Real estate investment trusts (REITs) are passive investors in real estate leased to tenants. They often adopt a corporate structure, although in some jurisdictions they are constituted as trusts. They allow share or unit holders to invest indirectly in professionally managed real property, held for long-term benefit and with the benefits of portfolio risk diversification. They tend to have a broad investor base and are usually listed on a public stock exchange. All REITs share a common aim, which is to provide indirect investors in real estate broadly the same after-tax returns as are available to a direct investor.
Against this background, this article discusses the increasingly important role REITs are playing in the world's capital markets. In particular, it examines:
The global presence of REITs and the extent to which they are used in different jurisdictions.
The key tax benefit offered by REITs and the accompanying restrictions relating to passive investment and dividend payments.
Gearing limits imposed in certain jurisdictions, restricting the level of payments that are made by the REIT as interest rather than dividends.
Measures taken by governments to prevent the diversion of taxable income into a REIT.
Conversion charges.
Taxation of foreign investors.
Factors involved in creating a successful REIT market, including the performance of real estate as an asset class, competitiveness with non-REIT structures, and reduced cost of capital compared with non-REIT structures.
The current REIT market.
REITs are present in all of the world's major capital markets, and form an important element of the FTSE EPRA/NAREIT Global Real Estate Index. This index consists of over 300 of the largest and most heavily-tracked real estate stocks in Asia, Europe and North America.
REITs have been an established part of the landscape for some time in the US, Canada, Australia, New Zealand, The Netherlands and Belgium. More recently, significant REIT markets have emerged in the UK, France and Japan. REIT markets are also developing in Singapore and Hong Kong. Some important future REIT markets are expected to be Germany and Italy.
German REITs, known as G-REITs, came into being on 30 March 2007 through the G-REITs Act (REIT-Gesetz), which has retroactive effect from 1 January 2007. Italy's Finance Act 2007 introduced Italian REITs, known as SIIQs, though the terms of implementation, at the time of writing, have not yet been published.
At the end of May 2007, the global REIT market had a total capitalisation of around GB£418 billion (about US$849 billion). The amount of listed real estate as a proportion of total institutional real estate differs considerably from jurisdiction to jurisdiction, as does the proportion which REITs make up of total local listed real estate. (See box, REITs in a global context, May 2007).
Interestingly, the growth of REIT regimes in Europe has not occurred as a result of any EU harmonisation or centralised initiative. Rather, it has happened because of similar local market pressures and successful local lobbying by industry groups in each jurisdiction.
Governments have been keen to introduce REITs for a number of reasons:
There is a perceived need to create or maintain a liquid real estate market. For example, only 30% of US commercial real estate is owner-occupied. In Germany, the figure is closer to 75%. It is only marginally lower in many other continental European countries.
There is a need to stabilise the frequent boom/bust behaviour of real estate prices that can fuel wider economic instability.
There is an increased ability for governments (particularly in the EU) to offer enhanced financial returns to the private sector as they strive to fund more regeneration, infrastructure and public sector projects through private finance.
Governments receive the benefit of taxes levied on conversion to REIT status.
Property-rich companies have also recognised that their stock market ratings can improve when they release capital tied up in real estate and use it more effectively in a core business or in a return of capital to shareholders.
These factors have coincided with a dramatic increase in investor demand for REITs, both at the retail and institutional level, at least until recently. However, investor demand for REITs looks set to continue in the long term (see below, Current market).
The poor-performing equity markets of the early 1990s left many investors more cautious about their attractions. In many jurisdictions, life companies and pension funds wanted to materially increase the proportion of their assets that were applied towards real estate, because of the more predictable annuity-style, or growing dividend yield that a real estate investment typically offers, together with its capital growth potential. This has led some to regard REITs as a third class of asset, with risk and return profiles positioned between equities and fixed-income securities. At least for a while, investment managers were also looking for the liquidity that only listed vehicles can provide. More recently, however, there has been a shift by institutional investors back in the direction of private funds (see below, Current market).
REITs are attractive because they are in effect substantially exempt from tax, generally both on income and capital gains, leaving tax to be levied only at the level of the investor. This is achieved through exempting the REIT from tax or by entitling the REIT to deduct qualifying dividend distributions from otherwise taxable profits.
