Will recent government proposals see the emergence of residential REITs in the UK? Ros Rowe is confident 2012 will be remembered for more than just the Olympics

This year might be remembered in the UK not just for the Olympic Games but also for new, large-scale residential letting.

In late 2011, the government delivered its proposed changes to tax law relating to real estate investment trusts (REITs) which will become effective in the summer of 2012, just about the same time as the games.

In the short term there are new REITs coming to the market; in the longer term the Olympic Village, with its privately let housing, could benefit from these changes.

A REIT can be a single company or, more likely, a UK tax-resident parent company with subsidiaries, which invests in rented property in the UK and overseas.

There is no UK tax levied on rental income from UK property or on overseas properties held by UK members of the group. Furthermore, there is no tax levied on the REIT on gains realised on the disposal of such properties.

The investors are treated as if they held a direct investment in property. The REIT has to distribute 90% of the rental income, which benefits from the tax exemption (PID). There is a withholding tax of 20%, which is levied on distributions to investors such as individuals and offshore investors.

Investors pay tax on that distribution as if it were rent. A tax-exempt institution, such as a pension fund, would not be taxed, while a UK corporate would pay tax at the current rate of 26% and an individual could be taxed at up to 50%. Overseas investors may benefit from treaty relief, which may cut their tax rate to below 20%.

The proposed changes are focused on a framework to encourage new entrants - ranging from start-ups to institutional investors - to increase returns through reducing the tax cost with the abolition of the entry charge and increase the efficiency of REITs through some technical changes.

There are potentially two types of new entrants - small investors and large institutions. To encourage small investors, the government has relaxed the listing provisions permitting trading on AIM (or a similar overseas platform) as well as a full listing on the London Stock Exchange (or any other recognised stock exchange). A REIT can be ‘close' (a complex concept but, essentially, where a small group of investors controls a company) at the point of listing, with a grace period of three years in which the shares must become widely held.

Furthermore, where certain institutions, such as funds that invest on behalf of numerous investors, have significant holdings, these will be treated as ‘good' investors when determining whether a REIT is close, thereby permitting a wider range of ownership structures for REITs. The list of good investors appears to be narrowly defined, with some surprising omissions, such as charities, social landlords and companies with diverse ownerships, including other REITs.

The government has accepted the need to reduce the tax and operating costs of REITs, as the yield from residential property is generally lower than commercial property. There are three changes. In 2011 there was a reduction in stamp duty land tax levied on the acquisition of a portfolio of rented housing. Unlike stamp duty land tax on other real estate, where the rate is 4% of the aggregate value, the charge for residential is now based on the average value per residential property in the portfolio, and can therefore be as low as 1%. Further changes will apply from this summer when the entry charge (currently 2% of the market value of assets, ignoring debt) is abolished and the listing on AIM (or similar) will reduce listing costs.

There were two major technical changes that will benefit the REIT regime. The financial cost ratio has been reworked. It was introduced to prevent REITs avoiding paying out a property income distribution (PID), which is 90% of tax exempt rental income, through being highly geared and paying out profits as interest. However, the original legislation unexpectedly included costs of commercial transactions such as debt breaks. The government listened to the industry and simplified the income cover ratio, which will compare rental income with only interest and no other associated financing costs.

Cash will now be treated as a good asset when applying the balance-of-business test where at least 75% of the assets of the REIT have to be real estate. In the current commercial environment, certain REITs have built up cash reserves by issuing bonds and placings to provide funds for opportunistic purchases, since it is harder to get debt. There were other minor technical changes, which included permitting REITs to make good any underpayment of the PID in line with their distribution timetable.

These changes are encouraging because they reflect the requests made by the property industry when its views were sought by the previous government. There are some areas where clarification is needed and representations are to be made by PricewaterhouseCoopers.

At the beginning of 2012, the government announced a consultation on an initiative to shut down sub-letting of social housing (up to 160,000 homes) by making it illegal. While sub-letting social housing may be high profile, there remains the need to house people who either cannot afford to buy their own house or require mobility in work in difficult economic times.

Former students will be familiar with renting properties and, given increased student debt, most students are unlikely to have saved a deposit to buy a home when they leave home. Consequently, there will be increased demand from these students, for whom the phrase ‘generation rent' has been coined.

The challenge is to meet housing demand and provide an acceptable return for investors. Rented properties can be accessed through buying existing properties, which might not be efficient to manage if they are spread over a wide area.

However, built-to-rent residential property developments are more likely to deliver acceptable returns. They can be designed with standard construction providing for easier maintenance and reduced chance of obsolescence. For such properties we expect there could be a net property yield of more than 5%, which should allow a dividend to investors of more than 4%, which is comparable to a commercial REIT.

With the proposed changes and some astute developments, 2012 could be the year when residential REITs become a new acceptable asset class in a diverse portfolio of real estate.

Ros Rowe is a partner at PwC