REITs three years on

Commentaries on the UK REIT sector inevitably start with the disappointing investment returns since REITs were introduced in the UK on January 1, 2007. But the case for REITs was never about guaranteed investment performance. It was about creating a way of investing in property via a vehicle offering much greater liquidity than direct property, but the same effective tax treatment. It was also about attracting new sources of capital into the sector.

For a conversion charge of 2% of the value of our assets, we were allowed to begin a new life as a REIT. And, in less than 3 years, we have already achieved full ‘pay back’ on the conversion charge - which would be regarded as an attractive investment by any measure.

However, the misfortune for REITs was to arrive at a time when the markets were about to witness an unprecedented global downturn. The survival of the REIT regulatory structure against such extreme stress testing is to be welcomed. And in terms of liquidity, it also proved the point that investors in REIT shares have far greater liquidity than investors in direct property. A number of UK general equity funds were very successful in selling down their exposure to UK REITs either before or at the beginning of the downturn - and then reinvesting via Rights Issues, IPOs or through more normal market acquisition of shares.

However, the activities of UK institutional shareholders do not represent new sources of capital. For that, the industry was looking to overseas institutional investors and to private investors.

With the first of these categories, overseas institutional investors, it was clear that international investors looking at property applied a screening process, under which one of the first questions was whether satisfactory REIT legislation was in place in a country? Our experience is that the introduction of REIT legislation in the UK has prompted significantly higher levels of investment by overseas shareholders. Since the beginning of 2005 the international component of our share register has increased from 22% to 39% - a material shift in terms of sources of capital.

Where we have not seen any great change is in the level of investment by private shareholders, whether directly or via retail funds. It was investment by private individuals which drove a lot of the growth of the REIT sectors in both Australia and the USA, but this has so far been absent from the UK market.

There is a general perception that private investors are attracted by high income yields. The question is whether UK REITs should be wholly focused on income yield?

My experience with all forms of investment in property is that the goal is to deliver an attractive total return through a combination of income yield and capital growth. At various stages in the property cycle, the relative emphasis between income yield and capital growth will vary. Investor preferences will also vary according to the tax treatment of capital gains and income; and, of course, current personal taxation in the UK favours capital gains over income.

Historically, there have also been good reasons why the UK property sector has tended to focus more on NAV and less on income yield than our international peers. In some overseas markets the pattern of regular third-party property valuations has not always been the norm. And the high stable yields historically offered by overseas markets naturally play to an income focused REIT structure in a way that the UK market has not.

Our assessment is that the current focus of the market is still on capital growth, and hence NAV growth. We do not see the market moving to valuing property companies by reference to earnings yield until investors are confident about sustainable earnings growth. But with the sharp fall in rental values we have seen, allied to the UK lease structures, portfolios are now typically over-rented which means that income growth from fully leased properties will take some time to come through.

So what are our priorities? We never saw becoming a REIT as a reason to walk away from the essential attributes of making money from property. That is: buy, sell, manage, refurbish and develop. These are the areas where the skills of the business can add value.

At this point in the cycle, with our expertise, the opportunities in our portfolio and our outlook on the West-End rental market, we would be failing investors if we did not take advantage of the superior total returns that developments can offer. And at the same time, these developments will ultimately make a big contribution to our income, delivering a high yield on cost when let.

We will also begin to build earnings growth through the re-letting of vacant space within our portfolio and from earnings accretive acquisitions. However, we may have to wait a little longer for the fundamental driver of portfolio income growth - from rent reviews - to kick back in.

So three years into the arrival of REITs in the UK we can say that the model has achieved many of its aims. We have created a level playing field that has attracted overseas capital, the regulatory system is robust having been tested beyond anyone’s expectations and REITs have given shareholders good liquidity. The debate about the balance between income and capital growth will continue – and there will be ebbs and flows in this debate through the cycle and according to the tax position of investors. We are a property investment business focused on total return, but recognising that income is an important part of total return across our portfolio and for our shareholders.

Source: Land Securities