Reits' Budget boost

By Stephen Wilmot, 01 April 2011

Sector Focus

Hidden in George Osborne's 'Budget for growth' was an arcane-sounding pledge to reform the rules governing real-estate investment trusts (Reits) - the tax-efficient property vehicles launched to much uncorking of champagne in January 2007. Lobbyists, trained to expect the worst in the age of austerity, were stunned yet delighted. "Taken together, these proposals could have a real impact on boosting investment in the sector," enthused Peter Cosmetatos, director of Policy at the British Property Federation.

Most strikingly, the government offered to abolish the conversion charge that property companies have to pay upon entry into the lower-tax Reit regime. Back in 2007, at the top of the property market, the likes of British Land and Land Securities were only too happy to fork out 2 per cent of their net asset value in return for the cancellation of tax liabilities on their vast but unrealised capital gains. But the ensuing 40-50 per cent decline in commercial property values made the trade-off much less attractive to the property groups that have remained outside the structure. And the charge made no sense at all for other sources of Reits: start-ups have no assets to tax, while listed funds - which are typically domiciled in tax havens such as Guernsey - have no tax liabilities to clear.

Something for everyone

The government hopes to lure offshore funds back onshore by ditching the conversion charge. Meanwhile, it is soliciting other potential Reits with other reforms. The rules that currently require the vehicles to list on the main market will be removed to encourage the more speculative property companies on the Alternative Investment Market (Aim) to convert. And a rule on 'diverse ownership' designed to ensure Reits remain a publicly accessibly investment product will be relaxed to encourage institutional investors, possibly even banks, to float their property portfolios.

For existing Reits, such as British Land and Land Securities, there were also a couple of technical tweaks to make the regime slightly less onerous. They will be able to count cash as part of the 75 per cent of assets they have to hold in property, for example, easing the disposal and acquisition process.

All this is good for the sector's profile and may help it rebuild credibility after the property crash, which has left it a good deal smaller than at launch. However, it is far too early to call a Reit renaissance. For a start, the reforms are only in "informal consultation" stage, to be enacted in next year's Finance Bill. The reforms are also aimed squarely at new entrants rather than the Reits that have already paid their 2 per cent dues and converted, which include all the major players.

The big issue

But the main reason for caution is that the fundamentals of the market are poor, with the crucial exception of London prime office space. Deregulation can help at the margins, but the only important thing the government can do for Reits is to steer the UK economy successfully out of recession. Only that will eventually push up rents and property values across the sector - the dual keys to its success.

It has become clear that the property crash and subsequent recovery have polarised the UK market. The value of central London offices bounced back strongly in the final quarter of 2009 and continues to grow, underpinned by international buyers and insatiable demand for office space. Most commentators expect that to continue, exacerbated by bottlenecks in supply due to the crash putting new projects on pause from mid-2007. Property agent Knight Frank is pencilling in 9.1 per cent growth for prime City rents this year.

At the same time, activity in the so-called secondary market remains subdued, with rents flat and capital values still falling in many cases. The outlook remains grim, with the industry fretting about an "overhang" of properties controlled by the banks that could flood the market just as public-sector demand for offices sags, dragging the associated retail market down with it.

Luckily, most of the Reits have high-quality, London-centric portfolios (see graph). Derwent London , Great Portland and Shaftesbury are particularly well-positioned and should see decent growth in net asset value (NAV) this year. The problem is that their shares all trade on a premium to NAV as a result. Meanwhile, the larger Reits - British Land, Land Securities and Hammerson - trade at around NAV but have significant exposure to the provincial retail sector.

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