Real Estate Investment Trusts (REITs)

Although Real Estate Investment Trusts (REITs) were launched in the USA on 1960, they were not launched in the UK until 1 January 2007. The hype surrounding these listed property trusts has been largely been fuelled by the Chancellor’s pre A-day eleventh hour decision not to allow pensions to invest in residential property. REITs are expected to provide an alternative avenue for those disappointed by the Government’s decision, as they allow investment in residential real estate, alongside a wide variety of property types, from commercial premises and shopping centres to doctor’s surgeries.

Basic Facts

REITs are closed-end listed property trusts that invest solely in income producing real estate assets.

They are currently listed in the investment trust sector, under property, alongside property investment trusts, although a specific REITs sector may be launched later.

There is no minimum investment, as investors buy shares in REITs, yet dealing costs may make small share purchases non-viable.

The maximum investment is restricted to 10% of the share capital under HMRC rules.

The only charges payable in buying REIT shares come in the form of dealing costs, although funds that invest in REITs will levy charges.

It is also the tax efficiencies of these new investment vehicles that have made REITs an attractive proposition for UK investors. Until now, shareholders in property companies listed on the London Stock Exchange have effectively been taxed twice. The property companies themselves have had to pay tax on rental income and on profitable property sales, with shareholders also liable to income tax on dividends and Capital Gains Tax (CGT) if they then sell their shares at a profit.

Under the REITs regime, these property trusts will not have to pay tax on UK property portfolios, saving the initial layer of tax. Rules for Undertakings for Collective Investment in Transferable Securities (UCITS) came into effect at the end of 2005, making REITs eligible for ISA investment, meaning that investors can benefit from double tax relief, albeit within the ISA limits.

Relaxing the rules

The development of the UK’s REIT structure has not been without its problems, as there are a number of complex tax and qualifying issues involved. REITs have to meet a long list of conditions, as detailed below. If these conditions are breached, a REIT may be subject to a tax charge and REIT status can even be withdrawn if the breach is not rectified by the end of the next accounting period.

UK REIT qualifying criteria

The REIT must be a property letting business.

The REIT must be UK resident.

The REIT must be listed on a recognised stock exchange (including the London Stock Exchange and the Channel Islands Stock Exchange but not AIM or OFEX.)

75% or more of the REIT’s income must come from property rents.

75% or more of the REIT’s assets must be investment property.

The remaining percentage is likely to come from “development or other services”.

90% of a REIT’s net taxable profit must be paid out to investors by the usual tax return filing date (currently 12 months after the end of the accounting period). These are concessions by the UK Government, as figures of 95% and six months were originally mooted.

The REIT must operate at least three properties during each accounting period. A property is a single property if it is designed to be rented out as a single commercial or residential unit. This definition allows an asset such as a large shopping centre to be treated as multiple properties for the purposes of this condition.

No single property can represent more than 40% of the total value of the properties held in the property letting business.

The REIT is not allowed to sell any building that it has developed for at least three years after completion.

The Chancellor also confirmed in the Pre-Budget Report a reduction of the interest cover test or gearing. REITs will now have to have rental profits of at least 1.25 times their loan interest payable. The original figure given was 2.5 times and, again, is a major concession by the UK Government.

Source: Law Society of Scotland

Tax treatment of REITs

REITs are exempt from paying corporation tax on profits and gains from their investment business, that is the tax-exempt property rental business. In compensation for these tax savings, however, REITs – both property companies converting to REIT status and start up REITs – must pay a charge of 2% of the gross market value of the properties involved in the property rental business. This is payable at the end of the first year, either paid upfront or in instalments over four years. REITs will also continue to pay stamp duty land tax on property purchases.

REITs must pay distributions equal to 90% of exempt rental income, known as Property Income Distributions (PIDs). But if a REIT pays in excess of this limit, it can choose whether or not this will be an additional PID or a normal dividend, with the latter treated as usual with a non-reclaimable tax credit of 10%, with only higher rate taxpayers liable to further tax, at 22.5%.

For many shareholders, PIDs suffer a higher rate of tax than normal dividends to reflect the fact that profits distributed are exempt from tax within the REIT.

PIDs are taxable as property letting income for shareholders who pay tax and are paid out after deduction of tax at the basic rate of 20% (withholding tax). Tax will not be deducted for certain classes of shareholder: UK companies, charities, local authorities and UK pension scheme, alongside REITs held within ISA wrappers. Basic rate taxpayers therefore have no further tax to pay, but higher rate taxpayers must pay an additional 20%.

Non-tax paying shareholders or starting rate taxpayers can reclaim the 20% withholding tax. PIDs received by unit trusts/investment companies with variable capital are treated as property income, less 20% tax, with unitholders paying tax as if it were a normal dividend, ie, with a 10% tax credit. Shareholders must pay capital gains tax on disposal of REIT shares as with any normal shares, at the individual’s rate of tax (20% for basic rate and 40% for higher rate), set against the annual CGT allowance (£10,100 in 2010/11).

There has been criticism in the industry over some of the originally proposed rules and the Government has been forced to make a number of concessions.

