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Chapter 1: Introduction
A Real Estate Investment Trust (REIT) is a mode of indirect investment which buys, sells, develops and manages property investments. REITs have an advantage in that they experience gains from certain taxation rules. Before REITs were introduced in the UK in 2007 listed property companies suffered from double taxation, with corporation and investors tax being paid on their dividends. With direct property investment there was only one taxation charge on rental income. In order to alleviate this problem the REIT structure was adopted in the UK, by making companies exempt if they met certain requirements.
The birth of the REIT structure came from the United States and dates back as far as the 1880's. Originally they were simple modes of investment were it enabled investors to avoid double taxation by distributing their income to beneficiaries. In this essence they have not changed however are more heavily regulated than these early days. Although this tax advantage was ended in the US for a period they quickly re-emerged in 1960's, were their structure has been developed since. Certain changes such as allowing pension funds investment access has saw the mode of investment sore.
Although REITs offer advantages of taxation it also has numerous benefits over direct property investment vehicles. The heterogeneity of property can lead to uncertainty about its market value which can be compounded by thin trading in some locations with a lack of transparent data on transaction prices also. Thin trading can lead to delays in the sale and slow legal transfer process. These disadvantages of direct property create the potential for illiquidity and prevent fund managers from actively managing their portfolios. Property also has higher management and transaction costs than the paper asset quality of REITs which can be sold in smaller divisible units. Direct property is “lumpy” in that only the largest financial institutions can afford to buy in any large volume. REITs have the benefit of being a paper asset tradable on major exchanges with their dividend linked to the income from property. Information for REITs are freely available and regulated by accounting policies. REITs also have the benefit of the opportunity for investors to diversify risk in their portfolio. This has the benefits of property but without the difficulties linked to direct property investments.
In the REIT structure there are 3 different types of REITs generally on offer. Equity REITs offer investment trusts where greater than 75% of assets are in the form of direct ownership of income producing properties. These are the most popular form of REIT. Mortgage REITs however deal in the ownership and investment of property mortgages, they loan money to owners of property or invest in existing mortgages or mortgage securities. These are debt instruments were income is generated from the interest they earn on the mortgage loans. A Hybrid REITs combine both equity and debt instrument.
Although REITs appear to offer many advantages in comparison to direct property investment their history in UK since their instigation in the UK has been greatly chequered with the global economic downturn having effected fund values greatly.
The proposition for this paper is;
“Investor confidence in the UK-REIT has been permanently affected by the timing of their introduction to the UK during the recession.”
1.3 Aims and Objectives
Indirect investment in property has been a steadily growing mode of investment in the UK over the previous years. With Real Estate Investment Trusts being introduced to the UK in 2007 my overall research aims to establish the effects recent years have had on investor confidence in UK-REITs performance as an indirect investment mode in portfolios. In order to meet this aim a number of objectives are assembled. These are:
- To look at how the recession has affected investment in property as a whole.
- To compare how direct and indirect investment in property have performed in the UK during the recession.
- To establish whether there is an inherent problem with the structure of UK—REITs or has the recession been the main driver for their underperformance.
- To interview a mixture of fund managers, property investors and general property professionals in order to support theoretical findings of the poor performance of UK-REITs since their introduction and establish any other underlying factors in the UK-REIT system.
1.4 Scope of Study
This research initially involves an overview of the structure of the UK-REIT and its performance history since January 2007. The scope of the study is then further narrowed down, with emphasis on why the UK-REIT has performed poorly supported by interviews to indicate investor's views of the future performance of UK-REITs.
1.5 Structure of Study
Chapter one: Introduction
Introduces the field of this study and states the hypothesis that will be investigated. The chapter also sets out the aims and objectives of the dissertation to “understand the history of REIT performance within the UK and ascertain if investor confidence has been permanently affected by the recession” and concludes with a brief discussion of the methods used.
Chapter two: Research Methodology
States the research methodology utilised to carry out this study. It looks at the various types of research and data that will be employed and how these findings will be analysed.
