Melanie Stern is section editor of Families in Business magazine.
UK REITs could offer families the liquidity and diversification they search for without the hair-raising volatility of hedge funds and conventional stocks, says Melanie Stern
With the failure of the UK Government's housing investment trusts (HIT) in mind, the Treasury is taking its time consulting investors and industry players about what form the country's proposed answer to the US' real estate investment trust (REIT) would take, and in particular whether their tax treatment will be favourable for the buy-side.
British family offices are excited about the prospect of property investment funds (PIFs) because of the liquidity aspect of what is proposed to be a stock exchange-listed product. But unless the tax structure of the products compete sufficiently with unit trusts – currently the next best thing to a PIF, and usually a private entity – and are more attractive than existing offshore routes to property investment, observers fear the movement will be 'still-born'.
The first PIFs were supposed to be available next Spring, but observers think there will be nothing ready to invest in until as late as 2007.
"The intention is that the vehicle will have a sensible tax treatment," explains Mark Watterson, UK tax expert with lawyers Freshfield Bruckhaus Deringer. "Exemption from capital gains and an effective exemption from tax on real estate income, both of which might be achieved by forcing the PIF to distribute its income in a deductible form like taxable income on the way in, and deductible distribution on the way out. There is still a lot of consultation to be done." High up on the list will be the concern that the Government will only introduce PIFs if they will not result in any cost to the Exchequer. Without going into the minutiae, this could mean that some of the most attractive elements of any offshore property investment vehicle will not be possible to replicate in a PIF.
HITs were introduced in the early 1990s to channel investment into residential property, They failed because laws required that funds could only hold properties to the value of £185,000, or £125,000 in London, making them far too small to be of interest to institutional or wealth-backed investors.
At least the reason for the Treasury to offer PIFs and the impetus for UK family offices to take them up is the same; the former wants to increase liquidity in the country's property sector, while the latter want that liquidity for their portfolios and to supplement their dividends.
"The property sector is important to our families, who have substantial investment in it through their own homes or commercial holdings, but you need an awful lot of money to do that," says William Drake, a partner at UK multi-family office Lord North Street, which manages £1bn of family wealth. "If you don't have that cash as a family, you'll tend to achieve portfolio diversification by investing in funds instead, but current UK offerings have high fees and do not offer much liquidity, so we see PIFs as potentially a very interesting way round that."
As well as being able to invest in a PIF, some observers think that British families who own multiple properties will consider converting those portfolios into PIFs. This could make sense for families that own commercial properties, such as chains of stores, to maximise on those assets and provide another income. "There is an opportunity for family businesses here," says Watterson's partner and real estate expert at Freshfields, Chris Morris. "We don't yet know to what extent the Government will ask these vehicles to diversify their portfolio and management – for example it might not be OK for Sainsbury's to put all their stores in a PIF and manage that as a listed company – but perhaps they could list and then rent the space out."
The laws surrounding UK stamp duty land tax (SDLT) changed earlier this year to a 4% charge on investment in, or transfer of an investment vehicle to a PIF, in order to close up the use of limited partnerships in UK property holdings. This pushed more funds offshore and in many cases through unit trusts – so in its aim to claw those monies back, it is in the Treasury's interest to make PIFs competitive with property investment funds, like those in Guernsey in order to attract vehicles such as family offices.
Additionally, because British property stocks have not had the tax exemption status of US REITs, awarded in exchange for REITs distributing between 85–90% of their earnings to shareholders by dividend, they have traded at a discount to net asset value (NAV).
The market is looking for a total tax exemption for PIFs which would bring the products closer to an opportunity of trading at NAV.
"Tax-exempt funds must be able to invest knowing their returns from UK REITs will be free of direct tax, just like their returns from direct investment in UK real estate," says real estate tax expert Lee Nuttall of UK law firm Wragge & Co, who has been campaigning for progress in developing PIFs. "[With 4% SDLT] there is little incentive for new investment."
In response to the consultation paper issued by the Treasury, property market think-tank Urban land Institute has suggested an 0.5% SDLT charge.
One of the strongest lines the Government's proposals have taken is that all PIFs should be listed, so they can be closely regulated and managed, and to keep an eye on the tax coming off them. Many think this should be flexible to allow private PIFs just as in the US, and in the case of family offices, a listed entity of this sort might look too risky even if it does offer good liquidity – additionally, the perceived cost of listing for a PIF might have a knock-on effect on investor costs or returns, again making them untenable.
However, Lord North Street's Drake thinks his clients are more attracted to the potential upside than put off by the potential downside. "There are already a number of private property funds – such as Delancey – and there are UK or international ones UK family offices can choose from," says Drake. "But if you wanted liquidity and the option of selling out of a PIF quickly, then listing them is the only way to go.
"Also, PIFs will provide a way to diversify from one's own physical portfolio of properties into larger, more lucrative assets like shopping centres, giving families so much more choice. Our families like a lot of diversification so I think PIFs would fill that gap well."