Recent changes to the UK REIT regime have resulted in a relaxation of the requirements for qualification as a REIT and the reduction of barriers to entry for new REIT vehicles.
After a lengthy consultation process, the Finance Act 2012 (the “Act”) finally received Royal Assent on 17 July 2012. It brings into force a number of measures designed to encourage institutional investment in UK real estate, attract existing property investment companies to convert to REIT status and persuade property managers seeking to launch new UK real estate investment funds to consider the REIT structure as a viable alternative to offshore vehicles.
Since the introduction of REITs in 2007, relatively few companies have taken advantage of registration under the REIT regime. The Act introduces a number of amendments to the REIT rules in an attempt to remove or relax some of its more onerous requirements and to make the REIT structure more attractive both to new funds and to existing investment companies.
Do the changes introduced by the Act go far enough to achieve this purpose and is the “REIT” badge a sufficient draw for property companies and managers to take another look at the regime?
Summary of key amendments
- The 2% entry charge has been abolished. New entrants were previously subject to a charge of 2% of the total market value of their property rental business on conversion. This may tempt a number of offshore property vehicles back onshore.
- The shares which form a REIT’s ordinary share capital are no longer required to be “listed” on a recognised stock exchange (e.g. the Official List or CISX). This means that “unlisted” property investment companies currently traded on recognised stock exchanges, e.g. AIM, will now be eligible for conversion to REIT status.
- The requirement that at least 75% of the value of a REIT’s assets is interests in land (the “balance of business assets” test) has been amended by allowing cash or cash equivalents to be included in the calculation of the 75% figure. Breach of this condition will also now be entirely overlooked for a REIT’s first accounting period.
- A three year grace period has been introduced for new REITs to meet the “close company” condition. Previously, REITs had to comply from the point of entry into the regime, with certain ownership restrictions which broadly prevented the REIT or the principal company of a group REIT from being under the control of five or fewer persons. The fact that a REIT need no longer comply with this condition for the initial three year period means that it will now be possible to bring new REIT vehicles to market prior to obtaining external investment, subject to meeting the requirements of the relevant exchange with regard to free float.
- A company will now avoid falling foul of this condition where it comes under the definition of a “close company” solely on the basis that it has certain institutional investors. This is defined as trustees or managers of unit trusts and pension schemes, persons acting on behalf of collective investment scheme partnerships, OEICs, insurance companies, charities and social landlords.
- The interest cover rule has been relaxed. REITs will still be subject to a tax charge should the income profits of their taxexempt business fail to cover the cost of financing by 1.25 times. However, the definition of “financing costs” has been narrowed. In addition, whilst REITs in breach of the interest cover ratio will still suffer a corporation tax charge, this will now apply to a maximum of 20% of the profits of the taxexempt business.
The amendment of the balance of business assets test to include cash and cash equivalents as qualifying assets should benefit both new entrants to the regime and existing REITs. It enables new vehicles to raise initial funds more readily and, for existing REITs, removes an obstacle to obtaining additional investment. A number of the companies currently registered are hybrid businesses and their number is likely to increase following this change.
The revision of the calculation of the interest cover ratio to limit the costs constituting “finance costs” is an attempt to alleviate the borrowing restrictions on REITs. When taken together with the requirement to distribute 90% of income profits this can leave REITs with reduced cash flow with which to finance property acquisitions. The relaxation of this restriction, coupled with the extension of the time period for distribution of profits by an additional three months, may improve the cash position for REITs and reduce the need to resort to the capital markets for additional funding. However, more could have been done to relax this restriction.
The relaxation of the listing requirement means that all the tax advantages of registration as a REIT will now be available to property investment companies currently trading on markets such as AIM. It also removes the need to meet the stringent requirements and cost of listing for new REIT launches. This has been a significant discouragement for new entrants in the past; approximately 80 per cent. of REITs are companies which were already listed prior to conversion.
Uncertainty is also introduced by the fact that the Act stipulates that, in order to meet the trading requirement, the company’s shares must be “traded” on a recognised stock exchange rather than simply admitted to trading. How this will be applied in practice and how frequently shares will be required to be traded in order to satisfy this rule in respect of any one accounting period is not yet clear. However, for the first three accounting periods the requirements have been relaxed so that the company’s shares need only be traded at some point during the initial three year period as a whole, rather than during each one year accounting period.
Residential and social housing
Although some existing REITs include residential property among their investments, no purely residential REIT has yet been formed. The social housing sector in particular has struggled to attract institutional investment and the majority of its private financing has been delivered in the form of conventional corporate debt. As such funding has become more challenging to arrange in recent years, housing associations have increasingly turned to the capital markets to source debt financing through bond issues. Equity investment has proved more difficult to obtain.
One of the objectives of the reform of the REIT scheme has been to encourage investment in the residential property sector and in social housing in particular. Housing associations were deterred from establishing REITs under the old regime by barriers such as high set-up costs and the new measures certainly go some way to reducing this hurdle.
Another problem for this sector has been that yields have struggled to meet investor expectations as, although they provide an indexlinked revenue stream, the typical returns from social housing property have been considered insufficiently high to attract many institutional investors. More recently, however, investors have shown an increased willingness to accept lower, more secure yields and the reforms to the REIT regime may therefore be particularly timely for this sector.
Perhaps also relevant to the development of residential property REITs is the 15% charge SDLT charge on residential property acquired for more than £2m by non-natural persons (such as companies). This currently catches REITs although we understand that HMRC are considering a carve-out based upon either a “close company” or “genuine diversity of ownership” test.
The amendments have generally been well received. The removal of the conversion charge is welcome and it will be interesting to see what the response will be among property investment companies currently offshore.
The Act addresses many of the problems which initially inhibited take-up of the scheme, making it a far more attractive proposition as a structure for a new vehicle, while the extension of the carveout from the “close company” rule opens the door to a much broader range of potential institutional investors.
Obtaining the REIT “badge” may still be a worthwhile exercise.