Rewrite of UK rulebook opens door to a new wave of REITS

Relaxation of conversion charge will allow variety of firms to become REITs, reports Alex Catalan

In July, the UK’s REIT regime will get a big overhaul, its first since being launched in 2007. The property industry hopes the changes, enacted by this year’s Finance Bill, will spawn more of these property companies that enjoy tax advantages; there is talk of 30-40 potentially listing.

The companies lining up for a listing are “truly very varied, all different sizes and different asset classes, from residential to commercial to healthcare”, says Phil Nicklin, real estate tax partner at Deloitte.  “I’ve got a number of mandates that are looking at it very seriously.

“Some family companies, with say, £100m of assets, are such a rag-bag that they need to sort themselves out before being in a position to become a REIT. Others are ready now – they have a good portfolio and will be able to raise more capital on a more private basis than by just doing an initial public offering.”

The hope is that institutions, family companies, private equity houses and social landlords will list, adding to the disappointingly small number of UK companies – just 24 – that now occupy the sector.

The key legislative change is that there is now a free pass into the REIT sector. The entry charge of 2% on the market value of assets for companies getting this beneficial tax status has been abolished.

are those that have property and capital gains and would be put off by the entry charge,” says Nicklin. “Abolition of that charge makes a big difference.”

For companies with big portfolios, saving 2% involves serious money. But smaller fry will also benefit, particularly as new REITs will now be allowed to trade on alternative platforms such as AIM, Plus-Traded (and overseas equivalents), rather than go for a fully recognised stock exchange listing, as was previously required (see below).

“The 2% conversion charge for a tiny company could be quite a lot of money, so probably a few AIM-listed companies will convert,” says John van Marle, an analyst at JP Morgan Cazenove.

Free pass for takeovers

The free pass also applies if an existing REIT takes over a non-REIT, which will make takeovers a lot easier. ‘That becomes more interesting, and hopefully could make a difference as well,” says van Marle. “For example, if there is a good-quality family business that isn’t very big, but doesn’t have a REIT structure, then someone such as British Land could take it over and convert it to a REIT immediately, which is beneficial for everybody involved.”

The second major change is a new diverse ownership rule allowing specific institutional investors to own majority stakes of up to 100% in REITs without breaching regulations. These investors are: UK pension funds, insurance companies, sovereign wealth funds, authorised unit trusts, open- ended investment companies, charities and registered social landlords.

“This institutional change is very interesting,” says Nicklin. “Sovereign wealth funds, pension funds and life companies can now set up a REIT by themselves or in joint venture with other institutions or investors and use that as a platform for holding their property.”

However, overseas REITs are excluded from the list of institutional investors, which could inhibit US REITs such as Simon Property or Westfield from taking over or setting up UK REITs. They are not being exempted from ‘close company’ regulations, which stipulate that a REIT cannot be established and controlled by fewer than five participants. The property industry is continuing to lobby for their inclusion.

Capital raising still tough

Nicklin expects to see new REITs emerge this year, but cautions that listing will clearly be easier for those that are not look-ing to raise capital at the same time. Equity market conditions are not favouring initial public offerings by REITs.

“At the margin, it helps not to have an entry charge,” says Deutsche Bank property analyst Martin Allen. “But people are going to be price-sensitive in terms of the rating they get on their shares when they create a REIT. In the current environment it is quite hard to float a REIT. “The valuations aren’t very attractive for an issuer. At the moment the sector is trading at a 19% discount to net asset values at the end of last year.”

How REIT rules have been relaxed

Entry charge abolished: property companies can become REITs without paying 2% levy on the market value of their assets. Trading rules relaxed: New REITs will not require a full listing on a recognised stock exchange, but will be allowed on other platforms, such as AIM, Plus-Traded and foreign equivalents. Annual, but no minimum, trading required. Plus, they will have three years to meet these conditions.

This change in trading rules does not apply to existing REITs New ownership rules: Allow specific institutional investors – UK pension funds, insurance companies, sovereign wealth funds, authorised unit trusts, open-ended investment companies, charities and registered social landlords – to own up to 100% of a REIT, without running foul of  ‘close’ company regulations.

Big European property players find that bonds beat bank debt

Investment-grade European REITs have improved their debt structures and have strong liquidity, according to a report by Fitch Ratings.

They have deleveraged and now have “ample undrawn committed facilities and enough cash to cover their liquidity uses in 2012”, says Fitch.

Since the financial crisis of 2008, REITs have deleveraged and reorganised their debt, replacing bank lending with longer- term borrowings. “Some 75% of their debt is now unsecured bonds,” says Jean-Pierre Husband, director in Fitch’s European corporate finance department.

“This should be positive for sector ratings, as bond issues usually extend debt maturities and match them more closely to the long-term investment properties financed. Greater reliance on long-dated bonds will materially reduce refinancing risk for European REITs and hence improve their risk profile.”

Despite the ups and downs of the capital markets, since 2008 the bigger European REITs have raised £4.4bn by issuing bonds.  Even though European property markets are subdued, investors, particularly institutions with longer-term liabilities, like the defensive nature of the rental income backing the bonds. “The market for bond issues is not bad at all,” says Husband. “We may see one or two issues this year.”

Last year, Land Securities and Unibail-Rodamco both used this route to refinance existing borrowings; their total £1.3bn of issuance was the highest since 2007. Others, such as British Land, Great Portland Estates and Liberty Living (which isn’t a REIT), have used US private placements.

The proceeds from these issues are helping to wean REITs off bank finance.  Fitch says the major REITs’ bank debt fell to 24% of their total debt by the end of last year. With banks constrained in the amount they can lend and increasingly picky about the borrowers they back, REITs have slimmed down and reorganised their banking clubs.

For example, in February, Great Portland Estates agreed a new £150m, five-year revolving credit facility with four banks including Santander, RBS and Lloyds. The original facility it replaced was for £200m – £50m remained – and due to expire this year.

Margins on bank debt have been increasing, partly because banks are facing higher costs of funds themselves, but also because they are no longer viewing revolving credit facilities as loss-leaders that will bring in other business, such as swaps.

GPE was paying 50 basis points on its original facility; the new one carries a margin of 175bps, rising to 250bps depending on leverage. However, since LIBOR is now markedly lower than when the original facility was taken out, the overall interest cost is not that much higher.

REITs are also turning to alternative funding sources, disintermediating the banks. Encouraged by their favourable treatment as real estate debt providers under the forthcoming Solvency II capital regime, insurers are lending to REITs.

“We’re starting to see some of the US institutional players, such as Met Life, lending,” notes Husband. The US insurer provided some of the £315m funding for SEGRO to acquire the UK Logistics Fund industrial portfolio.

US equity players are also moving in. “Simon Properties has taken a large share- holding in Klépierre,” Husband says. Last month, the US shopping mall REIT bought BNP Paribas’ 28.7% stake in the European shopping centre operator for €1.5bn.