Real Estate Investment Trust (REIT)

The world’s most tax – efficient vehicle for property investment

Overview

Last year’s (2005) pre-Budget has significantly changed the tax landscape for Real Estate Investment Trust (REIT). Soon abstemious investors may now legitimately avoid some commitments in taxable instruments by utilizing certain Reit structures.

Detailed Structure

The Treasury’s draft legislation is set to address the intensity of property industry in recent years. The new tax-efficient ruling introduces several incentives including:
1. Promoting diversification in real estate investment by engaging in the acquisition, management and sale of residential, retail, hotels and resorts assets.
2. Advocate an accumulation of a pool of money through shares or initial public offerings
3. Reduce corporate-level tax exposure in the conventional construction companies.
4. Give retail investors greater access to property without the risks of direct ownership.
These results can generally be achieved through the formation of Reit: a high-yield investment tool by way of offering “mortgage”, usually finance companies, or issuing “equity” in which mostly, we would be talking and reading in the news. The third, “hybrid”, is a Reit consisted of “mortgage” and “equity” operating structures.
By most measures, Reit features are akin to common unit trusts: accumulation of a pool of money through shares or initial public offering. The only apparent different is Reit generates and regularly distributes income through leasing, renting and selling of property.
Reit will give retail investors greater access to property without the risks of direct ownership although no shareholder will be allowed to own more than ten per cent of a single Reit.

Draft Legislation

Based on the draft framework, Reit will have to apply withholding tax at the basic rate of 22 per cent on the distributions. Higher-rate taxpayers on the other hand, will have to pay any extra tax outstanding.

With the aim of corporation tax free incentive, Reit will also have to distribute 95 per cent of the net taxable profit to shareholders. The net income shall be obtained, not more than 75 per cent from property rents. Only 25 per cent is allowed to derive from development or services.


Likewise, Reit will have limits on how much they can borrow based on an “interest cover test” to ensure they are operating at financially healthy level. This precautious measure would avoid a deleterious effect of over-develop in property market.
The Treasury is expected to favour Reit in tax-free Individual Savings Account (ISA), rather than Self-Invested Personal Pensions (SIPPS). Beyond that, Reit will have to be closed-ended, corporate designated and resident in the UK.


There is no denying the largesse shown by the government. The abstemious investors have waited eagerly as properties are getting pricey. Given that the legislation is on the way, applicable from 1 January 2007, analysts have prophesied the size of property sector to double or even triple.



Others are worried that the market will grow too quickly and like common stock, could fluctuate out of the control, overwhelming the underlying market principle. Despite of the worries, the government expects Reit to start off focused on high-yield stock especially commercial property and gradually to invest more money in residential Reit. How about investors? How should they react on these new legislations?


Given that single assets would not be allowed in a Reit, a subtle investor should allow the portfolio properly diversified. The expected growth factor between residential and healthcare Reit is substantially different. Even though, the latter sector is fairly recession resistant, its dependency on the medical reimbursement from government impeding the possible higher return.


Industrial Reit, on the other hand, tends to generate steady and predictable cash flow albeit in longer terms is highly cyclical.
Second, selective in picking fund managers. Four out of five successful investments are rested on management and their track record in executing the best strategies. The manager’s ability will determine whether the investment will flush with dividends or will be flushed down the toilet.


The most vital item is income distribution facility. It measures the overall performance of REIT since almost 95 per cent will render dividend payout. However, in estimating the value of a Reit, most professional analysts prefer to use an ‘adjusted fund from operations’ in which capital expenditure is not taken into consideration. This treatment offers a better benchmark for a Reit capacity to pay dividends.


With the approval of real estate trusts, savings and properties prepare to gear upward by early next year. Yet, the investors must always remember that Reit is a highly attractive investment where still needs to be evaluated and analysed as such.

Originally published in January 2006