InfoBurst. Urban Land Institute UK Residential Council: REITs Seminar. ULI Europe. July 2011

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1 ULI Europe InfoBurst July 2011 Urban Land Institute UK Residential Council: REITs Seminar Adam Challis, Head of Research, Hamptons International Alexandra Notay, Vice President Strategic Programmes, ULI This InfoBurst is a summary of the ULI UK Residential Council s seminar on REITS, held in London in June This select group of 25 leaders from across the UK housing industry is chaired by Nick Jopling, Executive Director of Property at Grainger PLC. ULI is a neutral, non-lobbying and not-for-profit research and education Institute. ULI Councils are formed to share best practice and experience and Council meetings are run under Chatham House rules so no statements in this InfoBurst are attributed. However, a summary of the discussion is provided as a useful addition to the current debate around REITS in the UK. Individuals interested in joining the UK Residential Council are required to be ULI Full Members and should apply to ULI for consideration by the Chair.

2 Introduction The UK Government introduced Real Estate Investment Trust (REIT) enabling legislation on January 1, Initial take-up was encouraging; nine REITs were created that day, with a total of 17 trading by September Like the wider property market, values were severely impacted by the subsequent economic downturn and according to DTZ, the market capitalisation of UK REITs is currently 28.2 billion. Market Context One of the strongest arguments for encouraging an active UK residential REIT market is that it would provide an avenue for institutional investment in residential property. Importantly, with the current low supply of new housing and declining affordability of owner occupation, REITs could also facilitate the construction of purpose-built private rented accommodation. Despite this apparent success, REIT investment has remained solely the purview of the commercial property sector, as no residential REITs have been created in the UK. Nonetheless, residential REITs have proven to be highly popular and successful in other countries, notably in the United States and France where investment totals billion and 52.1 billion respectively. The residential development market has suffered since the economic downturn. It is estimated by Hometrack that there are 260,000 residential units on actively marketed residential schemes that have not begun construction. Housing supply levels are significantly lower than normal averages and more worryingly, fall well short of estimated annual need. Total Units of Housing Completed, per annum The Urban Land Institute UK Residential Council (the Council ) met in June 2011 to consider the reasons why residential REITs have not enjoyed the same level of success as the commercial sector in the UK and to identify the barriers that have prevented the sector from developing. This InfoBurst summarises the salient points from that session. Source: Department of Communities and Local Government The fall in house prices since Q reduced activity in the housing market, made worse by limited mortgage availability for all but the most credit-worthy buyers. On the supply side, traditional sources of development finance from banks have also been severely curtailed. Within this context residential REITs potentially have a role to play by encouraging institutional investors into the sector, providing a new source of money to facilitate the supply of new homes. From an investment performance perspective, residential property has proven to be resilient through the downturn and has provided stronger risk-adjusted returns than other asset classes over the past decade. Some commentators have also suggested that the recent volatility experienced by the commercial property sector has increased the relative attractiveness of residential property. 02

