Are you all REIT?
SOURCE: SCOTTISH BANKER, FEBRUARY / MARCH 2007
As from 1 January 2007, Real Estate Investment Trusts (REITs) will be available in the UK. Basically, a REIT is an entity that owns and operates income producing real estate, and satisfies various conditions, which enables its profits and gains to be exempt from UK corporation tax. The favourable tax status will give REITs an advantage over some of its competitors and is likely to have a major impact on the UK property industry, including banks and borrowers.
The tax exemption is a major incentive for a UK entity as it will increase the profits available for distribution, but the qualifying conditions to gain that exemption will mean that REITs will not be suitable for all organisations. As with any HMRC creation, there are various regulations that will apply (some of which have not yet been published).
Semple Fraser can provide you with a full analysis of the regulations if required, but a brief summary of a REIT is a UK company that:
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is listed on a recognised stock exchange;
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is controlled by more than 5 participators; and
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derives at least 75% of its income from the rental of properties.
Therefore, the ideal “shape” of a REIT is a property investment company (as opposed to developers and/or traders), which has: a number of investors; sufficient equity to pass the gearing test; and is prepared to distribute 90% of its profits. In advance of the regime, a number of significant UK entities have indicated that they will take advantage of REITs, including British Land, Land Securities and Hammerson. However, some (e.g. Capital & Regional, and Quintain) have indicated that they will not convert.
Conversion is relatively straightforward, and involves an application to HMRC once you are satisfied that you will meet the conditions of a REIT, along with payment of an entry charge of 2% of the market value of investment properties held. The entry charge seems high, but it can be spread over 4 years, and will effectively extinguish any gain within the property.
REITs are likely to revitalise the UK listed property sector as many property companies currently trade at a discount to net asset value as a result of double taxation suppressing the value of the shares, and investors will also benefit from easy access to property as an asset class and relatively healthy dividend returns (there should be more profits to distribute).
REITs will also promote some activity in the property sector, which will be an opportunity for banks. Companies are likely to change shape possibly by de-merging their property development business so that the investment business can qualify as a REIT. Also, REITs may be more aggressive when bidding for properties as REITs may be more able to absorb pregnant gains within a target (by paying the 2% entry charge) than non-REITS.
Due to the regulations and the interest cover restrictions, lending to a REIT will be relatively safe and it may lead to aggressive pricing among the lenders. Also, the secondary equity market will come into play, as REITs try to ensure that they remain within the interest cover restrictions.
REITs will have a major impact on the UK lending market, and will be both an opportunity and a threat for banks. The loan and security should be relatively straightforward, but the opportunity to lend will depend on the ability of the lender to both identify the situations where REITs and non-REITs, require funding, and to demonstrate that it understands the borrowing structure.
author: alex innes