Real Estate Finance: Challenges remain
In recent years real estate investment trusts (REITs) have spread from their US origins right across the world. With a few exceptions, European governments have been relatively slow to embrace the structure. But moves from France, the UK and – at long last – Germany look set to provide the sector with its next big boost. But challenges remain for a Europe-wide structure. Mark Baker reports.
The real estate investment trust (REIT) has been one of the fastest growing investment phenomena of recent years.
The concept of a tax-efficient investment vehicle for the property sector – whereby the vehicle is tax-exempt provided that it passes through almost all its cashflow to investors – had its origins in 1960s America, before spreading across the world. This spread has been most notable in Asia, where the structure has been taken up in various forms in markets including Japan, Australia, Singapore and Hong Kong.
As at the end of 2006, the market capitalisation of the global listed real estate sector was in the region of US$800bn, of which just over US$500bn was in REIT form. That marked a jump of about 23% from the previous year for the total market cap, and a similar increase in the size of the REIT sector. From accounting for about 40% of the listed real estate sector seven years ago, REITs have now stabilised at about 65% of the listed sector.
According to Merrill Lynch research published in late 2006, REITs have now achieved a critical mass; they are outperforming broader equities as an asset class, and they continue to have upside. Although the sector underperformed in 2006 in Australia and Hong Kong, in all other REIT regimes the outperformance was significant, ranging from 11% outperformance in the US to 22% outperformance in Singapore. Overall, the global REIT sector showed a return of about 10% above all equities in 2006.
Until recently, the European REIT sector had lagged well behind other global markets. That was partly due to the prevalence of alternative property investment vehicles that meant there was less incentive to construct new methods for participating in the sector, but it was also a function of the fragmented political and economic profile of Europe.
Nevertheless, certain markets pioneered REIT-type structures in Europe. "Tax flow through" vehicles have existed in the Netherlands since 1969, where they are known as FBIs (and are now going through an overhaul). The highest profile name in the country is Rodamco Europe, which has a market cap of €9.3bn.
Belgium has traditionally been the other main example of the structure in Europe, where such vehicles are known as Societes d'Investissement a Capital Fixe (SICAFI). Spain and Italy had made tentative moves towards a listed property fund sector, albeit without the tax advantages of the full-blown REIT structure, and Germany had a well-established open-ended property fund market that included tax transparency.
"What became clear by early 2000 was that the REIT was becoming the sophisticated property vehicle of choice," said Simon Clark, a partner at legal firm Linklaters. "Western European jurisdictions were becoming more interested in REITs as they could see global competition in the sector."
But while some countries had already benefited from a REIT or REIT-type structure for some time, the sector was never going to fulfil its promise in Europe without the full-scale participation of the three big economies – the UK, France and Germany.
The French broke the logjam by finally acting fairly quickly to bring in a similar structure – the Societe d'Investissement Immobilier Cotee (SIIC) – in 2003, with revisions to the structure in subsequent years. There are now more than 40 such vehicles in France with a market capitalisation of over €50bn.
After years of wrangling, the UK finally enacted its own REIT legislation and launched its regime on January 1 2007. To benefit from the tax exemptions offered by the structure, property investment had to represent more than 75% of a company's assets and profits, and at least 90% of exempted rental income was to be paid in the form of Property Income Dividends (PIDs).
The developments in the French, UK and German real estate regimes – the most significant progress in the sector since REITs were first developed – have provided striking examples of the way in which one regime can build on the experiences of others.
One example was the conversion charge that the French imposed on companies in the sector that wished to convert to REIT status. The charge was fairly innovative for a sector of this size – it had also been used in Belgium, but had not had the same significance because of the smaller size of the market.
When the French government opted to impose a conversion charge it was quickly picked up on by the UK, which was looking for a way to mitigate the tax loss to the exchequer of granting REIT status to companies. According to those close to the discussions held within the UK treasury, that move within the French regime changed the dynamic within the UK talks.
"The UK had not focused on that possibility – the arguments had all been about whether moving from a taxable to a tax-free regime was affordable," said one source who worked with the government on drawing up the UK structure.
The charge certainly proved to be no deterrent in France, where it had been set at 16.6% of unrealised capital gains, payable in four annual instalments. The French listed property sector had totalled just €14bn before the new regime was introduced, and now stands at more than €50bn.
The UK conversion charge was set at a one-off payment representing 2% of property assets. As of the end of April this year, 13 UK companies had converted to REIT status, with at least seven others expected to do so in the future. The 13 that have already converted represent a total market cap of about £35bn.
And there have already been the first examples of primary equity capital market activity from the UK REIT sector. Local Shopping REIT, a company that invests in local shopping parades in England and Scotland, raised £160m through an IPO in April 2007, with the deal priced at a 5.5% premium to net asset value.
But that deal will be dwarfed by the first big test of appetite for new REIT issues in the UK when Vector Hospitality completes its mooted £2bn IPO, which is expected to include a retail tranche. The company is owned by Alternative Hotel Group, RBS and HBOS.
In Germany, the G-REIT has taken a long time to get off the ground, but is expected to be implemented imminently at the time of writing. Open-ended property funds have been a big industry in Germany for some time, but have seen outflows in the last two years and suffer from the usual liquidity problems of such structures.
The future – an EU REIT?
With the European REIT sector having developed at very different speeds in different jurisdictions, the future of the sector is likely to take a somewhat twin-track approach. In those markets where the sector is already maturing, the future is likely to feature consolidation as well as a gradual move towards the private sector.
In the US, property trusts are already falling prey to buyout firms. The US$38.3bn buyout of Equity Office Properties Trust by private equity firm Blackstone, which was announced in early 2007, is the most dramatic example so far, but bankers agree that it is only a matter of time before the trend spreads to Europe in earnest.
The other significant development from a regulatory and legislative perspective is for harmonisation across the different regimes in Europe, with a view to creating a pan-European REIT structure. However, any such plans would be mired in extensive bureaucracy, with progress likely to be slow as governments struggle with the concept of giving up local control on taxation as well as ownership.
"A Europe-wide REIT structure would be good, but much more complex because governments would be reluctant to give up their taxing rights on land without the comfort of taxing shareholders themselves," said Linklaters' Clark.
The issue of who would have taxing rights is very probably going to be the major sticking point in any discussions on the subject of a Europe-wide REIT, although one option would be some sort of pooling arrangement as is already the case with value added tax in Europe. Very early stage discussions are in progress, but any significant developments are likely to be years away.
"Any investor can see the advantage of a single, tax-efficient, pan-European property investment vehicle," said Michael MacBrien, director general of the European Property Federation, speaking at the annual industry meeting in Barcelona in November 2006.
"The 'tax harmonisation' aspect to the EU REIT shouldn't be a very big obstacle, because the goal should be to co-ordinate only the essentials, leaving each member state the freedom to adapt the other aspects to its particular taxation, housing and savings policies."
Another issue – and one that will also take some considerable time to overcome – is that it will be hard for a successful Europe-wide structure to be formulated while there remain relatively few countries with robust regimes of their own. Only when national structures are firmly established across the continent, and not just in a handful of large markets, will the impetus exist to push ahead with a new regime.
"Progress on national REITs is crucial to the whole process," said MacBrien. "It creates a REIT culture without which an EU REIT would be a non starter. At the same time, the European debate fosters interest in national REITs, even in countries that won't be signing up at EU level. In fact, the national and EU REIT efforts fuel each other in a virtuous circle."