To obtain this exemption two key restrictions are commonly imposed:
Virtually every jurisdiction requires the REIT to limit its activities to predominantly passive real estate investment rather than development or other trading activities. Jurisdictions vary as to how they apply this requirement. Most include definitions of investment activity that permit at least a measure of development of new properties with a view to retaining them as an investment, as well as the re-development of existing investment assets, without that constituting a trading activity. A number of jurisdictions permit somewhere between 20% to 25% non-investment activities without the overall REIT status being threatened, although most require tax to be paid on these trading activities.
Germany permits a measure of own account non-investment activities, on which no tax is payable, but requires trading activities for third parties, which are only permitted up to a certain level, to be carried out through wholly-owned and fully-taxable subsidiaries.
Australia is particularity tough in requiring no trading activities to be carried out by Listed Property Trusts (LPTs), as listed Australian REITs are known. However, structures have been developed in Australia to allow investors to have exposure to other trading activities such as development, construction and asset management. The units in many LPTs are stapled to units in businesses involved in these other areas but run by the same management team.
There is a requirement to pay out high levels of income as dividends, maximising the return that is received by investors, on which tax can then be levied at the investor level.
In various jurisdictions, including the US, the UK and Germany, not less than 90% of income must generally be distributed to maintain REIT status. The level is set at 85% in France and Italy and 80% in Belgium. In some jurisdictions, such as Australia, a similar result is achieved by taxing at a penal rate any income that is not distributed.
Jurisdictions differ in relation to the requirement to distribute realised capital gains. There is no such requirement in The Netherlands, the UK or Italy. In France, however, 50% of any realised capital gain must be distributed within two years. Similarly, a G-REIT is required to distribute 50% of its capital gains immediately. The other half must either be reinvested or distributed within two years. The capital gains of a Belgian REIT must either be reinvested or distributed within four years. In Australia and the US, all realised gains are usually distributed because of adverse tax consequences for any such gains that are retained.
Some jurisdictions, including the UK, The Netherlands, Belgium and Singapore, impose a gearing limit, restricting the level of payments that are made by the REIT as interest rather than as dividends. One reason for this is that under a typical double tax treaty the home jurisdiction will not be able to tax most interest payments made to a resident of the counterparty jurisdiction, but will be able to tax dividend payments through a partial, or sometimes full, retention of withholding tax. Protecting investors in difficult times from the amplified under-performance that comes from gearing is another consideration for regulators.
US, Australian, French and Italian REITs are not subject to any specific gearing limit, leaving the markets to impose their own disciplines.
Most jurisdictions that do impose a gearing limit have opted for a loan to value ratio (which considers the amount of debt compared with the value of the property). The UK is unique in having chosen an interest cover ratio (which calculates a REIT's ability to pay interest on its debts). The UK property industry lobbied successfully that the spread between interest rates and property yields in the UK (lower than in most other jurisdictions) justified a higher gearing limit compared to other jurisdictions, not a lower limit as had originally been proposed. In any event, with a tax-free entity such as a REIT, the advantage that debt normally has over equity as a source of capital (the ability to deduct interest from taxable profits) is diminished.
Governments are concerned about REITs being used to divert taxable income away from trading operations and into a REIT, where that income would not be taxed, in circumstances where the shareholders in the trading operations and the shareholders in the REIT are effectively the same.
In the UK, owner-occupied property, including property leased by a holding company to its subsidiary or leased to a company whose shares are stapled to those of the UK REIT, does not count as part of the tax-exempt property rental business of the UK REIT. This prevents a property-rich retailer from turning itself into a REIT simply by leasing its property to its retailing subsidiary. If this had been permitted, the subsidiary could have deducted its rent from its taxable profits and that rent would not have been taxed at the holding company level.
In the US, a special regime exists to allow certain classes of trading business (particularly hotels and, in more limited circumstances, healthcare businesses) to operate alongside a US REIT. For example, "lodging" REITs generally hold hotel assets through taxable subsidiaries that pay rent to their REIT holding company. The taxable subsidiary cannot operate or manage the hotel itself, this must instead be done by an independent hotel operator that has a management contract with the subsidiary. The difference between the subsidiary's income from the management contract and the rent it pays to its parent represents its taxable profit (subject to any other income or deductions it may have). The hotel operator cannot own more than 35% of the US REIT and shareholders owning more than 35% of the US REIT cannot own more than 35% of the hotel operator.
