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The Reit generation

Simon Hildrey says the new tax-efficient property investment vehicle introduced earlier this month is expected to become the most popular structure for property funds despite the high costs of conversion and continuing attractions of offshore funds.

Anyone who watches daytime television must think the easiest way to make money is to invest in houses.

This is unsurprising, given that the average UK house price rose by 187 per cent from the start of 1996 to September 2006, according to the Halifax.

The Investment Property Databank shows that UK commercial property delivered an average annualised return of 10.9 per cent over 25 years to the end of 2005.

The property sector has been boosted further by the introduction of real estate investment trusts on January 1. Part of the reason for launching Reits has been the Government’s desire to stem the flow of capital into offshore property funds, such as Jersey property unit trusts.

Offshore property funds have been popular because they are a tax-efficient way of accessing the UK commercial property market. A JPUT, for example, does not pay income tax and it is possible to defer or avoid capital gains tax.

The Government has sought to make Reits competitive from a tax point of view. Rental income and gains on disposals of investment properties in Reits are exempt from UK corporation tax. Distribution of income and capital from Reits are subject to withholding tax at the UK basic rate of 22 per cent.

Investors now have to decide whether they should favour the new UK-domiciled and London-listed structure.

Comparing the relative attractions of Reits and offshore property funds is complicated, however, by the fact that as yet no funds have been structured as Reits.

Scottish Widows Investment Partnership investment director of real estate Ian Haly says there are obstacles to launching funds as Reits. For example, funds must pay a conversion charge of 2 per cent of the market value of their investment properties at the date of joining the new regime. A further deterrent is the fact that the Association of Investment Companies says start-up costs can be as high as 8 to 10 per cent of assets. It has been estimated that for a non-listed company to convert to a Reit, there will be a 4 per cent stamp duty charge on the transfer of the properties.

Nevertheless, Haly believes funds will be structured as Reits. He says: “We expect there will be new iterations of the Reit regulations. In France, for example, there have been four iterations since the Reit regulations were introduced in 2003. It is now quicker and more cost-effective for funds to be launched as Reits in France. We expect a similar process to take place in the UK.”

Even if these obstacles are overcome, there are reasons why some investors will continue to prefer offshore property funds. Non-UKdomiciled investors, for example, may prefer offshore funds for tax reasons. If gains from these funds are kept offshore and are not enjoyed in the UK, then it is possible for a non-UK domiciliary to avoid UK tax on them.

Philip Le Cornu, partner at Channel Islands law firm Ogier, says Reits are less attractive to some investors because their rules are more prescriptive than for offshore property funds.

He says: “For example, Reits have to be listed on a recognised stock exchange, 75 per cent of the Reit must relate to property rental business, there can only be one class of shares, they must distribute 90 per cent of their net taxable profits as income, one shareholder cannot own more than 10 per cent of a Reit and no single property must represent more than 40 per cent of a Reit.”

The level of gearing of Reits is restricted to 1.25 to one and they must comprise at least three properties. Such restrictions do not apply to offshore property funds.

Le Cornu says it can cost hundreds of thousands of pounds to list on the London Stock Exchange compared with a cost of around £10,000 to list on the Channel Islands Stock Exchange.

John Shenton, tax director at Ernst & Young in Guernsey, points out that Reits are limited to holding UK property at a time when many fund managers argue that commercial property in continental Europe offers better investment value than the UK market.

Offshore property funds can be structured as open or closed-ended funds whereas Reits can only be closed-ended corporate structures.

However, there are reasons why some investors will prefer to invest in Reits.

Being listed on the London Stock Exchange could make it easier for funds to raise capital through new share issues and this may make it easier for Reits to expand. There may be a perception that investor protection is greater when investing in Reits as they are UK-listed.

It is also argued that liquidity may be better among Reits than open-ended offshore funds.

Fidelity International head of IFA channel Peter Hicks says there have been examples of liquidity drying up, such as in 1991.

He says: “It may take a long time to redeem capital from an open-ended property fund if there is little liquidity. In contrast, Reit investors will be able to redeem their money by selling shares whenever they want, even if it is not at a price they like.”

What is likely to drive investors’ choice of structure is ultimately the fund manager and the outlook for returns.

It is important to check whether the mandate is for a Reit or an offshore property fund.

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