By Theodore Murphy

Chancellor of the Exchequer Gordon Brown (the U.K. equivalent to Secretary of the Treasury) handed a boon to the U.K. property industry in late March when he announced eased rules for the introduction of REITs.

Presenting his 10th budget, Brown allayed fears that his REIT legislation would be less than favorable for most would-be converters. Rather than basing the conversion charge on capital gains, as many in the real estate industry feared, Brown said that property companies will be charged 2 percent of the gross market value of their investment assets upon conversion. The report released after the speech showed a range of other positive moves, including a reduction of the minimum interest cover test from 2.5 times to 1.25 times on a pre-capital allowance basis, a lowering of the minimum required profit distribution rate from 95 percent to 90 percent, and an easing of rules concerning shareholding limits. The legislation was introduced on April 7 in the 2006 Finance Bill and REIT status will be available beginning Jan. 1, 2007.

The market-friendly proposal comes after more than two years of dialogue between industry leaders and the government, initiated after the REIT structure was first given the go-ahead for study by the government in December 2003. For much of the debate period, the fate of the REIT model was an open question—most analysts expected that legislation would be created, but there was doubt as to how inviting it would be. As recently as early March, shares of publicly traded property companies in the U.K. dragged on fears that the Treasury would roll out an overburdened structure. The actual proposal was a relief for the industry.

"The U.K. REIT is sensible because all major economies should have an efficient and flexible listed property sector. I think that most companies in the sector will convert. This legislation will allow the sector to grow and will lead to company IPOs," says John Gellatly, a spokesman for the Investment Property Forum, part of the pan-industry group that led consultations with the government on REIT legislation.

Favorable Market Response

The market agreed with Gellatly, who is also the head of indirect property investment and strategy for the U.K. at Merrill Lynch Investment Managers. On the London Stock Exchange, listed real estate share prices leapt after Brown's speech in their biggest-ever single-day rise. Land Securities' shares climbed more than 12 percent within minutes of the announcement, moving above the £20 level ($34.91) for the first time ever. British Land surged 11 percent, its best gain in 13 years. Hammerson closed up 9 percent.

Each of the seven-largest U.K. property companies listed on the FTSE 350 Real Estate Index closed at a record share price. All told, the FTSE 350 Real Estate Index climbed 9 percent, the biggest one-day gain in its 20-year history. The stock prices of retailers, mortgage banks, port owners and other firms with structures that suggest a possible REIT spin-off also appreciated. Most shares gave back much of the gains as investors took profits later in the week, but the positive reaction was a clear sign that investors were encouraged by Brown's proposal.

"We were expecting another delay, some more thinking," says Jim Rehlaender, portfolio manager for global real estate securities at European Investors, Inc. But with such favorable terms, Rehlaender says, "it looks like the U.K. companies will want to convert."

Gellatly relates four reasons the proposed U.K. REIT legislation is going to benefit the market. First, private investors are looking to get exposure in real estate and high yield products but as yet have no real way to do so in the U.K. Second, REITs are expected to rejuvenate the real estate market, both commercial and especially residential, through private sector capital. Third, Gellatly believes that REITs provide a number of productive benefits to the economy, including allowing corporations to take assets from their balance sheets and put them in the investment market, therefore becoming more capital efficient vehicles.

"The last reason is that without REITs, we would effectively be the last major economy not to have them," Gellatly says. "We have a listed sector that traditionally trades at a discount, and which is rapidly shrinking as it becomes more privatized and as a lot of U.K. assets go to offshore vehicles. Without a REIT structure, we would see the demise of the listed property sector."

Cost of Conversion

A number of would-be REITs hinted at conversion plans after the announcement.

"We are confident that the company would be an attractive REIT in the light of our size and specialization," says Sir Robert Finch, chairman of Liberty International. More than 85 percent of the company's £7 billion ($12.2 billion) in assets are in prime regional shopping centers. Other large companies, including Brixton, British Land, Land Securities and Slough Estates have also publicly made pro-conversion statements.

But conversion will be costly, and will in some cases require extensive reconfiguration of ownership. Slough Estates, which owns five of Britain's largest industrial properties, for one example, said in its most recent earnings statement that its stock of investment properties has a gross value of £4.4 billion ($7.7 billion). The 2 percent conversion fee would come to £88 million ($153.5 million). Under the proposal, the company would have the option of spreading the costs over a four-year period, but with an effective interest cost on deferment.

