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| South Africas Conversion to REITs |
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The conversion to a best-of-breed REIT (Real Estate Investment Trust) structure is being proactively pursued by the sector
Investment property as an asset class has distinct characteristics. The capital value of investment property assets is typically secure and not volatile, and the trend is for capital values to increase in line with or in excess of prevailing inflation rates. Likewise, investment property produces predictable cash flows escalating in line with or in excess of inflation. Capital stability and reliable cash flows allow for cost-effective gearing against investment grade property. In most conditions, the effect of this gearing is that it reduces the entry price to equity investors in property and enhances the returns to equity investors.
Capital stability, predictable cash flows, attractive income yields relative to other savings investment products and the accessibility of cost-effective gearing for the benefit of equity investors are all factors that make investment grade property suitable for the investment of a nation’s savings, either directly by individual investors or collectively through retirement funds. However, investment grade property is typically too expensive for the ordinary investor, more so on a diversified or portfolio basis.
As a result, the securitisation of interests in property portfolios serves to afford all kinds of investors access to their choice of exposure, focused or diversified, to investment grade property.
But for the accessibility provided by securitised property portfolios, few retail investors would be able to afford investment grade property and exposure to property as an asset class would, for most individuals, not conceivably extend beyond owner-occupied residential property and some indirect exposure through retirement funds.
The benefits of a dynamic, vibrant and successful investment property industry extend beyond the investment attractions and the benefits in respect of a nation’s savings. Construction is labour intensive and provides employment opportunities, both for those skilled in this industry and those whose lack of skills otherwise diminish employment possibilities.
Investment property also has the potential to attract foreign direct investment, as in the case of the V&A Waterfront.
Globally, investment grade property has seen a re-rating in value and a surge in investor demand. The performance of investment grade property internationally has been one of the factors to fuel the move toward listed Reit structures around the world.
The South African investment property sector has delivered attractive returns over the last few years, but does not offer international investors the uniformity and simplicity which would facilitate international investment. In addition, the potential for tax controversy is in itself enough to put off international investors.
The opportunity in South Africa is to establish a best-of-breed Reit vehicle and to provide for a conversion process allowing existing property investment vehicles to choose to convert to a Reit. This would serve to address disadvantages and weaknesses in the investment property vehicles currently in use in South Africa and to give the public face of listed property vehicles the uniformity and simplicity that could serve to attract international capital.
The best-of-breed Reit for South Africa should have certain distinct features. A South African Reit should be designed to optimise flexibility and maximise the access of investors to revenue streams and opportunities related to immovable property. Around the world Reits take many forms, from trusts to companies to combinations thereof. However, for uniformity and simplicity Reits should be carried on in the form of companies incorporated under the Companies Act, 1973.
A corporate Reit could pay dividends and give effect to the flow through principle. This is already in place in our tax legislation as regards dividends of property owning companies held by collective investment schemes in property.
As regards other features of the Reit, the preference for maximum flexibility would entail the following:
• the management of the Reit could be undertaken internally or externally pursuant to a management contract;
• the Reits’ assets and property related activities should not be narrowly circumscribed as long as investments and generation of revenue relates predominantly to immovable property;
• the level of gearing should not be tightly regulated either directly or through stipulation of interest cover ratios;
• the Reit should be able to hold assets including shares in property owning companies and assets in or outside South Africa;
• there should be no limitation regarding the maximum shareholding of any one shareholder or the like. This kind of regulation has previously been attempted in relation to Puts and fell away as it was unworkable in the South African market;
• Reits should be listed or unlisted;
• Reits should not be subject to any regulator or investor protection body other than the JSE Limited, if listed, and the Securities Regulation Panel, as market forces create the correct incentivisation and scrutiny; and
• tax should result in flow-through of both income and capital gains in respect of all revenue and capital gains paid out to shareholders. If not paid out within the applicable tax periods, ordinary corporate tax implications should follow;
• the board (or in the case of a trust or CISP, the trustee or management company, respectively, of the company) in conjunction with the auditors should certify compliance with the criteria for qualifying for Reit tax treatment. Loss of compliance, if not remedied within a period of say one financial year, should result in loss of the Reit status.
These criteria should include:
• the major part, perhaps as much as 90% of income should be paid out; and
• income should be principally derived from or related to immovable property.
Brian Azizollahoff - Redefine Income Fund
Of the countries that have a listed property sector, the overwhelming majority of them have adopted Reit structures. Whereas there are subtle differences between the REIT structures in different countries, the similarity lies in the regulatory and tax features. The underlying principle is that a Reit provides an investor with pre-tax income.
