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A history of REITs - real estate investment trusts

Insight 17 May 2021

A history of REITs - real estate investment trusts

As we wish a happy 60th birthday to the first Real Estate Investment Trusts, born in the USA at the start of the 1960s, it seemed fitting to reflect on the history of the REIT regime and how it has evolved over those six decades.

The History

Way back when, the goal of President Eisenhower and his lawmakers was to open up opportunities to regular Americans for investment in large-scale, high-quality and professionally managed, income-producing commercial real estate. This had previously only really been possible for professional financial intermediaries or the very wealthy. By exempting the REIT from tax, the new regime was designed to put those regular Americans in a position where, from a tax perspective anyway, it was as if they held the property directly. It was an important feature then and remains so now, that to ensure the regime’s benefit is passed on to the ultimate investors, the majority of the REIT’s tax exempt income is distributed.

That fundamental objective and approach continue to be the key features of most REIT regimes worldwide. After the US, the Netherlands was next to launch its equivalent regime, FBI, in 1969, closely followed by Puerto Rico’s REIT in 1972. After that, a bit of a lull before Australia introduced new Unit Trust legislation in 1985. From there, a short journey north up the Java Sea to Singapore, the first Asian country to introduce REIT legislation in 1999. However, despite Singapore’s preparedness, the first Asian REITs appeared in Japan in 2001, taking the number of global regimes to around a dozen, with the first S-REIT only springing up in 2002.”

Simon Vardon
Global Head of Real Assets

More than 22 countries followed suit during the first decade of the new millennium, including France, Spain and the UK, where REITs have all been well adopted. Some countries, such as those three, have fought to keep pace with evolving markets.

They have reacted to economic change and legislators have updated their REIT law, iteratively, to preserve the REITs’ attractiveness and to promote investment and economic stimulation. Changes to REIT legislation over the years has meant that, in certain countries such as the UK, it is much more common now to see single owner or joint venture REITs with sophisticated, institutional investors rather than the originally envisaged average man or woman on the street.

The UK-based Centre for Economics and Business Research said recently, that as a result of China’s response to the Covid-19 pandemic, its economy will overtake the US by 2028, five years earlier than previously forecast. In addition, it has been said that within the next decade China’s REIT market will dwarf the US market, which currently has nearly 200 REITs. Therefore for China, a country where there is still a vast and growing wealth gap, there is a huge opportunity for the C-REIT, as it matures, to deliver on that fundamental REIT objective to provide quality investment options to ordinary people.

That said, the C-REIT pilot scheme rules are narrow. They are specifically aimed at infrastructure, and the stated objectives are not to open up investment to all, but to provide an alternative funding tool to facilitate investment in infrastructure projects, to reduce local governments’ exposure to debt and to boost domestic Chinese capital markets.”

Jo Cox
Real Estate Senior Tax Manager - PwC UK

The first C-REIT shares are expected to be offered to a small number of institutional investors only. It is therefore still early days for the baby of the REIT family; but expectations are still high and the world watches with interest as it prepares to take its first tentative steps.

Key Features

The OECD, recognising the importance of the REIT market in globalising investments, carried out a detailed review in 2006 of cross-border tax issues for REITs. In their report titled “Tax Treaty Issues Related to REITs” they describe a REIT as being “a widely held company, trust or contractual or fiduciary arrangement that derives its income primarily from long-term investment in immovable property (real estate), distributes most of that income annually and does not pay income tax on income related to immovable property that is so distributed”.

From a tax perspective and for investors, perhaps the dominant feature of all REITs is that the REIT itself is not subject to tax on its property rental income (e.g. by exemption or via a deduction for distributions made). Instead REITs are either transparent for tax purposes or their investors are taxed on the distributions they receive according to their own tax profile (that bit is important and we will come back to it later on).

The OECD found that in some countries REITs were developed using the tax rules generally applicable to trusts and companies; in others, they developed a specific REIT tax regime. As a result there are significant variances in how countries structure their REITs and how the tax exemption for property rental income is provided.

Let’s look at some examples:

This requirement is designed to encourage the widespread investment in real estate just as the US legislators had intended in 1960. In some countries, like the UK, there are now exemptions from the widely held condition which allow investment by institutional investors, and in others such as the US there are rules specifying the minimum number of shareholders and the number who together can control the REIT.

The range of rules determining what is widely held and what is close differ significantly from place to place. The UK for example considers a listed, traded, company which has 35% of its shares ‘held by the public’ to be widely held. In contrast, in Belgium there are no conditions relating to the REIT’s shareholdings, however the Belgian authorities specify that the REIT must be listed on a Belgian stock exchange which itself has a free float requirement of 30%.

The UK is currently consulting on whether it should wholly or partially remove the REIT listing requirement. Originally it was believed that the additional financial rigour required to list a company should offer a higher level of protection to relatively unsophisticated retail investors. However, now that Institutional Investors can set up ‘captive’ REITs this calls into question whether it is still appropriate. The new captive REITs are often listed on The International Stock Exchange (‘TISE’) in the Channel Islands. The TISE listing is convenient as TISE does not require there to be a free float or any trading of the shares.

There is also significant variation in what percentage of the REIT’s investments must be ‘property rental business’ assets (to use the UK-REIT vernacular). Comparing the jurisdictions, 75% is a popular choice, but others have a higher threshold (e.g. Israel at 95%) and some require 100% of assets to be of an approved sort, with a white-list of options set out in the rules and limits on each of those sub-categories (e.g. Bulgaria).

It should come as no surprise to hear that there is, again, much regional variation on how much of its income the REIT must pay out. The modal average is 90% but there are much lower examples, such as Greece which only requires 50% to be distributed. Greece is amongst those countries along with the UK, which do not require capital gains to be distributed. Other jurisdictions, also looking to promote reinvestment, will only require the distribution (and therefore taxation) of gains where proceeds are not reinvested within a set period of time (e.g. The Philippines).