In France, on the other hand, French REITs (Sociétés d'Investissements Immobilières Cotées) (SIICs)) can be controlled by one or more shareholders with a shareholding of up to 60%. As a result, many SIICs are owned by industrial and commercial operating companies. A well-known example of this is Mercyalis, which owns most of the shopping centres of the supermarket chain Casino.
Similarly, Italian REITs permit up to 51% ownership by a single shareholder so long as 35% is owned by shareholders with 1% or less.
The fiscal authorities of many jurisdictions impose an entry cost, or so-called conversion charge, on pre-existing property companies converting from their normal taxable status to non-taxable REIT status. The main aim is to compensate the fiscal authorities for the tax they will forego on latent capital gains within the REIT as a result of the conversion.
As a consequence of no longer being subject to tax, converting companies are able to release the deferred tax provision held on their balance sheets in respect of their property investment business, including deferred tax arising as a result of property revaluations. This has significantly improved the balance sheets of many companies converting to REIT status. The nine UK property companies that converted to UK REIT status on 1 January 2007 released aggregate deferred tax provisions of around GB£6 billion (about US$12 billion).
The conversion charge in the UK is 2% of the market value of the assets of the converting company. In the case of the long-standing property companies that have converted into UK REITs, this compares favourably with the tax rates of between 16.5% and 20% applied to the latent gains of French, Belgian and Italian companies wishing to convert to REIT status. However, a conversion charge payable by reference to gross assets rather than latent gains acts as a disincentive, compared to other alternative structures, to asset managers seeking to establish new REITs with properties where there is no material latent gain.
There is no explicit conversion charge for a US company electing for US REIT status, but asset sales within ten years after conversion result in tax becoming payable on the latent gain at the time of conversion. In addition, a US REIT is not permitted to have any earnings or profits accumulated from a non-REIT year. Consequently, companies converting to REIT status typically must pay a "purging" dividend at conversion and this can have material cash flow and other economic consequences.
A number of governments, particularly in the EU, have struggled with the issue of how to tax foreign investors as fiscal authorities are anxious not to lose the revenue derived from withholding taxes on payments of rent to non-resident landlords. This revenue is threatened when the income passes through a tax-exempt corporate vehicle such as a REIT, and is then passed to investors as dividends rather than rent. This is because many double tax treaties exempt foreign corporate investors from withholding tax on dividends paid by a company when they own more than a particular percentage of that company.
In the EU, the issue has been how to tax foreign investors without infringing EU rules that prohibit discrimination between domestic and foreign shareholders. Different approaches have been taken in different jurisdictions.
The UK government initially suggested a 10% limit on shareholdings in UK REITs to minimise the loss of UK tax. This is because in many cases a shareholding below this limit would not benefit from the full reduction in the rate of withholding tax available under a typical double tax treaty. However, the UK rules do now permit shareholdings of 10% or more so long as, in the case of a corporate shareholder, no dividend is paid to the relevant shareholder. There is no difficulty with dividends paid to individuals. So as not to infringe the EU anti-discrimination rules, this requirement applies equally to domestic and foreign corporate shareholders. There are a number of relatively simple ways in which a corporate shareholder wanting to own 10% or more may be able to satisfy the requirement, such as through holding the stake indirectly via a number of corporate vehicles each holding less than 10%.
Germany has followed an approach similar to that originally proposed in the UK and has barred any shareholder, whether domestic or foreign, from holding a 10% or greater direct stake in a G-REIT. As in the UK, the rules do not prevent German or foreign shareholders from holding a greater indirect stake. Because of possible difficulties in enforcing these rules (not least because G-REIT shares will generally be in bearer form), the legislation unilaterally overrides any tax treaty that might otherwise have entitled a shareholder who does hold 10% or more directly to make a more favourable tax treaty claim.
