Given the fanfare that accompanied the introduction of UK real-estate investment trusts (Reits) at the start of 2007, investors could be forgiven for thinking that their arrival had turned the property world on its head. However, the reality for those companies that have adopted Reit status is that it is still very much business as usual. Admittedly, the tax regime for companies that have converted to Reit status has changed and there are new rules about minimum dividend payments. But it simply means that the companies involved will pay less tax in future, and many of the Reit converts - such as the UK's largest property company, Land Securities - already met the rules on minimum dividend payouts before assuming their new guise.
The fact that little has changed in the day-to-day running of the UK property companies that have become Reits is great news for investors. That's because it means that the new Reit sector effectively already has a track record against which it can be judged. What's more, because the companies that have converted into Reits have been around for a long time, and have bought up much of the best commercial property in the country, Reit investors can immediately buy shares that offer exposure to some of the UK's most exciting property assets, such as the Bull Ring in Birmingham and the Broadgate complex in the City.
The new Reit converts are not strangers to shareholder scrutiny, either, which makes their management teams among the best in the industry. In fact, all five of the UK's blue-chip property companies - British Land, Land Securities, Hammerson, Slough Estates and Liberty International - have now become Reits. So, although Reits themselves are less than one month old, there is already a choice of 'established' UK Reits on offer.
What's new about Reits?
Reits remove some big problems with property investment. Previously, if you wanted to invest for rental income, and be a landlord, you would have had to buy property directly. Of course, that involves large sums of money, tricky transactions and getting exposure to only one property or, at best, a handful - unless you're mega-rich. Now, though, you can buy Reit shares quickly and easily, in relatively small quantities, and so gain exposure to diverse property portfolios. In addition, the Reit tax regime has eliminated the old system of double taxation, whereby tax was taken at both the corporate and investor level, which means Reit shareholders are taxed as if they were landlords.
Companies that become Reits no longer have to pay tax on the rent they collect or capital gains tax (CGT) on profits made from the sale of investment properties. This has eliminated the massive deferred CGT bills that property companies have accumulated after years of successful investing. This deferred CGT was calculated as the tax a company would have to pay on profits made from selling its entire property portfolio. Consequently, deferred tax liabilities have often been cited as the key reason why property company shares trade at a discount to their net asset value (NAV) - because reported NAV was not adjusted to take tax into account. So, under the Reit tax regime, discounts to NAV of up to 40 per cent should become a thing of the past.
That said, the new tax regime is not quite as generous as it first appears. The Treasury has made sure it will still get a decent slice of the action. Property companies must pay a conversion charge of 2 per cent of their gross assets to become a Reit. The Treasury will also collect more tax from shareholders to make up for tax lost at the corporate level. Reits will have to pay out 90 per cent of their rental income as dividends to shareholders - and shareholders will then be charged a 22 per cent withholding tax on those dividends, and up to an additional 18 per cent for higher-rate taxpayers.
Nevertheless, the good news is that the overall effect of the Reit tax regime makes all shareholders better off (see table below). And anyone holding Reit shares in an individual savings account (Isa) can reclaim the withholding tax, while anyone holding Reit shares in a pension won't have to pay the withholding tax in the first place.
Why have Reits been introduced?
The decision to offer this new tax regime reflects a recognition by the government that the old system of double taxation was keeping investors away from the listed property sector. It was encouraging riskier direct property investments, such as buy-to-let, and was stimulating the emergence of numerous property funds based in offshore tax-havens. No doubt the lost tax revenue on these funds helped to concentrate the Treasury's mind.
There is also a sound investment reason for making property investment more attractive. Since the dot-com bubble burst, there has been a growing consensus that investors should spread their investment risks across several asset classes, with property regarded as a very good complement to equity investments. What Reits offer private investors is exposure to property-related returns with equity-market liquidity.
What are property-related returns?
