying them - and that means defining and advertising their dividend policy.
Not surprising then in this context that the French SIICs have trebled their dividend payout since the regime was introduced in 2003. Dividend and diversity will be as important a sales pitch in Europe as it has been in the US.
Throughout the world the current turbulence in the capital markets has produced the same effects - current pricing below reported break-up value. A sustained discount to NAV is death to a listed property company. The sector in France was dying by slow strangulation - down to 12 companies by 2003. Today there are nearly 50. The phase of consolidation ahead is an opportunity to prepare for the future. Let us hope that the recent dive in stock prices is simply the market pointing out that NAVs are under pressure in the current environment, and not taking the scissors to a faulty design.
And those caught wearing the wrong trousers, or with a cash-flow which won't support a sustainable dividend because of over-gearing, shouldn't be surprised when the barbarians from the unlisted sector next door arrive at the gate!
Alec Emmott is principal at Europroperty Consulting