The French authorities had, until recently, taken no steps to impose tax in respect of distributions to investors from other EU jurisdictions. However, Spanish companies began acquiring French SIICs in the knowledge that no French tax would be withheld on distributions to Spain, and this has prompted a recent change in the law. Since nearly all French SIICs are currently owned by controlling shareholders, it would have been difficult to impose a 10% shareholding limit on SIICs comparable to that in the UK or Germany. The French government has instead introduced an exceptional levy payable by the SIIC based on the dividends it pays to shareholders who are not liable to tax on those dividends. The SIICs are responding by amending their bye-laws to enable them to deduct this levy from the dividends of those shareholders responsible for its imposition.
It remains to be seen whether the UK, French and German regimes would survive a challenge from the EU. As far as the UK is concerned, there is some doubt about whether the rules can continue to allow payment of all dividends free of withholding tax to UK gross funds but not to equivalent entities in other EU jurisdictions.
The most important factor in creating a strong REIT market is the performance of real estate as an asset class.
In terms of the REITs themselves, their success in a particular jurisdiction is not necessarily determined by the competitiveness of their regulatory framework compared with that of REITs in other jurisdictions. More influential factors are the existence of a strong local stock market with a track record of international investors and a long-established history of indirect property investments.
The ability to create unlisted REITs (or similar vehicles), and possibly use them as incubators before a listing, has been a factor in the growth of the US, Australian, Japanese, Dutch and Canadian listed REIT markets and has recently been permitted in France. There is no such flexibility at present in the UK, Belgium or Italy, although "incubator REITs" are permitted in Germany so long as an application for listing its shares is filed within three years. The ability to engage in normal capital market transactions, particularly the ability to buy and sell large portfolios of assets on a tax-efficient basis, is also a factor in creating a successful REIT market.
One of the reasons for the success of the US REIT market has been the Umbrella Partnership Real Estate Investment Trust (UPREIT) structure. This permits a property owner to contribute its property to the partnership on a tax-deferred basis in circumstances where a direct sale to the REIT would generally be taxable. The contributor's gain is deferred until it exercises its right to require redemption of its partnership units received as consideration, either for cash (based on the REIT's share price) or for REIT shares, with "as if converted" income rights during the interim period.
After an initial launch without an equivalent structure in France, the French sector received a boost through the so-called SIIC 2 legislation when it became possible for a certain period (which has now been extended) for vendors not normally regarded as property companies to sell their real estate to a French REIT at reduced rates of tax. This has contributed to a three fold growth in the market capitalisation of the SIIC sector over the last four and a half years.
Likewise, in Germany only 50% of the gains realised on a sale before 2010 of certain commercial German real estate to a G-REIT or a German "incubator REIT" are taxable. This, in conjunction with generally lower corporate tax rates from 2008, may be a major incentive for German businesses, many of which hold property that has appreciated significantly in value, to conduct sale and leasebacks with G-REITs, and in so doing free up capital for investment elsewhere. The exit tax can be retrospectively denied if certain minimum holding periods are not observed by the G-REIT, or if the seller still owns more than half of the G-REIT within a given subsequent period.
The UK property industry continues to lobby for the introduction not only of unlisted UK REITs, but also for a tax relief on gains arising on the sale of a direct property interest to a UK REIT. The UK industry would also like to see the introduction of a tax relief on the sale of a property-owning company to a UK REIT for cash (roll-over relief may be available where the consideration is shares issued by the UK REIT).
Normally there are no restrictions in relation to the sectors in which real estate investments can be made, and sector specialisation has been a strong theme in the US and Australia, although less so in Europe. In the US, for example, the REIT market is generally divided into a number of sectors including office, industrial, shopping centres, regional malls, apartments, hotels, healthcare, multifamily, self-storage and diversified. Within these sectors, US REITs can then have a large degree of further specialisation, for example, in prime Manhattan offices or R&D properties in Silicon Valley. The US also permits mortgage REITs.
G-REITs are not permitted to invest in residential rental property located in Germany and constructed before 2007 because of political concerns about the risk of exposing tenants to the forces of international capital markets. This provides an interesting contrast with the UK, where the prospect of residential REITs was the original rationale behind the UK government's support for the REIT concept. However, for market reasons, no UK residential REITs have yet been established.