3 In addition, George Osborne made the surprise announcement in the March 2011 budget to also review the structure of UK REITs. Representations from industry were due on June 10th, 2011 and it is anticipated that a response from Government will be provided in September of this year. The legislative structure of UK REITs is summarised in Table 1 and is common to all UK property sectors. Risk vs Reward: 10 Year Total Return vs Standard Deviation i Source: IPD Legislative Context A real challenge for industry stakeholders has been to address the lack of appetite for residential investment from professional investors, despite compelling investment performance figures. It is recognised that the residential investment market is less mature and therefore retains higher perceived risks. However, it is also felt that low yields and a lack of investment scale still remain the main barriers to entry for institutions. In the 2011 Budget, Government took the decision to harmonise Stamp Duty Land Tax (SDLT) for bulk investors of residential property; that is, SDLT will no longer be exercised on the total purchase price of a multiple unit transaction but on the average purchase price across these units. In practice, this has the effect of significantly reducing the SDLT liability to a purchaser. Previously, bulk purchasers would have been forced to pay a disproportionately large SDLT charge relative to individual unit purchasers, negatively impacting the anticipated yield from the investment and reducing its attractiveness. This change will improve the expected returns from large-scale investment in residential and should increase its relative attractiveness as an asset class. i Reward for your risk: the decade to 2010 The Sharpe Ratio identifies the investment performance premium over a risk free return achieved for each unit of risk taken, as measured by the standard deviation of returns. The risk free rate used here is that of 10 year government bonds. These efforts from Government are encouraging for the future prospects of residential REITs in the UK. It has however been noted by stakeholders that there are a wide range of industry perspectives on the outstanding challenges facing the sector. This is because there are a number of different investment models that are under consideration for residential REITs, each emphasising unique opportunities and often relying on particular aspects of the legislation for success. These differing views may confuse the collective voice of the private sector and may be counterproductive. Table 1: REIT Legislative Structure Criteria REIT Treatment Suitable investor type Suitable for marketing to all Not fully tax efficient for offshore investors Open/closed-ended Closed Conversion charge 2% Listing costs Yes Gearing restrictions in vehicle No limit, but 1.25:1 profit: financing ratio Management jurisdiction UK Tax in vehicle PRB: income and gains exempt Residual taxable Potential withholding tax 20% on property income distribution (unless gross recipient) Streaming 2 streams Distribution requirements 90% of PRB income Potential close company issues Yes VAT on management fees Yes SDRT/ SDLT on transfer of units 0.5% ISAable Yes Source: PwC, Berwin Leighton Paisner LLP The following section will outline some of the challenges that have prevented residential REIT investment to date and considers how the current legislation contributes to the viability of the proposed investment models. 03

4 Challenges Affecting Residential REITs As noted previously, one of the most important benefits of an attractive residential REIT structure is the opportunity to encourage new sources of money into the sector. The commercial property sector has had success in this respect, however residential property investment has very different attributes that have not been reflected in a one size fits all legislative structure. From an investment perspective, there are a number of distinctions that make the residential property sector different from commercial property. These differences are summarised in Table 2: Table 2: Investment Comparison, Commercial vs Residential Commercial Residential Notes on Residential Valuation basis Yield Vacant possession Discount up to 30% for tenanted property Market value driven Supply & demand Supply & demand by of occupiers of purchasers Primary source of Rental income Sale proceeds May require trading to investor returns deliver investor returns Gross Yield 5-7% 0-6% Varies on tenure type as well as market forces Gross Net leakage 10% 25-35% Higher management costs Net Yield % 0-4% Net yield may not cover interest payments Source: Augmented from Grainger PLC To summarise the main differences: Trading Returns Model: Unlike commercial property, returns from residential investments have traditionally been heavily weighted towards capital growth rather than income. As a result, existing property investors that might have considered converting to residential REIT status are typically reliant on a trading model. This means that cash flow (for reinvestment, operational needs or potential distribution to shareholders) disproportionately comes from selling properties in order to realise capital growth in the asset. The REIT requirement that limits the trading of underlying assets makes this traditional approach to residential investment unsuitable for conversion to REIT status. Levels of Debt: existing residential investors have traditionally relied upon high levels of debt. High debt interest charges relative to rental income has meant that the interest cover ratio of 1.25:1 (profit before interest and capital allowances: financing costs) required under REIT legislation is also a barrier to entry, particularly for many firms that were using optimum leverage before the downturn. This issue does not necessarily require legislative changes, but it will take time for investors to adjust the profit/ debt mix of their investments in order to qualify for REIT status. Investment Scale: Institutions require large-scale investment opportunities in order to absorb transaction costs (which negatively impact on the yield) and drive efficiencies in management of properties. Large residential investment portfolios are relatively rare, limiting the scope to build up this type of investment opportunity. In comparison, commercial property investments are on average much larger and more readily available at an appropriate scale for institutions. Entrenched Alternatives: The commercial property investment market is much more mature, ensuring that investors are familiar with the asset types and investment opportunities. By comparison, residential investment is still undergoing an education process in order to satisfy the concerns of unfamiliar investors, representing an additional hurdle. Management Perceptions: Although there are a large number of specialist and highly professional residential property managers in the UK, they do not enjoy the same brand equity as their commercial counterparts. Institutional investors are unlikely to be skilled as active residential property managers, so the perception of a lack of suitable managers is a potential barrier. As was recently recommended in the Mayor of London s Housing Market Task Force, an industry kitemark or seal of approval could provide the necessary reassurance of residential property management quality. There is an additional issue in this respect concerning a preference for internal management vs outsourcing. External managers would likely be required for residential REITs, as most institutional investors are unlikely to have the in-house management capacity for UK residential property. However, this can be perceived as being more expensive, further reducing the investment income return. Fund managers also prefer a higher degree of investment control, which would be diluted through arms-length property management. VAT Charged on Refurbishment: Unlike commercial property, residential properties must be maintained on an ongoing basis with the cost being borne by the landlord, representing a considerable leakage to the gross income. In addition, this significant expense is subject to VAT, again differing from refurbishment works on commercial premises that are VAT recoverable. There are further considerations required when comparing the conversion of existing residential investment portfolios to REITs against the development of new build stock expressly for the purpose of inclusion in a REIT. 04

