Real estate investment trusts Gawain Hughes and Charles Vermeylen consider the pros and cons of proposed changes to the UK’s REIT regime
As part of last year’s Budget proposals, the government announced that it would consult with the real estate industry with the aim of revamping the existing REITS regime, reducing barriers to entry and the regulatory burden for existing and future REITs. The subsequent “informal” consultation process produced more than 50 written responses, which were submitted prior to publication of draft legislation eight months later. These changes are expected to come into force at Royal Assent to the Finance Bill 2012 around July.
In this article we will look at advantages and disadvantages of some of these proposals. We will compare them with the more mature REITs markets in Australia and the USA to determine whether they go far enough to achieve the stated aims.
Background
With an aggregate market capitalisation for UK listed REITs of around £20bn, the initial regime has been a success, although it remains relatively small compared with the Australian market, at around £50bn, or the US market, at around £200bn. The number of UK REITs has grown to 20 since their introduction in 2007, compared with about 55 in Australia and about 130 in the USA. The UK REITS are generally large property companies such as Land Securities, British Land and Hammerson, many of which converted in order to crystallise latent capital gains. However, the system in its current form has been much less successful as a vehicle for new real estate funds. On several indicators the UK REIT industry lacks the scale and diversity of the US and Australian markets, even though the basic framework is, in principle, similar.
The proposals
Abolition of entry charge
The most highly publicised change is the abolition of the entry charge (currently set at 2% of the market value of the assets).
All the stakeholders who responded to the consultation were supportive of this reform as the charge was a significant barrier to entry; although it was a small price to pay for the larger, well-established property companies, given the CGT treatment of latent gains at the point of election.
Arguably, given falls in property values and lower latent gains, the concession will have a minimal effect on the exchequer’s take, which ministers hope will be more than offset by revenues generated by a revitalised real estate industry.
Abolition will align the UK system with Australia, which has no entry charge. Moreover, while there are US taxes on gains at election, these are often in practice deferred by like-kind exchanges.
Relaxation of the listing requirement
Under the present system, a UK REIT must be listed on a “recognised stock exchange” such as the Main Market of the London Stock Exchange. The new legislation will permit lower-cost AIM and PLUS listings, and their foreign equivalents, for the first time.
This is another change likely to be of particular value to start-ups, since these exchanges have lower entry costs and smaller companies can raise capital at lower cost. In addition, the lighter governance and reporting demands will also reduce ongoing administration and regulation costs.
Neither Australia nor the US requires their REITs to have any kind of listing, and “private REITs” make up a large part of those markets. Clearly, with lighter-touch regulation there may be an increased risk of REITs being mis-sold, in which case the public would soon turn away from REITs. However, this does not seem to have affected confidence in these jurisdictions and perhaps the UK should have followed suit.
New diverse ownership rule
The non-close company requirement will be amended to allow a REIT some time to become compliant. Additionally, the proposals include a “diverse ownership rule” so that certain institutional investors will not make a company close for the purpose of the regime.
The new rule should make it easier for companies with institutional investors to become REITs, which seems sensible, especially since many of these institutions are themselves widely owned.
However, many in the property industry will be disappointed that “institutional investor” is not defined as widely as it could have been. They had hoped it would broaden the investor universe even further, specifically including hedge and private equity funds and charities. It is quite likely that the Treasury will have to use its power to make regulations modifying the list at some point in the near future.
In Australia, there is no restriction as to the number of investors. However, the US has something comparable to the close company prohibition, since five individuals cannot own more than 50%. Both of these jurisdictions display relatively high diversity and it is difficult to conclude whether the decision to tweak the UK requirement, rather than remove it outright, was the right one.
Changes to financing costs test
Currently a UK REIT incurs a charge unless profit exceeds finance costs by 1.25 times. Under the proposal to ignore costs other than interest, the test will become easier. If the limit is exceeded, the amount of tax charged will only apply to 20% of profit.
Since its purpose is to discourage tax avoidance achieved by payment of interest (instead of dividends), the proposal improves the focus of the test.
There have been widespread issues with “over leveraged” real estate funds breaching their banking covenants in the past few years. That trend would perhaps justify a tightening of restrictions, rather than the relaxation proposed.
Neither the US nor Australia has this kind of interest cover test, or any equivalent gearing restriction. However, it is debateable whether this is a strength. Indeed, the SEC reviewed the US REIT leverage rules as recently as August 2011 amid growing concerns. Given the high levels of indebtedness in much of UK real estate, it is understandable that current proposals continue to regulate financing quite tightly.
Easier balance of business test
Currently, 75% of a REIT’s assets must be investment property. Under the new proposals, cash and gilts are to be treated as “good” assets for the purpose of the test.
This change should particularly help new funds. The cash raised on listing will help them meet the test, giving them time to identify worthwhile investments.
There are some concerns about the drafting complexities in this proposal. The fungible nature of cash means it can be difficult to trace the source, which may cause problems if HMRC adopts an uncompromising interpretation.
In Australia, REITs must invest primarily for the purpose of deriving rental income, though some other investments are permitted. The US has a 75% hurdle which already considers cash and government securities as “good” assets, so the current UK proposals might be characterised as a catch up.
Additional time for distributions
There will be minor changes to the requirement for distribution of 90% of net income profit. The amendment extends the date from three months after the tax return filing date to six months.
Industry will welcome the extension, since the previous rule was problematic for companies operating on a six-month dividend cycle. Even then, some timing issues may still arise this year, since the change will only apply to distributions made on or after the date of Royal Assent.
In Australia, all undistributed income and gains are taxed at a high level, such that 100% distribution generally occurs. As in the UK, a US REIT is generally obliged to distribute at least 90% of its ordinary taxable income. Interestingly, there is some scope for distributions made after year-end to be counted towards that 90%, so the UK is not alone in adopting a nuanced approach to enforcement of the target.
Where the changes leave us
In several ways, the proposed changes reflect established practice in the US and, to a lesser extent, Australia, and UK companies considering entry to the new REIT regime may wish to seek advice from practitioners with experience in these wider jurisdictions. The amendments are welcome but represent a missed opportunity not only to bolster the real estate industry but also to address some of its current problems.
As an example, the concept of “mortgage REITs” has not been accommodated in the current proposals. They could have been incorporated as an additional means of moving debt off the balance sheets of banks and asset managers. This is a concept advocated by the head of Ireland’s Nama, who recently expressed a hope that his indebted bank might move as much as €31bn of debt into UK REITs. The US Federal Reserve was able to dispose of $7bn of “non-government agency” mortgage securities during January 2012, so perhaps mortgage REITs would have presented a partial solution to the debt crisis in UK commercial property, as they are beginning to do in the US.
A missed opportunity is similarly evident in respect of developing a residential REIT sector. In a publication entitled Investment in the UK Private Rented Sector (September 2010) the UK government declared an aim to facilitate residential REITs. The current proposals generally reduce barriers to entry and may, for instance, encourage housebuilders to spin off unsold stock in AIM vehicles. However, they do not address other issues, such as problems with the balance of business test, which arise because residential portfolios have higher proportions of trading stock and “churn”. The proposed changes in themselves are unlikely to stimulate a new residential REITs market.
While the changes fail to address some pressing issues, they are generally to be welcomed. They can be characterised as evolution, mostly following a well-trodden path taken in Australia and the US. However, this leads to another question: given the current fragile conditions in the property markets, is conventional, incremental change sufficient? REITs II is a work in progress, and ultimately the markets will determine whether it is sufficiently bold.
Gawain Hughes is a partner and Charles Vermeylen is a solicitor at DLA Piper