Liberty International will have to pay even more. But the retail specialists' additional complication has to do with its ownership structure. Founder Donny Gordon owns 22 percent of the company, and under Brown's proposal, no one shareholder can own more than 10 percent. Wanting the transition to go smoothly, Gordon has already begun breaking up his holdings into a series of family trusts. Brixton and Great Portland Estates are two other potential REITs that will have to pare down the holdings of large individual stakeholders.

The 10 percent-rule was put in place to prevent tax revenue from going overseas without being subject to U.K. taxes in a manner that is consistent with European Union rules. Foreign holders of stakes greater than 10 percent enjoy broad tax credits under the U.K.'s foreign tax credit system. Yielding to industry pressure, Brown made it easier in his proposal for companies to cope with the shareholder cap. Whereas in his original draft, a company could lose its REIT status for violating the rule, in his revised proposal shareholders holding more than 10 percent will be penalized only by having to pay taxes on the additional holdings. Still, under this design there will be no incentive for family owned property companies to become REITs.

Inside the U.K. REIT Plan Among the noteworthy provisions in the U.K.'s REIT rules are to: Decrease by about half its prior debt coverage ratio limits for a U.K. REIT; Impose a two percent tax (deemed fairly reasonable by many British property owners) on the gross value of investment properties upon an existing company's REIT election; Allow a U.K. REIT to issue non-participating preferred stock in addition to common stock; Allow a U.K. REIT to pay a penalty (rather than be de-REITed) for shareholder(s)' failure to satisfy the ten percent ownership limit (unless "reasonable" steps were taken to avoid the failure, such as the inclusion of a U.S. "excess shares" type provision in the REIT's organizational documents); and, Decrease the distribution requirement from 95 percent to 90 percent of taxable income.

Gearing Up

The gearing restriction may prove an issue for some companies. Most listed companies are already within the 1.25-times interest cover test stipulated in the proposal, which in effect will allow REITs to borrow approximately 65 percent of the value of their portfolio. Some companies will have to tone down their borrowing in order to qualify as a REIT. Hammerson's gearing level was 66 percent at the end of 2005, for example.

"The legislation will apply a gearing limit, and the gearing legislation is attractive, but of course not as good as having none," Gellatly says.

The U.K. government was worried that some investors would gear up REITs and direct interest payments to lenders with tax capacity while channeling capital growth to equity holders. There is no gearing restriction in the U.S. REIT rules.

Other concerns surrounding the proposal involve the treatment of joint ventures and overseas assets. U.K. REIT investments in companies that are not U.K. REITs will only qualify as tax exempt if the U.K. REIT owns 40 percent or more of the ordinary share capital of the entity. As for overseas assets, REITs will receive no credit for overseas taxes borne, and non-resident shareholders will still have to pay U.K. tax on the overseas income. At least one potential REIT, Capital & Regional plc, has announced that these restrictions make conversion unappealing.

"U.K. REIT legislation will be a waste of time. The government has basically created a PIF (property investment fund) which is a passive unusable business that doesn't allow you to run a company in a comparable manner to before REIT legislation. The British do like to build wonderful projects that nobody really wants, like the Concorde," says Martin Barber, chief executive at Capital & Regional.

Development is also left out of favor. Development activities will only be tax-exempt if undertaken in order to generate future rental income. If the developed site is sold within three years, the sale price will be taxed in full—either as a trading profit or a capital gain, depending on the situation. Quintain Estates and Development, for example, which has a large development portfolio including prime sites around the Millennium Dome in London, will not be well-treated by the REIT regime. It may be able to package some of its investment properties and land parcels into a REIT once they are producing income, but any properties it sells will be taxed unless the REIT held the properties for at least three years.

Perhaps the biggest losers, though, are offshore registered property vehicles. These vehicles—there are some £30 billion ($52.3 billion) in assets in offshore vehicles, mostly located in Jersey, the crown dependency off the coast of Normandy, France—would have paid no tax under a capital-gains-tax-based conversion fee, but the conversion fee on total assets will make it unattractive to most.

"The feeling is that they won't come back on shore, 2 percent is too much," according to Liz Peace, chief executive of the British Property Federation, part of the pan-industry group. These vehicles were dealt another blow in the budget, as Brown announced that Jersey trusts would no longer be able to avoid paying the 4 percent stamp duty on commercial property purchases. These measures will further enhance the relative appeal of REITs.

Industry leaders will continue to work with the government as they prepare the Finance Bill to be sent to Parliament, and will work with legislative committees on regulatory details. Looking ahead to plans for next year's finance bill, Peace says that the industry will push for legislation establishing UPREITs and unlisted REITs as the next steps in what will be an evolving U.K. REIT industry.