If more housebuilding is the object then REIT regime must encourage the sector
The present rules governing real estate investment trusts are hindering efforts to make the UK residential sector attractive to investors. If the government wants to create a healthy residential REIT market, then some crucial changes are required.
First, institutions need to grasp the benefits of an asset class that provides a real alternative route to the delivery of long-term stable performance.
Second, the regulations need to make REITs as attractive for investors as the private fund alternative. If the latter becomes the preferred route, retail investors risk being excluded from the opportunity to invest in a diverse, liquid and well managed vehicle.
Following the introduction of REITs in January, a number of companies have converted, with more likely to follow. However, despite the government’s original motive for REITs – to pave the way for a broader base of investor in residential – no residential REITs have so far been launched in the UK.
At Invista, we recently decided against launching a residential REIT. But why did we decide that?
After all, the residential sector is part of Invista’s long-term fund management business, and UK residential has outperformed other asset classes over almost any relevant time period. Residential also has a negative correlation to equities and bonds and investment in the sector makes for a diverse portfolio.
Current regime blocks resi investment
There are three major problems with the current REIT regime: the cost of conversion, the fact it does not take account of the high overheads on housing and VAT recovery problems.
First, why would a company be prepared to pay a 2% conversion charge when there was little or no latent tax liability in a newly formed portfolio of assets? The original idea was to compensate HM Revenue & Customs for entities that had large unrealised gains which, in a REIT structure, would not be taxable.
It is, therefore, understandable for existing companies looking to convert. But the charge is clearly a barrier to the creation of new UK REITs – which is not the case in other countries with established REIT models.
Second, it is difficult to create an attractive dividend yield from residential under the current REIT rules. REITs by their very nature are seen by investors as an income investment with potential for capital growth. But in the UK residential market, there is less of a link between rental and capital growth, because they are driven by very different forces.
by making it hard to offer good dividends
After deducting the costs of repair, maintenance and insurance from gross rents receivable (a very different approach to UK commercial property), the resulting net yields can be around 50-60% of their commercial property equivalent. This means paying competitive dividends to residential REIT investors is very difficult.
Furthermore, at the current level of interest rates, the cost of borrowing is higher than the net income received. Combined with the 90% distribution rule for REITs, this means there is little surplus to cover the interest on bank debt.
The yield dilemma faced by UK residential REITs fails to tell the whole story. The residential sector generally delivers higher capital growth than other asset classes, including commercial property, but the primary requirement of REITs appears to be dividend growth, rather than a true total return. While it is arguable that the low dividend yield is compensated for by a higher potential return, investors do not seem to accept this.
Third, there is little opportunity to recover VAT on costs associated with managing residential property, which can reduce the income available for dividends and active management of the portfolio. This appears to be a side-effect of complex VAT rules and regulations, but nevertheless it worsens the problems.
Over the past decade we have witnessed the buy-to-let market grow to over £135bn, which has been almost solely funded by direct and private investors. The case for residential is, therefore, strong in the eyes of investors and there are compelling arguments why residential REITs could offer commercial-level returns – but with the transparency and liquidity that investors desire.
Duncan Owen is chief executive of Invista Real Estate Investment Management.