Chapter 3: Literature Review
This shall look at the generic fundamentals of the UK structure of the REIT in order to establish that the UK-REIT structure is not flawed. It will look at the theoretical determinants of the performance the UK-REIT.
will look at the key findings of the study.
Chapter 2: Research Methodology
The purpose of all research is fundamentally the same and is defined by “seeking through methodical processes to add to one's own body of knowledge and hopefully, to that of others, by the discovery of non trivial facts and insights.” Sharp and Howard (1996)
This chapter shall detail the methods to be implemented during the course of this study. It shall include a brief outline of different methods used; secondary data and primary data along with quantitative and qualitative data. It shall show the process with which the research shall follow, along with its limitations and finally an explanation of how the results can be analysed.
2.2 Types of Research Methods
The different types of research methods used during this study shall be described below.
2.21 Secondary Research
Secondary research involves the summary, collation and or synthesis of existing research. For my dissertation I shall look at a number of sources of secondary research in order to better inform my primary research. I shall use existing academic research on REITs from journals, in order to source such material from the Library catalogue. Textbooks shall provide another academic background to the subject. Articles from publications such as the Financial Times shall provide current views of property professionals. Search engines such as www.google.com and the Google scholar service shall provide further material for this paper. Historic data on the performance of REITs can be sourced from such bodies as the IPD and REITA.org. This quantitative data shall be statistically analysed.
Academic integrity of sources shall have to be taken into consideration when reviewing secondary sources. Academic journals have the Newton metaphor of “standing on the shoulders of giants” in that their material has been reviewed intensively by other academics before being published. However other material may not have such integrity in their views. For example articles are only one persons view point on a subject and thus may not be entirely correct.
2.22 Primary Research
Primary research involves the collection of data that does not already exist. My dissertation shall look to conduct primary research through semi- structured interviews with a mixture of fund managers, property investors and general property professionals. This research shall be in the form of a questionnaire emailed to the individual. The results of which shall be treated ethically following the research ethics guiding principle outlined by Dissertation Guide. This
Chapter 3: Literature Review
This Chapter shall aim to look into the work of previous academics on REITs. Firstly we shall look at depth the generic fundamentals of the UK structure of the REIT in order to establish that the UK-REIT structure is not flawed. Secondly it will look at the place of REITs in a modern portfolio, REITs as an inflation hedge, information transfer between direct and indirect property and REIT sensitivity.
3.2 The UK structure of the REIT
The introduction of REITs in the UK has been long in the making and regarded by many as long overdue. The 2003 Pre-budget report announced that “in line with the interim recommendations of the Barker review, the government has concluded that reform to the tax treatment of property investment would improve liquidity, transparency and scrutiny, provide access to property for long-term savings and could expand the private rented sector” This was the beginnings of the process that concluded with the introduction of Real estate investment trusts in January 2007.
In order to establish a Real Estate Investment Trust structure in the UK the HM Treasury published the Paper “Promoting more flexible investment in property: a consultation” in 2004. The purpose of this paper was to look at the possibilities of REITs in the UK and to look at successful structures which had been implemented in other countries. By looking at these other structures HM Treasury concluded that REIT structures which I had been successfully implement elsewhere were close-ended, publicly listed and internally manage. The Paper also outlined the requirement to distribute a high level of the income to investors, combined with restrictions on debt gearing and development activity permitted. In order for Real Estate Investment Trusts to be instigated in the UK the Government through this paper set out four key objectives for reform:
- “Improving the quality and quantity of finance for investment in commercial and residential property.
- Expanding access to a wider range of savings products on a stable and well regulated basis.
- Protecting all taxpayers by ensuring a fair level of tax is paid by the property sector.
- Supporting the structural change in property markets to reduce costs and improve flexibility and quality for tenants.”
HM Treasury 2004
3.21 UK Structural Features
The paper (HM Treasury, 2004) also outlined structural features that would be vital to the design of any proposed property investment fund for the UK.