An important factor in the success of the REIT market is its competitiveness compared with other investment vehicles used in that jurisdiction. One reason why the UK government was keen to introduce UK REITs was its concern about the rapid growth of unregulated offshore vehicles (many based in the Channel Islands), which were being used for highly tax-efficient investment in UK property.
These offshore funds continue to exist and have a material presence in the UK investment market. Some of them have a public listing, whether in the UK or elsewhere, but they do not suffer from many of the restrictions applicable to UK REITs. In particular they are not subject to the restrictions relating to trading activities, gearing or 10% corporate shareholders. Currently there is no compelling reason for these offshore funds to convert into UK REITs, although this may change if a situation develops in which investor sentiment is increasingly demanding the liquidity and high levels of corporate governance and disclosure that come from a UK-regulated and listed vehicle. The UK is seeking to introduce Property Authorised Investment Funds in 2008 as an open-ended alternative tax exempt vehicle, but it remains to be seen what impact this will have on the offshore funds sector.
It also remains to be seen whether the low level of historical investment in listed property vehicles in Germany changes following the introduction of G-REITs, bearing in mind the unusually high levels of historical investment in real estate in Germany through non-listed vehicles. G-REITS may also prove popular because, unlike the German open-ended funds that have suffered in recent years, they are closed-ended and therefore do not need to prejudice returns by retaining cash to meet redemptions, nor to threaten unit liquidity if that cash proves insufficient. Additionally, G-REITS will operate in an enhanced corporate governance and disclosure environment.
Large portfolios of residential properties have changed hands over the last few years in Germany, with significant numbers of formerly public sector owned properties being purchased by foreign private equity houses and investment banks. The limited access to existing residential properties for G-REITs may slow the growth of the REIT sector in Germany. However, German residential properties are still likely to find their way to interested investors, in particular from abroad, through alternative structures so long as rumours of a possible loss of confidence in that market prove unfounded.
In some jurisdictions, alternative structures can also have significant advantages in relation to multi-jurisdictional investments. For example, the UK, German and French REIT regimes are not currently particularly attractive for investments outside the home jurisdiction because of difficulties in recovering foreign tax credits. Even after gearing and management charges, there can be tax leakage that could be avoided by investing through a non-REIT structure.
Another key factor in the success of any REIT is its cost of capital compared to other alternatives, because this enables it to offer higher prices to acquire assets.
The experience of REITs in the US and Australia is that they are generally rated by reference to dividend yield rather than net asset value, and it is their dividend yield that has, in many cases, enabled them to trade at significant premiums to net asset value, and therefore raise equity capital on favourable terms.
Their high dividend yields come partially from the fiscal regimes within which they operate. For example, in Australia, the distribution by an LPT consists of two elements: one part is taxed as normal in the hands of the investor, and another part, representing depreciation at the LPT level, which the investor does not pay tax on. The tax-free element of the distribution reduces the capital gains base cost of the investor. Therefore, the investor ultimately does pay tax on the initially tax-free element of the distribution. In the meantime, however, this element serves to materially increase the investor's return on its investment.
In fact, even if the relevant fiscal rules requiring REITs to distribute a high proportion of their profits were relaxed, it is likely that high levels of pay-out would continue in order to attract equity investors. For example, French SIICs have in recent years steadily increased their dividend yields so that they now more or less match the yields from the more mature REITs in The Netherlands. Average US REIT dividend yields have in recent years materially exceeded the Standard & Poor's (S&P) 500 index average.
This stands in strong contrast to non-REIT property companies. Non-REIT property companies lack any incentive to drive returns through income, since income passing through their profit and loss accounts is taxable. Instead, they generally try to maximise total returns through net asset value growth, which is not immediately taxed. European property managers, converting non-REIT property companies into REITs for the first time, face the challenge of adjusting to an environment that requires them to manage REITs increasingly by reference to income rather than capital appreciation, and that requires strong capital markets skills as well as underlying real estate investment knowledge.
After some very high returns over the last five years, property as a listed asset class has been one of the worst performing sectors so far this year. This reflects wider predictions of an end to the commercial property market boom and increasing interest rates, which have resulted in a reduction, or indeed a reversal, of the differential between local bond yields and property company dividend yields. European investors have also been looking to Eastern European markets for higher potential returns.
