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REITs – Real Estate Investment Trusts

Gordon Brown’s 2006 Budget proposals heralded the arrival of REITs (Real Estate Investment Trusts). Property companies likely to convert to the new status warmly received the proposals.

But what are they and what do the proposals mean for investors looking to minimise tax?

What are Real Estate Investment Trusts

Real Estate Investment Trusts are a UK tax efficient way of holding property assets. Tax efficient for property companies that become REITs – and tax efficient for investors who buy into REITs.

They are not new and have been around a long time in places like the USA and Australia where they have proved useful to companies that want to raise money against property.

These tax efficient vehicles act like unit trusts or shares and invest in commercial and residential property.

Most property companies are expected to convert to REIT status because they will pay no corporation tax if they distribute 90 percent of their net profits to investors.

Three quarters of income must come from rents but the rest can come from other services and development.

Currently property companies pay corporation tax on their rents as well as on their profits when they sell.

Analysts expect many UK property companies that have gone private over the past few years will now convert to REITs, thereby expanding the number of listed property companies and increasing investor interest in the sector.

Are REITs right for you?

One of the reasons REITs have been created is as an easier way for investors to get an exposure to property, other than them owning the properties directly themselves.

REITs also enable small investors to get involved in commercial property as well as in residential property – and to diversify their investments across a wider geographical spread.

How attractive the proposition is depends on your view of property investment or what stage you’re at.

As a younger property investor you are likely to be going after strong growth.

By far the best way to do this is by directly owning a property, gearing up your investment as much as possible with an interest-only loan and covering the loan repayments with the rent (the interest of the loan being off-set against the rent for tax purposes).

REITs will never be able to provide the substantial growth you can achieve building a property portfolio in this classic way.

Instead REITs, where you own property indirectly as part of a pool of investors, are like shares and are more about producing an income than achieving exciting growth.

As such they may suit an older person who wants some exposure to property, without the management hassle of direct ownership, and who is looking at income rather than capital growth.

In countries where REITs are common, they have paid out a steady dividend rate of around 4.5 to 5 per cent.

But remember REITs cannot be geared – they are safe and reliable.

You just own a share in a property company, not a tangible asset like a buy-to-let apartment.
In simple terms you are exposed to property in a broad sense but you don’t own the actual bricks and mortar.

How to Minimise Tax using REITs

For property companies becoming REITs, the new status means they will reduce and may even eliminate taxes on earnings that would have been levied at the corporate level; instead the income is passed through the REIT to the investor.

In the past, the problem for shareholders in property companies is that they have been double-taxed, once as shareholders and once again as the owners of a property company.

REITs remove this two tax situation so long as 90 per cent of the net profit is paid to investors.

Investors in REITs will not pay tax on rental income in the way they would if they directly owned and rented out a property, or capital gains tax when properties are sold. Instead, they pay tax on dividend income paid on shares and CGT on the trust itself.

We believe most people will hold REITs in a limited company structure and will use them to roll over gains and avoid Capital Gains Tax.

This will be a major benefit for investors who have previously sheltered their investments in complicated structures off shore that make it difficult to bring money back into the UK without big penalties.

Other people may hold REITs in a self invested personal pension plan and trusts to further shelter the steady income stream.

Questions and answers about REITs

Are REITs risky?

Yes, in as much as shares can go down as well as up.

Investment trusts can also sometimes trade at a discount to their underlying asset values, so this can enhance their volatility relative to unit trusts.

However, this could also provide an opportunity to buy assets at a discount if, say, you think the discount could get smaller in the future.

They will also follow stock market sentiment much more closely than direct property holdings.

What can REITs invest in?

They can invest in commercial or residential property.

Why did share prices in some UK property companies go up after Gordon Brown's announcement?

First, existing property companies will be able to switch to REIT status on payment of a charge of two per cent of the value of their gross investment assets.

The stock market had thought that the Chancellor would have set the conversion charge higher than this.

So this was good for some property shares.

Second, the extent to which a REITs income must cover its interest payments was set lower than many had thought.

Third, the stock market believed REITs would have to distribute 95 per cent of their profits to investors, but Brown set the figure at 90 per cent - also better than the market had hoped.

That is why the shares in those companies that were thought most likely to want to convert went up.

Land Securities, the biggest property group, went up 13% on budget day.

However the Chancellor kept some limitations; most notably the rule saying that no individual shareholding could be bigger than 10% or else a tax charge would be applied.

Could other companies become REITs?

Yes. In particular, it's thought that some large retailers will be interested in converting to REIT status.

However, as they cannot invest in properties they also own, they would need to do a few complex transactions first - possibly selling their assets and then leasing them back.

When will REITs go live?

They will be introduced in January 2007 at the earliest.

Is it worth getting excited about REITs?

If you are a landlord, then investing directly in property REITs will probably seem a bit tame because with a share in a REIT, you'll just own a share in a property company.

So you can't drive past your asset, like you can with a property that you own directly.

You can't touch and feel it. All you can do is check its value in the FT!

However, REITs can produce a decent income.

In other countries where they have been tried, they pay out a dividend rate of about 4.5 to 5 per cent.

REITs will be slow and steady because their borrowing limits mean they are a lot less geared (ie. they can take on a lot less debt) than private investors in residential property can (and have) been doing.

REITs are especially attractive if you want an income and that means REITs may be of more benefit to older people, rather than younger investors who are likely to be focusing on growth.

This is because REITs will need to redistribute a large portion of any profit - rather than refinance to reinvest which is the classic way of building up wealth within property.

And this is why the government likes them - they should be a safe and steady way for Joe Bloggs to invest in property assets without needing to take on lots of debt.

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Page 2: Will REITs push up house prices?