Melanie Stern is section editor of Families in Business.
Observers had been convinced he would make it too costly, but Gordon Brown's thumbs up on the launch of UK real estate investment trusts mean family investors have some new investment options to examine – from both the buy and the sell-side, finds Melanie Stern
It is only about 20 years late but, in March, the UK government finally mandated the creation of its own market in real estate investment trusts (REITs), jumping on a bandwagon that has pumped cash to its US investors – and, more recently, Asian investors – since the 1980s.
REITs are publicly-listed companies that own and manage a property portfolio, whose shares can be bought and sold much like any stock. REITs give investors the opportunity to diversify their portfolios with a stable asset class, but offer far better liquidity than property trusts or buying up property directly, being a listed instrument and carrying no management requirements. Currently, UK families like to invest in property through unit trusts or syndicate portfolios run by professional property companies, as an alternative to buying up property directly. But market participants agree that wealthy British families will go mad for REITs.
US REITs have been around for years and are popular because they give investors access to lucrative non-residential property, like malls and hotel chains. Host Marriott is one of the country's largest, controlling the Marriott family's hotels portfolio. In order to take advantage of lucrative tax treatment, they must return 90% of their taxable income to shareholders annually in the form of dividends. There are some non-exchange traded REITs but most are on the markets. "It's all about choice for REITs investors – with the added incentive of liquidity," says Pierre Rolin, chief executive of real estate investment advisory Strategic Real Estate Investors (StratReal) tells Families in Business. StratReal manages some £3 billion in family assets for about 15 UK families.
It is for this reason the US REIT market is worth some $475 billion, with over 200 publicly-traded REITs to choose from. Many are family-owned, originating from families who converted their property holdings from retail or hotel businesses into REITs in the 1980s, though legislation for US REITs was formalised as far back as the 1960s. The tax treatment for business families has changed so much since then that many are now buying their REITs back from the public markets, while the UK and other parts of Europe like Germany are only just reaching the first stage of this cycle. However, the difference in capital gains and inheritance tax setups this side of the Atlantic means the UK REIT roll-out may not mirror that of the US and investors need to be wary – not that family offices would be.
In his hotly-awaited Budget statement on March 23, Chancellor Gordon Brown announced that UK property companies could start applying to convert themselves into REITs from January 2007. The markets responded quickly and later that day, supermarket giant Tesco reportedly started looking into converting its multi-billion pound freehold store portfolio into a REIT, while share prices in British property companies like UK Land Investments rose by as much as 10%. This gives an indication of the simmering demand for these instruments in the UK.
UK REITs will be modelled broadly on the US vehicles, and after a couple of years' consultation with the markets about how to structure them the government's proposals seem to make it fairly easy to get involved. Observers had been convinced Brown would make it too expensive to be workable and competitive. Instead of paying 30% corporation tax, UK REITs will pay no tax if they return 90% of their earnings to their shareholders. Property companies that want to convert themselves into REITs will pay a conversion charge at 2% of the gross market value of their portfolio, but that charge is spread over four years.
This is all broadly positive for UK families. For those who want to invest, they will have access to a relatively cheap and stable, but lucrative, slice of the property world. For families that own sizeable property portfolios (for example, retail, hotels, or those who own factories) converting into a REIT could be another potential revenue stream and a way to gain exposure to the public markets.
However, family businesses may hit a problem if they consider this option. As part of the new UK legislation, no shareholder in a REIT will be allowed to hold more than 10% of the shares in the vehicle. Fine for the likes of UK Land, but it doesn't sit well with business families who like to have majority ownership and control of their companies. Some in the family wealth world believe there will be a lot of interest from families, particularly family offices and trusts, in converting their portfolios - but the ownership issue will be the main stumbling block. "It is generally good news for the chance to invest in UK property in a new way, but not so good for privately-owned property trusts," William Drake of London-based family office Lord North Street tells Families In Business. "Not being able to own more than 10% of the shares, family businesses may have to re-organise their holdings in some way, and try to find ways to circumnavigate this. Families like to keep control themselves and the second you dilute that in any way, they lose the point – they would prefer just to remain on the buy-side rather than the sell-side."
StratReal's Rolin also points out that families will have a familiar governance issue to face if they want to convert. "Families will go head over heels for REITs as investors, but they don't have the breadth of management to convert to REITs," he believes. "They have a very sporadic and emotional mixture of real estate holdings and management of those holdings. Most family offices and foundations have some joint ventures or partnership and own some property directly with other partners, but it isn't at the stage where it can be converted into a REIT – that is for the professional UK property managers. Let's not be romantic about the possibility that everyone will convert their portfolios into REITs. You can't just take a family office and turn it into a REIT just because the family owns a bunch of buildings in New York and London."
He goes on. "London, for example, is one of the world's most important property markets. The City has one of the most valuable miles of real estate in the world which is only going to become more publicly traded. Some of the best management teams in the international real estate market are based in London. At a banker's level, a property management level, and an investment management level, British pension funds and insurance companies have developed significant in-house teams. I wouldn't be surprised even if the most traditional of these decided to spin off their operations in some way. But the City will scrutinise the management of a REIT very closely and I don't think family businesses and trusts could stand up to that."
There may be a ray of light though, and this may prove vital for family organisations. Indeed, Chancellor Brown made a point in his Budget speech of reassuring potential REIT converters that he would provide some guidelines for companies to manage this cap using internal rules, hinting at future flexibility. "Under the revised proposals, a shareholding of over 10% should not disqualify the company and the tax charge will not apply, if the company can show it has taken reasonable steps to avoid paying distributions to holders of over 10%," says Sue Porter, head of the London tax practice at law firm Freshfields Bruckhaus Deringer. "These steps would include inserting a provision in the company's articles to the effect that any dividends in excess of the 10% limit would be withheld."
Families that do consider this avenue will have hefty institutional competition, as Rolin identified. "We would now expect most UK property companies to be seriously considering converting to UK REITs status," Freshfields Bruckhaus Deringer's Porter believes. "Non-resident property companies may also consider moving their residence to the UK and converting."
All that aside, some think the UK property market has had too good a run for it to last much longer, and that foreign REITs may be the smart money. "My clients feel the market has had a terrific run and isn't looking that cheap anymore," says Lord North's Drake. If this is too much risk for families, they may look to a number of REITs run out of Europe that offer a basket of REIT investments across the world. One example is the Luxembourg-listed Aviva Funds Global REIT, run jointly by Morley Fund Management and CB Richard Ellis, the real estate giant. Launched just days before the Budget statement, this fund followed similar launches from players like Schroders and Standard Life, and will provide a way into property on all five continents where REIT markets are already up and running (Australia and Singapore being two hot spots for established REITs), or are due to start, such as Germany, mooted to have its first REITs in 2007. Says StratReal's Rolin: "the potential in this market is huge".