The FTSE NAREIT Equity REITs Index was down nearly 5% for the first half of 2007, whereas the S&P 500 was up by more than 7%. While the Asia-Pacific REITs have performed better than this, those in Europe have performed slightly worse. Most of the recently converted UK REITs are now trading at significant discounts to their net asset values with stock markets perhaps anticipating major write downs (reductions in book value) of previously perceived asset values.
This has resulted in a tough market in which to launch new listed real estate vehicles in established markets. The recently attempted initial public offerings (IPOs) by Vector (UK hotels), Boetzelen (German real estate), Uni-Invest (Dutch property), Shurgard Europe (European self-storage) and Dolmea and Resico (both French residential property), have all floundered. It has also proved difficult to launch new LPTs in Australia. Existing LPTs have, however, continued to expand and diversify by investing offshore, particularly in Japan and Europe, as have Singaporean REITs in Japan.
In the UK, property-rich companies have not been as eager to surrender ownership of their real estate as some had predicted. In particular, retail and hospitality chains have been wary of the loosening of control that a sale and leaseback can entail, and the markets have been cautious of the rental and capital value implications that can flow from a tenant-friendly leasing arrangement.
Private equity vehicles have also had a materially lower average cost of capital than REITs, mainly because of their ability to leverage to a significantly higher level. This has reduced the REITs' historic cost of capital advantages and diminished their competitive advantage when bidding for new assets. Private equity buyers have not only been strong purchasers of stand alone portfolios, but have also been successful in persuading companies of the advantages of off-market joint ventures as a way of releasing value from their real estate holdings.
The strength of private equity, and the relative weakness of publicly-listed property companies, has resulted in no shortage of M&A activity in the sector, particularly in the US. There was over US$60 billion (about EUR44 million) of M&A activity in the US REIT sector in the first half of 2007, most of it as a result of public-to-private deals. There has also been significant M&A activity in Australia. It is expected that pressure for increased sector specialisation will continue, although it is not yet clear how that will affect sentiment towards multi-jurisdictional investment. Although there have been one or two deals (such as Derwent Valley/London Merchant Securities and Unibail/Rodamco Europe), the expected wave of M&A activity in Europe has not so far materialised.
Despite the current markets, when measured over the last five years global real estate has still outperformed global equities and global bonds by a significant margin. A tightening in the availability of credit may stem private equity's advance. It is also the case that the value of securitised commercial real estate as a percentage of total commercial real estate in Europe is still only around one third of the equivalent percentage in the US. The expectation, therefore, is that although the flow of real estate into the public equity markets may have stemmed for the time being, over the longer term, particularly in Europe, that trend will continue.
The author would like to thank the following for their assistance with this article: Sébastien de Monès (Bredin Prat), Friedhelm Jacob (Hengeler Mueller), Robin Panovka (Wachtell, Lipton, Rosen & Katz), Nico Blom and Gerald Van Walle (NautaDutilh), Lian Ee Teoh (Drew & Napier), Yuko Miyazaki (Nagashima Ohou & Tsunematsu), Derek Heath (Allens Arthur Robinson) and Roberto Cera (Bonelli Erede Pappalardo).
Total REIT market capitalisation | Listed real estate as a percentage of total institutional real estate | Listed real estate as a percentage of stock market capitalisation | REITs as a percentage of listed real estate | |
US | GB£213 billion (about US$433 billion) | 9% | 3% | 82% |
Australia | GB£58 billion (about US$118 billion) | 39% | 12% | 85% |
UK | GB£35 billion (about US$71 billion) | 10% | 3% | 47% |
France | GB£31 billion (about US$63 billion) | 8% | 3% | 69% |
Japan | GB£28 billion (about US$56 billion) | 9% | 4% | 24% |
The Netherlands | GB£14 billion (about US$28 billion) | 12% | 6% | 76% |
Canada | GB£14 billion | 8% | 3% | 38% |
Singapore | GB£9 billion (about US$18 billion) | 46% | 12% | 20% |
Germany | nil | 2% | 1% | nil |
Italy | nil | 2% | 1% | nil |
Source: AME Capital, Bloomberg, EPRA