Markets & Finance

Real Estate: Britain, Germany Get It REIT


From Standard & Poor's RatingsDirect

The likely introduction of real estate investment trust (REIT) regimes in Britain and Germany over the coming year represents landmark events in the European real estate market, as these are by far, two of the largest markets in Europe. This is expected to significantly increase the number of listed real estate companies in Europe, which will increase alternative real estate investment opportunities for individuals and institutional investors.

The establishment of tax-efficient, REIT-type regimes in Europe is nothing new, however. The Netherlands introduced its system in 1969, and other countries in Central and Southern Europe have been early adopters. Standard & Poor's Ratings Services already rates seven European real estate companies operating on a tax-exempt basis under REIT regimes.

A typical REIT is an equity-oriented, tax-efficient vehicle that allow investors to pool funds for indirect participation in real estate ownership or financing. "REIT" is the abbreviation for the U.S. tax-efficient real estate vehicle that was initiated in the 1960s, and is used as a common term for these types of entities worldwide.

LISTINGS SURGE. The free-float market capitalization of listed real estate companies in Europe -- at more than €100 billion -- is relatively small compared with other regional markets, and only about 30% of these companies operate under REIT legislation. The REIT system is well established in the U.S., and most large Asian economies have introduced a REIT regime over the past decade.

The introduction of REITs has in all cases led to a surge in real estate listings in these countries. The introduction of REIT regimes in Britain and Germany could garner more than $100 billion in additional market capital over the next five years alone, and is likely to result in increased capital market activity for the European real estate sector.

Tax-efficient vehicles are seen as an important tool for stimulating the growth and development of a listed real estate investment market. The establishment of a liquid and transparent real estate equity investment class provides access for small investors to participate in commercial property, which is characterized by stable rental returns and predictable distribution returns.

PRESENT PROBLEMS. Direct investments in commercial real estate are heavily capital-intensive and burdened by administrative costs and leasing campaigns, which make them available only to large investors such as real estate companies, funds, and financial institutions. Real estate funds, such as the open-end, closed-end fund system in Germany, have provided access for small scale investment.

But it is a system plagued by structural problems, such as the relative illiquid nature of closed-end fund shares and problems with immediate redemption requirements of open-ended funds (open-ended funds are required to redeem shares at the investor's wish with an asset base that is illiquid, leading to severe liquidity problems at many funds). An introduction of a REIT system should help resolve these issues in the German real estate market.

Listed British property investment companies have historically been trading at a deep discount to net asset value (NAV), which has made the issuance of new capital and the search for attractive asset acquisitions difficult. The introduction of UK-REITs is likely to lead to property shares' discount to NAV being heavily reduced, or even to them trading at a premium to asset value. This would increase the attractiveness of real estate investments and improve liquidity and access to capital.

BUY-AND-HOLD. The British government recently revisited its proposal to introduce tax-transparent UK-REITs by Jan. 1, 2007, introducing a far more flexible regulatory package than the initial proposal to qualify for tax exemption. The proposed German G-REIT regime is well-defined, but the change in government in autumn 2005 has led to a slight delay in the implementation of the system.

There is a high probability, however, that the system will be introduced toward the end of 2006 or at the beginning of 2007. The main creditor-friendly element of this proposal is the limit on disposal of assets, encouraging a more passive buy-and-hold strategy, which should lead to a more predictable revenue stream.

GREATER DEMAND. The tax status of non-REIT European property companies has put companies under significant pressure from shareholders to increase both operating and financial leverage to boost return on capital in the light of falling yields. Tax-paying property companies have to create value for their shareholders by either taking on more debt or increasing their property development activities, or both, as these activities, while carrying more risks, offer greater rewards than traditional rent collecting.

Ultimately, tax-exempt status should enable property companies to enjoy better equity performance while maintaining a fairly conservative approach (that is, holding assets for the long term and limiting exposure to speculative developments). The introduction of REITs in Europe's two largest markets could raise greater awareness -- and demand -- for these vehicles in the years ahead.


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