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What are REITs and how do they work?

Stepeh-Borg-Calamatta-Cuschieri

Property investments have always enjoyed a certain degree of popularity among Maltese investors looking to diversify their portfolio of assets.  This trend was particularly evident in recent years as a low interest rate environment and an increased volatility in financial markets, corresponded with a boom in the domestic real estate market.  This was driven in part by the growth of a number of niche industries and the consequent influx of foreign nationals seeking to work here.  However, in view of certain features of real estate assets, like the lack of liquidity, lack of transparency as well as the significant capital outlay involved, many investors have not been able to reap completely the benefits of an investment in property.  The solution lies in creating alternative forms of indirect real estate investments already present abroad, amongst which are the so called Real Estate Investment Trusts or REITs.

The case for REITs locally

With this in mind, the Maltese government has in last year’s Budget speech announced its intention to create the necessary regulatory framework for the introduction of REITs on the local market.  To this effect, the Malta Stock Exchange (MSE) has recently issued a consultation document on the subject in order to allow all the parties involved to provide their feedback to the proposed regulatory framework. This proposed legislation is a welcome development for both investors as well as the industry itself.  Through this development, a broader range of investors will now aspire to invest in the real estate market and be able to diversify their portfolio of assets further.  Moreover, REITs provide investors with a liquid and cost-efficient way to earn the investment returns typically available from direct real estate investment without actually having to go out and buy, manage or finance property.

Whilst most of the investment vehicles available locally today are primarily directed towards ‘speculative’ capital gains in the real estate market (e.g. a number of property-related equities listed on the Malta Stock Exchange), REITs will allow for a new asset class to be created, intended to produce rental income to the public.  At the same time, this should also provide property companies with an alternative funding mechanism and liquidity, by being able to collect capital from as many investors as possible.  REITs allow anyone to invest in portfolios of real estate assets in the same way they invest in other industries – through the purchase of individual company shares or an investment fund or an exchange traded fund (ETF).

What are REITs?

REITs are companies that own and manage various types of income-producing real estate properties.  These may include office buildings, shopping malls, apartments, hotels, storage facilities and so on.  These companies, which are often listed and traded on major stock exchanges, earn a stable source of income through the rental of these properties which is then distributed to shareholders in the form of regular dividends.  The companies also offer investors the potential to gain from long term appreciation in value of the property portfolio.

Compared to other listed real estate companies, a REIT does not normally develop real estate properties to resell them.  Instead, a REIT buys and develops properties primarily to operate them, as part of its own investment portfolio.  Also, shares of property development companies are normally much more volatile than those of REITs and tend to pay less in terms of dividend.  Obviously every investment comes with its’ own benefits and risks.  Given their high distribution pay-outs, REITs tend to re-invest less of their profits back into the business which effectively limits their potential for growth.  Moreover, given their high reliance on income as a source of return on investment, REITs are commonly believed to be quite sensitive to fluctuations in interest rates.  In effect, in the current low interest environment, the REITs sector was one of the best performing sectors so far this year.

The REITs concept is very similar to investment funds in that they permit investors of any size to have a share of the ownership of real estate assets that produce income.  The key difference between REITs and unit-linked property funds are that, unlike REITs, funds are not legally required to distribute part of their net property-related income to shareholders, on a yearly basis.  REITs can take the form of sector-specific REITs which invest in one specific real estate sector such as residential properties, retail properties, industrial properties or offices.  Alternatively, they may own a more diversified portfolio of properties, spanning across various real estate sectors.

History of REITs

REITs find their roots in the US some sixty year ago when the US Congress created the REITs structure.  The law gave all Americans the opportunity to invest in large-scale, diversified portfolios of income-producing real estate and earn similar benefits as direct real estate owners, in the same way they typically invest in other asset classes – through the purchase and sale of liquid securities.  This federal law allowed REITs to avoid taxation at the corporate level on income distributed to shareholders and created the basis for the present REITs structures.  Today, nearly 40 countries worldwide, including 13 EU Member States have established a framework for REITs, with more countries in the works.  The US is still by far the largest REITs’ market in the world, representing more than half of the overall market, with Australia, France and the UK following at a distance. There is no EU internal market for REITs and as such EU member states cannot take advantage of a common REITs structure.

