In our introductory article on REITs, we looked at how the underlying property rental business is taxed, and how the tax position of the fund is effectively transferred to the investors.
In particular, we saw that there is no tax, both on income profits and capital gains at the fund level. The profits are taxed as property income when distributed to the shareholders, while capital gains accrue in the fund, and are only taxed when the shareholders realise their investment.
But what does it take to be a REIT and to qualify for the tax breaks? This is the topic that we explore in this article.
Recall that a REIT is a company that invests in real estate on behalf of its shareholders. It provides investors with access to opportunities that might not otherwise have been open to them individually. By acquiring a single equity holding, an investor is supplied with a ready made property portfolio. The best way to understand the conditions is to ask the following questions:
The main conditions fall into three distinct classes, which we shall look at in turn. These are:
During the course of the following account, we shall mention some of the historic conditions that applied when REITs first came on the scene, but were recently abolished. These modifications have been made in order to lower the barriers to entry for companies wishing to convert to REIT status.
Before we start, it should be pointed out that REIT status is not automatic, even though the conditions are satisfied. The company must actually make an application to HMRC to join the regime1. Likewise, a group of companies that satisfies the conditions for a group REIT, is not a group REIT unless and until it gives notice of its intention to convert.
These conditions deal with the way in which the company is structured, and have no bearing on the way the underlying business is run2. There are six conditions:
We shall now look at some of these conditions in more detail.
When REITs were first introduced to the UK property market, they were required to be listed, rather than admitted on a recognised stock exchange. What's the difference and why is it so important?
In a nutshell, being listed means that the shares must not only be admitted to trading on a recognised exchange, but also be included in the Official List of the UK, or an analogous list in a country outside the UK. This would be the case with shares trading on the London Stock Exchange. However, this doesn't include junior markets such as AIM - while the latter is a recognised exchange, it is not included in the Official List9.
The consequence was that a company intending to operate as a REIT was faced with the compliance burden of a full listing, which can be quite expensive. Since 2012 however, it has become possible to trade on AIM and comparable markets, which are more lightly regulated.
This change in the rules has come about as the requirement for full listing had been perceived as a significant barrier to entry especially for start-up REITs.
Take the example of London and Stamford, which subsequently merged with another company to become LondonMetric. London and Stamford started life as a normal company in the aftermath of the credit crunch, and was set up specifically to take advantage of the slump in property prices. Initially the company was a cash shell, and was AIM listed before moving up to the main market - once on the main market, it was able to convert to REIT status. The effect of the rule change means that companies like London and Stanford can start as a REIT on AIM and stay there as long as they like.
The requirement to be admitted on a recognised stock exchange provides retail investors with the means, not only to buy into the real estate market, but also to make an exit. It is worth comparing the position with direct property investment, and all the attendant hassles involved in buying, managing and selling the assets making up the portfolio. All that a REIT investor needs is an online brokerage account, one click of a button and that's it!
However, the fact that there is a market for REIT shares doesn't in itself guarantee ease of access - it will depend on the particular stock that the investor wishes to buy or sell. For example, the shares of a blue chip company such as British Land will have a higher degree of liquidity than those companies at the smaller end of the market, especially AIM listed companies. This is one factor to bear in mind for investors who wish to explore more specialist sectors as opposed to general REITs.
This requirement reflects the intention that ownership of the property vehicle should be diverse -an investment for all, not just for the more sophisticated investors.
A close company is a company that cannot be controlled by five or fewer persons or "participators"10. The tax definition is a lot more complicated, as it has to cater for a number of situations to ensure that the rules work properly. For example:
The second example makes sense - one looks to the ultimate owners of the company to see whether control is concentrated or widely spread. So subsidiaries of blue chip companies whose shares are traded daily on the London Stock Exchange, are unlikely to be close. The parent company has too many shareholders.