Firstly one of the primary objectives for introducing a REIT structure to the UK would be to be listed on the stock exchange. This would expand the opportunity for small investors to invest in a wider range of property. It would also ensure fairness restricting private companies taking advantage of the tax arrangement without delivering some of the wider public benefits. The paper also outlines further benefits to being lists on the stock exchange; ensuring a wide investor base and encourages access to the retail investor. The listed property structure also determines frequent market scrutiny with the regulation structure already place in the stock market ensuring transparency for the investor, whilst also increasing liquidity of the asset type. Another potential advantage would be that the fund might trade closer to its net asset value, which would make it easier to raise new capital on the market.
A second key structural feature of the UK-REIT was to establish if a close-ended or open ended fund structure would be more suitable. An open ended structure could mean that the scheme may have to liquidate asset quickly, at a time which might not be appropriate for the market leading to instability. The nature of property as an illiquid asset and with the requirement of some degree of liquidity to be present in the portfolio causes difficulties in the open ended structure. With the close-ended structure the UK-REIT these difficulties do not arise. If an investor wishes to withdraw an investment they may simply sell shares, where the price reflects market equilibrium for the share.
Thirdly in this early stage of the looking at the possible UK-REIT structure it was decided that there would be a high level of income distribution to investors. This was to ensure that that investors had good returns. However the exact distribution percentage needed to be designed to reflect conditions specific to the UK in order to for there to be sufficient cash to maintain properties in the portfolio.
The report also looked at the levels of borrowing that the property investment fund should be allowed. If there was high borrowing allowed then this would imply high debt service costs, reducing the level of income to investors, perhaps also changing the balance from an income return based investment to a capital value return. With high borrowing, then the structure may resemble that of an ordinary property company.
The report also looks at concern over the development activity in the UK structure. The government had two objectives for this; firstly to encourage greater renewal within the property industry, to develop new commercial and residential property. Also secondly to ensure that the property sector contributes its share of tax, with high levels of income and capital being distributed to investors. With the high distribution costs and borrowing restrictions it was decided that the fund should not be a vehicle which newly developed property would be sold and managed.
In December 2006 HM Revenues and Customs published their pre budget report, outlining the UK- REIT structure that would be implemented in January 2007.
- 90% of the income from the tax exempt business is to be distributed to shareholders within 12 months of the end of the accounting period.
- The company must not be controlled by five or fewer shareholders.
- Shares must be recognised on a recognised stock exchange
- An entry Charge of 2% of the market value of their investment properties is chargeable at the date of conversion
- 75% or more of its assets must take the form of investment property and 75% or more of its income must be rental income.
- The company must not borrow money on terms that are linked to its profits.
- Distributions of UK-REITs tax exempt income are treated as income from property.
- Where a UK-REIT carries on a joint venture, the activities of the joint venture company can be taken into account in deciding if the UK-REIT meets the regime conditions.
- Restrictions on gearing; profits must cover interest payments by at least 1.25times failing this the company will pay corporation tax.
3.3 REITs place in a Portfolio
The place of REITs in a portfolio has been the subject of much debate. Chiang et al. (2002) conducted research into the place of REITs in a contemporary portfolio. It states that the business of investment management is a decentralised, top-down one in which practitioners must estimate the optimal asset class mix. Therefore fund managers must have an understanding of what exactly Real Estate Investment Trusts are at the macro level, in order to be effective in optimising and diversifying their portfolios. If an investment manager was able to mimic the returns of REITs, the less understood REIT would be likely to be operationally redundant. However if the price behaviour of REITs is unique then including REITs into portfolios would be essential and beneficial to practitioners, as their portfolios are further diversified at the macro level. The Chiang et al paper is motivated to provide evidence regarding the benefits of diversification from including REITs in multi asset portfolios without or combined with unsecuritised real estate.
Liang and McIntosh (1998) however include a more complete set of asset classes over a longer period of time in order to derive more conclusive results. The research concluded that REITs are a unique asset class which cannot be mimicked at the macro level by investing in other asset classes. The paper also investigated that styles of REITs can change over time, while the returns remained unique throughout the sample period.
However in a study by Glasgock et al.(2000) claims that previous research only looked at linear relationships and without acknowledging the long run economic effects that may occur. In their study they used integration analysis to examine long term economic relationships among REITs and other markets.
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