A comprehensive index for the REIT and global listed property market is the FTSE EPRA/Nareit Global Real Estate Index Series, which was created in October 2011.  The global index includes 476 stock exchange listed real estate companies from 35 countries representing an equity market capitalisation of about 1.6 trillion US dollars, with approximately 81% of that total from REITs.  The industry struggled in 2007 as the global financial crisis kicked in.  In response, listed REITs responded by deleveraging (paying off debt) and re-capitalising (selling shares to get cash) their balance sheets.

Common REITs’ requirements

To qualify as a REIT, a real estate company must satisfy certain requirements which vary from country to country but which in principle rely on the original regime established by the US many years ago.  As a general principle, all REITs must primarily own income-generating real estate assets for the long term, must be widely held by shareholders and must distribute income to shareholders.   Thus, generally speaking, over three quarters of the overall market value of the assets of a REIT and a similar percentage of the company’s gross revenue must be related to the assets of the property rental business of the REIT.  In most jurisdictions, REITs are permitted to hold assets from foreign jurisdictions, effectively allowing for further diversification.  There are also jurisdictions which specify a minimum capital requirement for REITs at inception and provisions to ensure a minimum level of free float thereafter.

As a common feature, all jurisdictions allow for shareholders to receive a high percentage of the profit made from REITs, with distributions ranging as high as 100% in some jurisdictions.  In return for distributing most or all of their taxable income, REITs are generally exempt from paying any corporate tax on the distributed income.  However, this tax exemption does not normally apply at the individual shareholder’s level, who is generally liable to pay tax on both the dividend and any exempt capital gains received.  Nonetheless, by exempting REITs from corporate tax, the shareholder in such a property company is placed in a comparable position with an investor who owns a property portfolio outright, since the rental stream for such an investor will only be taxed as income.  In other words, corporate tax exemption creates a level playing field between the direct segment and the indirect segment of the property market.

A common feature among European REITs is the requirement for the company in question to be listed within an EU or European Economic Area (EEA) stock exchange.  This requirement is not imposed in the US but still the majority of REITs there are traded on a recognised exchange.  The fact that a majority of REITs’ structures require these companies to be listed, grants additional safeguards to the investor, by ensuring transparency and imposing further reporting disclosure on a frequent basis.  Through REITs, properties are professionally managed, bringing benefits to both shareholders as well as tenants who use the properties being rented out.

The proposed local structure

In the consultation document issued by the Malta Stock Exchange, it is mentioned that for a company to qualify as a REIT, it must first and foremost has its shares listed on the main market of the MSE.    The proposed structure is primarily built on the Irish regime and requires an eligible issuer to distribute not less than 85% of any property related income in each financial year.  At the end of the REIT’s first accounting period, a minimum of 75% of its income, as well as the market value of the assets, must be linked to assets of the property rental business.  After the first three years, the REIT must oversee a property rental business with a minimum of three properties in Malta or abroad.  Each property must not account for more than 40% of the total market value of the properties.  Finally, a Maltese REIT must maintain a loan to value ratio of up to a maximum of 50%.

Conclusion

REITs can play an important part in an investment portfolio.  While some may consider REITs to be similar to either shares or bonds, what makes them a distinct asset class is their differentiated source of returns.  Through the contractual rental obligation of the tenant to the landlord (the REIT company), a stable and predictable income stream is generated.  And through growth in occupancy, increase in rent, or redevelopment of properties, REITs have the ability to grow their income stream.  So, whether through attractive potential total returns, stable and significant income, enhanced diversification, or a hedge against inflation, REITs can serve most investors’ objectives

 

This article was issued by Stephen Borg, Head of Wealth and Fund Management at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.