For the purpose of the REIT legislation, the close company definition has been recently modified to ensure that the presence of certain types of institutional investor will not adversely impact the company's status. The list includes pension schemes, life insurance companies, authorised investment funds, as well as charities, social housing associations and sovereign wealth funds13.
Again, this makes sense, on two counts:
The close company requirement has also been relaxed by allowing a REIT to take up to three years to become "un-close"14. This will make it easier to start a REIT from scratch, as with the London and Stamford case, or even to spin out an existing property portfolio which is privately held. For example, a number of investment trusts such as Hansa Trust, or Caledonia, started life as simply being a vehicle for a wealthy family's equity investments - could we see something similar happening in the property world?
These conditions deal with the actual business itself - what does it involve and how is it run? The conditions are15:
The distribution requirement does not however extend to any capital gains made on a property disposal.
Let us look at the first three conditions.
The requirement for three properties is consistent with the need to keep the investment portfolio diversified - investing in a single property means that all the risk is concentrated in one asset. Admittedly, this begs the question whether three properties are sufficient for diversification purposes - but three eggs are certainly better than one.
However, it is still possible for a REIT to own a single building, provided that the property is split up into separate units that are individually let22. For example, a shopping centre or a block of flats, would count as multiple properties - as long as there are at least three units, the condition is satisfied. Of course, a single building still concentrates risk, especially in insurance terms - what if the building burns down? However, the risk that the rents will dry up, has been spread by the fact that there are multiple tenants.
Given that one can split up properties, owner occupation is possible in one sense. The condition is satisfied if an office block split is into several floors, with the owner occupying one floor and letting the rest. This is because the other floors are all treated as independent, provided that they are effectively sealed off from each other.
The "40% condition" is also consistent with the idea that risk should be spread amongst the various assets in the portfolio. One investment principle is that when a holding becomes overvalued, or makes up a substantial part of the portfolio, it is best to sell. However, there are arguments against such a policy. This illustrates that other principle of investment, which is to "run your winners".
One should note that the valuation is on a fair value, rather than a historic cost basis. What this means is that although the condition may have been satisfied when a property was first acquired, it can still fail if the property appreciates in value, to the extent that it dwarfs all the other assets in the portfolio. In other words, one can have a wildly successful investment, but be forced to sell it simply because it has become too successful.
What would be the position if there were five properties, all, except one of which has proved to be a dud? It makes more sense to sell the duds and keep the cash cow, not the other way round. But the more duds that are sold off, the greater does the breach of the "40% condition" become. One could always buy more properties to compensate, but what if there are no suitable investment opportunities available?
REITs are permitted to have a certain level of "residual" activities, such as trading, or property development as opposed to letting. Furthermore, certain types of indirect property investment such as holding shares in other property companies and authorised funds fall into this category.
The residual part of the REIT's business is ring-fenced from the property rental part, and subject to corporation tax in the normal way23. The consequence of the ring-fence is that taxable profits and gains from the residual part cannot be relieved by losses from the rental business24.
But while non-rental activities are permitted, they must not take up a significant portion of the company's profits and balance sheet25. This means that:
One of the most important of the recent changes is to include cash, together with investments in other REITs as an asset relating to the property rental business - even though technically, they might not have this status in other parts of the legislation.
This is a very fundamental and important modification, especially in the case of cash. If one takes a start-up situation, the company is likely to be flush with cash from share subscriptions, but may take time in building up a portfolio. Furthermore, although the company has plenty of cash to spend, there may not necessarily be suitable investments available at the right prices. In the case of Stamford and London, there was a one year waiting period before the first property was acquired.
The above are the basic conditions that should give some idea what a REIT is about - how it is structured, what the boundaries are on its rental business and to what extent it is permitted to go beyond these boundaries.
There are of course, lots of other conditions, which we shall come across in later articles. Two conditions worth noting:
That completes our overview of the basic conditions. We shall come across these conditions and the concepts behind them in later articles in this series.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
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