In addition to differences in those fundamental characteristics there are other jurisdictional nuances. REIT regimes will often have rules controlling:

  • gearing or interest levels
  • the type and location of assets
  • whether REIT shares/units need to be listed
  • the level of permitted property development or other non-core activity

REITs are now a globally recognised investment platform for investment into real estate. As mentioned above, today around 45 or so jurisdictions have REITs, or REIT equivalents, including all the G7 nations. The US body, NAREIT, the National Association of Real Estate Investment Funds, was formed in 1960. Its European sister the European Public Real Estate Association EPRA was formed in 1969 and APREA, the Asian Pacific Real Estate Association in 2005. All represent and promote the interests of REITs and listed real estate companies.

The FTSE EPRA/NAREIT Global Real Estate Index Series (the “Index”), created in October 2001, is a widely used index for REITs.

REITs are primarily an income product in part because of the minimum distribution requirement. Those listed and traded on international stock exchanges have played an important part in providing retail and institutional investors access to the steady income returns which real estate portfolios can deliver. At the time of writing, the Index comprises 492 listed real estate companies representing a market capitalisation of $1.5 trillion. The growth in REIT platforms has been fuelled as allocations to alternative assets, including real estate, have steadily risen for the largest institutional investors, such as pension funds, in the past two decades. REITs have benefited, either directly as the targeted investment, or complementing a real estate portfolio, often providing the more liquid portion.

REIT structures are vulnerable to many of the same risks as direct investment into real estate, so an understanding of the underlying asset class and sub-sectors is important for any prospective investor. One of the benefits of a REIT compared with other investments such as open ended funds is the liquidity offered to investors without the need for the fund to dispose of illiquid assets or keep a reserve of more liquid investments to fund potential redemptions.

An analysis of the pricing of REITs can occasionally return some strange results. Some REITs have been trading at very deep discounts to the net asset value of the portfolios they hold. Such pricing discounts may arise where market participants are sceptical of the underlying values and sector risks but also listed shares are often affected by the underlying market conditions.

In recent times this has been most pronounced with REITs which have invested in retail, leisure and hospitality assets. Understanding this apparent pricing arbitrage (or premium) is important prior to making
any investment.

Whilst many jurisdictions allow for private REITs (neither listed nor traded), the fact that many REITs are listed does provide an association of good or better governance for the REIT brand. The debate about the relative pros and cons of internally or externally managed REITs and the associated impact on the quality of REIT governance and performance rumbles on. In some of the emerging market locations, the higher standards of corporate governance that are to be found with, for example the Singapore REIT (S-REIT), have helped it become established as a product which can attract international capital. Nevertheless, recent studies in Singapore have shown that whilst better governance can decrease share price volatility, not surprisingly it does not necessarily lead to superior financial performance.

Today REITs offer a global brand. From a taxation view, there are also a number of international treaty relationships and taxation provisions which enhance the investment proposition for the REIT.

The fact that the REIT pays no tax on property rental income and that the ultimate investor is taxed on this income as if they held the property directly means that investors from different jurisdictions, or with different tax profiles can invest alongside one another. In order to ensure that tax is collected (self-assessment regimes are not fail-safe after all), most REIT regimes impose a withholding tax on their distributions.

In particular the withholding tax ultimately suffered on distributions from a REIT may be lower than the effective tax rate for investors had they invested directly. For example the withholding tax rate on dividends paid by US corporations to non-US shareholders is 30%.

However under the reciprocal tax treaty between the US and UK in 2003 UK pension funds may invest in US REITs (up to a maximum holding of 10%) at an effective zero rate. In addition to many treaties having an effective tax rate on dividends lower than local taxes on income, this zero withholding tax treaty provision (subject to a maximum holding limit in some cases) has been widely replicated bilaterally in other treaties. As jurisdictions seek to be attractive to the international flows of institutional capital, increasingly international investors may be encouraged to invest in local property markets through, or by establishing, REITs.

Although Japan (which now has nearly 70 REITs) flourished early on, in recent times Singapore has become the dominant Asian REIT (with around 40 now) for pan-Asian investment, and S-REITs have started to invest globally.  Where this has taken place, S-REITs have set up regional investment platforms specific to the portfolio of assets.

The question of how investors and fund managers should structure portfolios across multiple jurisdictions is an interesting and sometimes challenging one. Some countries, like the UK, now allow for investments in REITs by other REITs and allow UK REITs to be controlled by “equivalent” overseas REITs. This double-REIT structure makes sense in theory because investment in a particular jurisdiction is rewarded via the local REIT exemption, so you would expect a level of efficiency by selecting the approved vehicle to hold assets in a particular country. In some cases this can work, however, on occasion this can come unstuck according to the interaction of the relevant treaty and domestic law. In certain unfortunate circumstances, rather than the attractive treaty rate they might expect, the ultimate investors could end up worse off than if they had invested directly into two separate REITs.

For the most part however, REITs offer a well understood and tax efficient way of investing in property. There can be other benefits too; when a UK REIT acquires UK real estate via a corporate acquisition the property values are rebased. This is so that REIT shareholders are only taxed on distributions of gains arising within the REIT’s period of ownership.

REITs have already played a big part in society through the democratisation of asset ownership, and now, given the assets they collectively control and with the climate crisis upon us, REITs will have another important societal role to play in the requisite ESG agenda. We may also see countries increase the range of asset classes which REITs are able to hold and broaden permitted activity to allow for wider real assets projects and therefore will have a significant role as governments seek to meet their ESG targets.

The future looks bright for the REIT, 60 years young.

Let's talk... If you would like to know more, please contact Simon or Jo.

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