Returns from Reits can only be described as 'property related' because Reits themselves are equities which, depending on market sentiment, can still trade at a discount or a premium to the underlying value of the property they own. Hammerson's finance director, Simon Melliss, says he thinks it is likely that Reit share prices will trade in a range from a 15 per cent discount to a 15 per cent premium to NAV, which implies quite a bit of equity-related volatility.
And, already, even though Reits have only just been introduced, share prices have been extremely volatile. So, if fears that UK commercial property has become overvalued turn out to have some foundation, then discounts could once again become a serious problem for investors and a poor advertisement for the sector as a whole.
What are the pros and cons for investors?
For investors who chiefly want a secure source of income, though, this volatility could be something of a side issue. That's because, while share prices may fluctuate, the dividend payments most Reits will offer are expected to be reliable. After all, the Reit minimum dividend payment rules require that 90 per cent of rents generated be paid out to shareholders. In addition, the UK property market benefits from some of the most robust lease agreements in the world, which helps ensure that rents keep on rolling in even when times get tough - and even if some areas, such as the London office market, are more cyclical than others.
Even so, there are some concerns that higher dividends will come at the expense of NAV growth. That's because the requirement for Reits to distribute a large proportion of rental income, and to generate at least 75 per cent of their profits from property rental, could stifle development activity, which has traditionally driven strong NAV growth. Many property companies have denied that this will be the case, but the picture will not become clear until Reits have been up and running for at least a couple of years. It seems likely that some will feel the pinch, while other larger, more-focused players will not - assuming the experience of overseas markets is anything to go by (see 'How will UK Reits develop?' below).
In fact, the experiences of overseas markets suggest that the Reit sector - and individual Reits - will evolve gradually, as the UK market becomes more established. But, for now, there are a number of first-class Reits already on offer to UK investors, which represent a great way to get exposure to high-quality property portfolios without the traditional tax disadvantage.
How will UK Reits develop?
Clues as to how the Reit market might develop in the UK can be gleaned from looking across the channel to the youthful French Reits market and, for a longer-term perspective, across the Atlantic to the established US market.
One key lesson from France is that, even though UK Reits have already come into existence, the laws that govern them will probably continue to change for some time. Indeed, pub company Enterprise Inns recently said it might be 12 months before it knew whether it could take advantage of Reit legislation for its pub estate. It's not just the law that's likely to evolve, either. There has been some disappointment about the low level of dividend yield that UK Reits offer. So, as happened in France, companies may soon begin to respond to shareholder pressure for faster-growing dividends and start distributing more of their earnings in this way. That said, in France, investors have still proved willing to buy into companies that are particularly good at growing NAV on a much lower dividend yield than their peers.
In the longer term, the US experience suggests the Reit market will require companies to become large and focused. So there has been significant speculation that the advent of UK Reits could trigger a wave of consolidation between UK property companies seeking scale. Recently, there was a takeover battle for West End property firm London Merchant Securities, and there are big tax advantages for Reits that take over non-Reits with large CGT bills - as these CGT liabilities disappear following the deal.
Investors in the US favour Reits that concentrate on one area of the property market, and a number of UK blue-chip property companies have already sought to restructure their portfolios around a few specialist areas. British Land, for example, is still undergoing such a process by increasing its exposure to City offices and out-of-town retail parks. Reits could also encourage the emergence of new companies focused on areas that offer particularly high-growth prospects or attractive yields. For example, Big Yellow - which hopes to convert to a Reit later this year - will offer exposure to the self-storage market. Similarly, Primary Health Properties has a portfolio of GP surgeries - and has already become a Reit. And there are plenty more attractive stories in property that look eminently 'Reitable', such as student accommodation, residential property, and retirement villages, to name but a few.
American investors also have a preference for Reits that manage their property funds internally, rather than externally - in other words, management teams that are employed directly by the Reit, rather than external property managers whose services the Reit pays for. However, external managers such as Invista, which hopes to launch a residential Reit in April, argue that there is little proof that one form of management is superior to the other.
But while the US and French examples offer some interesting indications about how the UK market will develop, UK Reits are likely to take on their own distinct characteristics. After all, they are based on a property market that is itself very distinct.