In analyzing the international Reit market, the differences in structures between countries are evident. However, certain common features emerge such as the requirement to invest in property assets, the ability to borrow without limit, the lack of regulatory oversight other than by the respective revenue services and company legislation and the ability to invest in other property companies.
At the Property Loan Stock Association’s (PLSA) conference on Reits, held in 2006, a number of international speakers and investors were in attendance including the doyen of Reits, Sam Zell from the former Equity Property Group, the then largest Reit organisation in the USA. These foreign experts agreed on a number of fundamental principles but the two of greatest importance were, firstly, that “it may look like a duck and it may quack like a duck but if it is not a duck then it is something else”. Secondly, “if you want to play with us then you have to look like us”.
For South Africa to assume its rightful place in the international arena, our property companies need to do more than “quack” like Reits. Both property unit trusts and property loan stocks have elements of Reits but neither of them are in fact Reits. As a sector, we need to work extremely hard to simply “look like them” and to convert to a true Reit-based sector. National Treasury has engaged with the PLSA in a most positive manner and this opportunity is being vigorously pursued.
A Reit based sector will pique international interest in South Africa as our offerings are attractive with quality assets at relatively high yields. That said, international investors will be influenced by size and liquidity and it is arguable that no listed property company yet offers the kind of critical mass or liquidity which will attract fresh capital from offshore investors. Further consolidation is crucial for South Africa to become a global property player.
And what of the case against? Someone else will have to tackle that subject as my view is that there is no case.
Craig Hallowes - Fortress Asset Management
There has recently been a fair amount of media coverage regarding the conversion of property unit trusts (Puts) and property loan stock companies (PLSs) to real estate investment trusts (Reits), but perhaps the issue could use some more clarity.
Reits were originally created in the US in 1960 to afford people the opportunity to invest in large-scale commercial properties in a tax-efficient manner and a legislative framework was set up, within which they could operate. In more recent times, numerous countries, including Australia, Belgium, France, Hong Kong, Japan and Singapore, have established a legal framework for Reits for investing in commercial and residential property, in most instances only in the last ten years. The UK introduced Reits from January 1 this year.
Looking at what constitutes a Reit is easier said than done. Obviously, with tax regimes and laws differing between countries, the structure of a Reit can vary quite markedly between them, so there is no single global entity which bears the name Reit. Rather, there are a host of different Reit structures around the globe.
There are a number of common features, which include the distribution of income from the property investments in the form of a net rental or an interest distribution, which is taxable in the investors’ hands; restrictions on the type of assets in which the trust invests (typically, types of property investments); guidelines on the amount of income that needs to be distributed and limitations on the level of debt on the balance sheet.
Significantly, a Reit is a well-established model for listed property investments and is the prevailing global model.
Typically, Reits are investment structures that have various portfolio mandates, from pure commercial property, such as retail centres, industrial parks and offices to oil-supply pipelines, with favourable tax dispensations in their jurisdictions to allow investors, such as retirement funds, to get the benefit of asset-based income streams without the risk of double taxation in the hands of the Reit and the investor.
The transparent tax structure means that the full net income from the properties flows through to investors, with no corporate tax being paid at the company or trust level. Investors would then pay tax at whatever rate is their own marginal rate.
Although the structure, regulatory issues and tax considerations vary from country to country, Reits the world over offer the same investment proposition – they are total return investments that typically provide relatively high and growing yields in the form of distributions, plus the potential for long-term capital appreciation.
Puts and Reits are, in fact, very similar. Leon Allison, an analyst at Macquarie First South Securities concludes that: “Puts are effectively Reits, (while) PLS is not dissimilar to Reits in other countries, sharing the key characteristic of being tax-transparent property vehicles.”
So converting Puts to Reits would not be a major step for the instruments and should serve the interests of all unitholders.
The Association of Property Unit Trusts is engaging with the Financial Services Board and the trustees of the respective Puts to relax certain of the restrictions currently imposed on Puts, which would result in them becoming de facto Reits. Essentially, the aim is to have greater flexibility in the level of gearing permitted and the potential to own units and shares in other listed funds. These steps would improve the marketability of the listed property sector in South Africa, both locally and internationally, which should have a positive impact on prices.
What a conversion to Reits would do, is bring consistency to the South African market and benchmark it to global best practice, as well as the fact that there is “product equity” in the term “Reit”, which would benefit the listed property sector.
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