UK jury still out despite strong case for M-REITs

M-REIT advocates say vehicle would diversify UK capital sources, reports Doug Morrison

When the pros and cons of mortgage REITs were last debated in the UK, in a 2012 Treasury review of REITs, the idea of an equity-based vehicle investing in property debt, but not the assets, was too much of a stretch for the  policy wonks; they dumped their mortgage REITs file into the “too difficult” box.

Mortgage REITs are apparently no closer to the legislative changes needed to enable their introduction as a means of exposure to the sector and an alternative lending source  for property. Yet, in some respects, the case for mortgage REITs is stronger than ever.

One big change has been the proliferation of debt funds, meaning that debt capital supply for core real estate is not the issue it was in 2012. However, these funds’ lack of transparency is a cause of concern for some.

As PwC director Gareth Lewis points out, Europe’s market is “overly dominated by debt” compared with the US, where listed mortgage REITs are long-established.

“Europe is weak in terms of the relative amount of real estate held in public markets, but also it’s much more clearly focused on private ownership and more reliant on debt for funding real estate,” he says. “In the US, there is a much healthier balance of funding for real estate, whether it’s public markets, private markets, debt or mortgage REITs.”

Lewis adds: “I don’t think anyone could  question that it would be a good addition to a mature real estate market, in providing access to real estate investment returns  and the liquidity of the market as a whole.”

However, there are no signs of regulatory pressure to launch mortgage REITs in Europe, or of demand from the industry, on either side of the Atlantic. For example, while US-listed Blackstone Mortgage Trust’s 2014 accounts saw Europe as “a significant opportunity”, it didn’t indicate a need to move from its New York base.

Cosmetatos, Peter FC13
Cosmetatos: “Visible, transparent way to diversify”

But Peter Cosmetatos, chief executive of the Commercial Real Estate Finance Council Europe, says the introduction of UK REITs  in 2007 followed years of “proto-REIT activity” with the formation of equivalently taxed, income-focused, off-shore entities.

Potential forerunners

He says similarly, relatively new, UK-based debt funds from the likes of Starwood and Cheyne Capital could be the forerunners of a formal mortgage REIT market in Europe: “A few are similarly built and you might expect, and want to see, a similar market evolution, bringing that kind of thing into a  clearer, more visible tax and regulatory treatment for national authorities.

“A vehicle like that would add a visible, transparent way to diversify the sector, which has become much more diverse but not necessarily in a structural, through-the-cycle kind of way. It remains highly opaque. Having a smaller number of listed, properly regulated and taxed entities, which are exempted but still subject to normal, visible rules, would be quite a helpful thing.”

Cosmetatos adds: “Entities that have permanent capital, like REITs, should have a greater resilience to the cycle than private equity-style funds with a fixed, eight-to-10-
year life, where a generation may mature at the wrong point in the cycle and everyone could lose money. It’s particularly worth thinking about in an environment where securitisation, the other public way to invest in real estate debt, remains challenged.”

Cane: M-REITs “Good for the sector and the wider economy”

Marion Cane, Ernst & Young executive director and a real estate tax expert, was a prominent mortgage REITs supporter in 2012. While acknowledging that the influx of non-bank lenders has changed the debt market, she points out that there is still not enough property lending in the UK regions, an area where “mortgage REITs would help. They would be good for the sector and for the wider economy in terms of financial stability and greater diversification.”

But a change in legislation is still needed so that interest earned by a mortgage REIT would become qualifying income under the REIT system – an ideological stumbling block for Treasury officials in 2012.

“They didn’t like it being called a REIT, because they think REITs are all about bricks and mortar, and didn’t like what was happening in the US, as the market had been quite volatile there at the time,” says Cane.

What Treasury officials ignored was that residential debt dominates the US mortgage REIT market, whereas the 2012 lobbying was on the premise that UK mortgage REITs would aid commercial real estate.

That premise has not changed, Cane stresses: “There’s still a case for the mortgage REIT. It wouldn’t be huge in volume, but I think it would contribute to the market.”