What investors need to know about Real Estate Investment Trusts.
Today, a few short years after their introduction, Real Estate Investment Trusts (REITs) dominate the property sector of the UK stock market.
The total market capitalisation of REITs is over £20bn, whilst non-REIT property companies and investment trusts together add up to about £7bn. In the official FTSE industry sectors, REITs even have their own sub-sector in recognition of their unique characteristics.
REITs were launched in the UK on 1 January 2007, in the wake of legislation enacted by the Finance Act 2006.
Before the REIT regime was introduced shareholders in quoted property companies suffered from double taxation. Their company paid corporation tax and they themselves paid income tax on their dividends. As such, they were disadvantaged compared to direct investors in property, for example buy-to-let buyers, who only had to pay tax on rental income.
The broad effect of the REIT legislation was to equalise the tax treatment of direct and indirect property investment. Companies which qualified for entry -- at a cost of 2% of the market value of their rental properties -- became exempt from corporation tax on their rental income and any capital gains made in the course of carrying out their property rental business.
A number of FTSE companies immediately converted to REIT status, and many others have since followed suit.
To be eligible for REIT status, a company has to meet a number of conditions. The main ones, from an investor's perspective, are:
- the company must be tax resident in the UK;
- it must be listed on a 'recognised stock exchange' (excludes AIM);
- at least 75% of its assets and gross profits must relate to its property rental business;
- the property rental business must consist of at least three properties, with no single property representing more than 40% of the total value of the properties in the rental business; and
- it must distribute at least 90% of its tax-exempt profits to shareholders.
In addition to affording shareholders a similar tax treatment to direct investors, REITs offer other attractions:
- only a small capital sum required, compared to purchasing a property directly;
- the opportunity to spread risk by investing in multiple properties and parts of the market that are otherwise very difficult for private investors to access, such as shopping centres and industrial estates;
- liquidity of shares versus illiquidity of direct property holdings; and
- lower transaction costs.
Property Income Distributions
The 90%+ of the tax-exempt profits that REITs are required to pay out to shareholders are known as Property Income Distributions (PIDs). A PID can include distributions of capital gains on disposals of assets involved in the property rental business as well as the tax-exempt rental income.
Shareholders are taxed on the PID at their normal income tax rate. Basic rate tax of 20% is deducted from the PID at source, with a tax credit given for that amount. As such, a non-taxpayer can reclaim the 20%, whilst a higher rate taxpayer will have additional tax to pay.
Most companies that convert to REIT status end up with a residual non-tax-exempt part to their business, consisting of property development or trading. In addition to the PID, the company may pay out a discretionary ordinary dividend from the profits of this part of the business. In the case of the ordinary dividend, the tax treatment is the same as for the dividend of any other company.
The introduction of the REIT regime sucked in many new investors, attracted by the income potential, and gave a final big puff to the noughties property bubble, before it was exploded by the credit crunch and recession.
Most REITs saw precipitous falls in their share prices, slashed their dividends and tapped shareholders for cash to rebuild their balance sheets.
However, for investors looking at the sector today, REITs are generally far more robust than they ever were pre-credit crunch, ratings are more modest, and lessons about over-leveraging, one would hope, have been learnt.
There are currently 16 REITs listed in the FTSE All-Share index:
More on property companies:
> G A Chester holds shares in A&J Mucklow.
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