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All REIT now

publication date: Sep 1, 2011
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REITBuried in the budget of March 2011 were some rather surprising, but welcome, proposals to reform legislation governing Real Estate Investment Trusts, REITs, widening their appeal to investors with potential for residential investment by REITs – at long last.

What is a REIT?
A UK REIT as defined by Deloittes, February 2010, is a UK residential listed company that undertakes a “property rental business” and has elected to enter the REIT regime, but which excludes income and capital gains from owner occupied buildings.

The intention of the REIT regime is to replicate the tax treatment of direct investment in property since income tax and capital gains are exempt at the REIT level but taxed at the investor level when received by way of dividend.

Tax Treatment
To ensure income and gains are taxed at investor level, REITs are required to distribute the majority of their tax exempt rental income known as Property Income Distributions, PIDs. Basic rate tax at 20 per cent is generally withheld from the dividend except when it is paid to a pension fund or a UK resident company. UK corporation tax is levied on any non-rental income or gains and taxed in the hands of investors as normal company dividends.

The History
REITs were invented in the USA, the largest and most varied REIT market. Over the years a range of specialist REITs have been developed focusing on narrow sectors of the property market – hotels, shopping centres, industrial parks, residential blocks and many more in addition to those with a more varied diet. Australia followed in 1971 with 70+ REITs and has become the largest market outside the USA. Canada followed in 1993 with smaller countries following suit, Finland joining in as late as 2010. The rules adopted by each country vary widely although the basic concept remains the same. Finland, for example, requires that 80 per cent of funds should be invested in residential property and that 80 per cent of income should be derived from the residential letting business: 90 per cent of income excluding gains must be distributed to shareholders.

REITs in the UK
Were established by the Finance Act 2005 and could begin trading from January 2007. The original rules were restrictive, limiting investment to commercial property. Companies wishing to join the REIT regime were required to be: 

• UK resident 
• Listed on an exchange approved by the FSA 
• Pay two per cent of net asset value as a joining fee 
• Distribute 90 per cent of rental income and gains to shareholders

Despite these restrictions, nine of the larger and well known property companies converted, including British Land, Hammerson, Land Securities, Liberty International and Segro.

Why invest in a REIT?
First, the vehicle gives all of the advantages of direct investment in rented property without the hassle of personal membership. Governance by both the FSA and the visibility of quoted company audits are some guarantee of proper behaviour by the companies concerned. There are clear tax advantages in the hands of those investors who pay tax at the basic rate, those who pay the higher rate, and even greater for pension funds. Again quoting Deloittes among other investment advisers:

Investment in a REIT is:

• Liquid and tradable
• Easily accessible
• Diverse, over many property assets
• A provider of regular income
• Inexpensive, stamp duty is only 0.5 on shares compared to SDL7 at four per cent on property
• A means of investing in a wider range of property such as business parks, shopping centres and industrial  property.

If all of the proposals are put into effect, the new REIT regime will be more flexible, less costly and attract new sources of rented property. 

The two per cent conversion charge will be dropped so that existing owners of rented property can convert to REIT status without a front end charge. The new investment universe could well appeal to pension and investment funds, pub groups, storage companies, owners of hotels, restaurant and entertainment chains where ownership of property and operational management are two widely different skills.

This more flexible environment will enable small pension funds to join hands and even those who compete at an operational level such as entertainment groups to offload properties to a single REIT.

REITs specialising in residential property will enable developers to build residential estates and blocks of flats while housing associations and local authorities may see conversion as a means of refinancing portfolios while retaining management orcontracting property management out to specialist providers. There are still many questions to be answered.

Some quite technical questions need early decisions such as a ruling on the deduction for Capital Allowances for plant and machinery which save tax for taxpaying companies. Since REITs pay no tax these allowances are of no value and are known as ‘shadow’ Capital Allowances, so a means must be found to deal with this anomaly.

A proposal included in the June 2010 budget under the last labour government would have allowed the payment of stock dividends as PIDs so that REITs could conserve cash to develop the business. The British Property Federation, BPF, has energised its legendary lobby power to persuade the Chancellor to pass the necessary measure which will cost the Treasury nothing since investors would pay tax on these distributions.

The House of Lords Select Committee on Economic Affairs supports such a move while describing the current legal set up as “Unduly Cautious” until all of the proposals are put in place.

Once the requirement for REITs to be listed on the official list (the Stock Exchange) has been removed they could
be listed on AIM or even unlisted to allow new ventures to be set up. The requirement that they should be diversely owned could also be relaxed if even a small number of shareholders, eg pension funds, are themselves widely owned or have a wide range of beneficiaries.

Will a flow of new REITs be delayed until there is stability in both commercial and residential property markets, even if there is no sign of price increases? It took a bust and a subsequent substantial improvement before the 
 American REIT market took hold. Since existing UK versions are London and south east centred, they are stable with useful increases in asset values and rents in 2011, but although the structures and mechanisms are in place it may well be 2015 before they are used and tested by new REITs.

If the Chancellor follows through on his proposals and accepts the property industry suggestion, perhaps he will look again and allow private pension funds to invest in the PRS.

Now that would increase the number of homes to let.