The proposed percentage of net taxable profits that must be paid out as property income dividends (PIDs) was cut from 95% to 90% in the final legislation, which was widely welcomed in the industry, as it allows REITs to retain more cash flow to develop new properties if required. The same change was made in the US when a number of rules were relaxed in a bid to give the REIT market a leg up. It was only after this that the market was able to flourish, some 30 years after launch.

There are still rules that the industry feels should be relaxed in the UK, however, such as the Government’s 10% measure which stipulates that no one shareholder can control more than a 10% interest in the share capital or voting rights of a REIT. Some believe that this will see even inadvertent breaches of the rule lead to additional tax being payable, affecting all of a REIT’s shareholders. The Investment Management Association and the Association of Investment Companies was lobbying hard last year to revise this rule, which is not as strict in Australia, the US or France.

The Chancellor has shown a little flexibility, choosing not to levy tax charges when this is breached mistakenly if steps have been taken to avoid such a situation. For example, where there are rules in the memorandum and articles of association requiring a forced sale if a shareholder holds more than 10% and does not make arrangements to reduce this.

Yet it is still also an annoyance to many that REITs cannot list on the AIM, preventing many smaller companies from taking on the status. As property funds, together with private equity groups, accounted for more than 50% of new issues on AIM by value in 2006, this will be a contentious issue for many.

However, lawyers and accountants have recently been raising awareness that AIM companies can take out a secondary listing in officially approved domiciles, such as Guernsey or Luxembourg, as a cheaper way of gaining REIT status.

Leg up for start ups

The Chancellor’s Pre-Budget Report at the end of last year contained some snippets of good news for those looking to enter the REIT market, effectively giving them a one-year grace period during which they do not have to satisfy the 75% income and asset test, which states that trusts must derive at least 75% of their income from property rental activity.

It was also revealed that the 2% entry charge, or conversion charge for those listed property groups that are switching to a REIT structure, will not be levied until the end of 2007. Originally payment was either required in full upfront or spread over four years, with the first annual payment made upfront. The change is a welcome move, as the charge – calculated from the gross market value of properties held – can run into millions of pounds.

There were only nine UK REITs that emerged on 1 January, all of which were formerly listed property companies converting to REIT status. Dividend yield for property companies has traditionally been low, sitting between 2% or 3.5%, with investors mainly looking instead for capital growth. But the tax efficiencies of he REIT rules, which see property companies paying no tax on rental income, means that dividends on the whole are set to increase.

Going for growth

But these improved yields are still not likely to rock the sector, especially as some in the market were anticipating REIT yields as high as 10% or 20%. Research from fund manager New Star estimated yields from property companies post-REIT conversion to sit between 2.6% and 3.5%, with most towards the lower end of the scale.

Most property firms already pay above the 90% PID qualifying criteria and will therefore not need to raise dividends to meet the minimum – many in fact will find it difficult to earmark much more towards dividends, with any increases largely coming only as a result of the tax savings made under REIT status.

Global Perspective

It is unanimously agreed that the introduction of REITs to the UK is good for investors, making property more accessible. But put in a global context, is the UK the best place to invest? With REIT yields not expected above 3.5%, better returns may be found overseas. However, there seem to be significant diversification opportunities by investing in property worldwide. Typical REIT yields in New Zealand and Australia also seem fairly attractive at 6.4% and 5.8% respectively. These countries also benefit from less restrictive rules, such as the UK’s 10% measure. US REIT yields are reaching up to 10.49% for mortgage REITs in the home financing sector and 5.22% for health care equity REITs.

Scottish Widows Investment Partnership

The Scottish Widows Investment Partnership (SWIP) already has a UK real estate securities fund which provides access to UK REITs, with many of the companies included being those that have converted to REIT status. Many global property securities and REIT funds will also provide access to the UK sector, but it would be foolish for fund houses to jump into the market with a UK only REIT fund with so few REITs currently available.

Schroder Global Property Securities

Andrew Cox, product manager of the Schroder Global Property Securities Fund, which invests in property shares and REITs worldwide, says that the fund will have exposure to UK REITs via those early converters, as 10% of the portfolio is invested in UK property companies. He cautions that the fund will not invest in companies that have converted simply because they are now REITs.

Schroder predicts that there will be up to 30 REITs in the UK by the end of 2007, with an increased focus on specialisation.

Reita – the body launched by the REITs and Quoted Property Group to raise awareness of these vehicles in the UK – also suggests that there is a UK REIT index on the horizon. This will further open up the investment possibilities, such as UK REIT exchange traded funds (ETFs), which are a form of share that tracks the performance of indices. Advisers have stressed their keenness to tap into UK REITs via ETFs, indicating that such an index launch would be welcome when there are enough REITs to make it worthwhile.

Conclusion

With predictions that the UK market will grow and divide into specialist areas over the next few years, it is likely that investors will, in time, be able to achieve low correlation even among UK REITs. For the meantime, the consensus is that REITs must be considered on a global basis and in the context of a wider portfolio, as with any asset class.

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