5 Urban Land Institute 29 Gloucester Place London W1U 8HX United Kingdom Tel: +44 (0) Fax: +44 (0) Web: Purpose-build REIT stock may represent a more compelling opportunity for Government by facilitating residential construction, however this approach is not without its own hurdles. Some of the more significant risks for institutional investors include: A reluctance by core institutional investors to take any development risk The void risk associated with the period of letting all units once the building is completed Timing disconnect between the initial commitment to invest and income returns from rents Conversion charge of two percent, as the buildings have not built up a capital gains tax liability that normally provides the incentive for REIT conversion. Collectively, these issues have proven insurmountable for purpose-built residential REITs. Some of the issues are inherent within the market and will be for the industry to find appropriate solutions. For Government, it may be appropriate to revisit the two percent conversion charge, which they may consider worthwhile if a change leads to increased volumes of residential stock development. The Future for REITs in the UK Despite some of the challenges that have to date prevented UK residential REITs from flourishing, there is a strong sense amongst industry stakeholders that conditions are nearly right for the sector to become viable. Legislation has played a part, but market conditions have principally prevented the residential sector from attracting institutional investment at scale to date. The opportunity for the UK is significant. Institutional investment can become a new source of funding to the sector and a panacea for the weak new build market. This is important for two main reasons: first, the current shortfall in the supply of new properties is likely to exacerbate future house price inflation and reduce social mobility, as need is well beyond the current level. Secondly, every house built in the UK contributes 1.5 full-time equivalent jobs, with the housebuilding industry contributing three percent to UK GDP ii. However, the benefits are not likely to end there. A viable access point for institutional investment in residential will increase the sophistication and quality of property management, potentially facilitating the creation of purpose-built private rented stock. The private rented sector is likely to become the second largest tenure type in the UK by 2012, having experienced an astonishing growth rate over the past decade and representing a home for approximately four million households in England alone iii. These trends are expected to strengthen in the foreseeable future. Residential REITs may also offer an alternative funding source for Register Providers (RPs). Although investment models for this sector are still evolving, there is precedence from continental Europe that shows the benefits from private investment within the affordable rent sector. With severe cuts from Government sources for the construction of new affordable properties, RPs will need to identify commercial opportunities in the private sector in order to continue to create new supply for the 1.75 million households on Social Housing Waiting Lists iv. In short, a vibrant residential REIT sector can be the vehicle that links institutional or private finance with housing delivery. This link is badly needed to shore up new supply of housing and ensure that private rental property is fit for purpose, including professional management with an interest in the long-term quality of life for tenants. To achieve this, industry stakeholders still have further work to do in order to clarify the opportunity for investors and to highlight the benefits to all. Government also has a role to play by acknowledging the significant benefits that REITs can offer to the UK. It may also need to make appropriate legislative alterations, using industry guidance, to ensure that residential REITs can make a vital contribution to the housing market. ii House Builders Federation: Building a Recovery, December 2010 iii Hamptons International forecasts iv ibid About the Urban Land Institute ULI the Urban Land Institute is a non-profit research and education organisation supported by its members. Founded in Chicago in 1936, the institute now has over 30,000 members in 95 countries worldwide, representing the entire spectrum of land use and real estate development disciplines and working in private enterprise and public service. In Europe, we have over 2,000 members supported by a regional office in London and a small team in Frankfurt. 05