Mature REIT market lessons
In 1969 the Dutch fiscal authority introduced article 28 in corporate tax law. The article states that a company which complies with a certain set of criteria is exempt from corporate tax. With the introduction of this law the Dutch were among the first in the world to introduce the so-called Real Estate Investment Trust.
The most important criteria a company has to fulfill to be treated as a REIT for Dutch law are, firstly, it must distribute 100% of its fiscal profits.
Secondly, it can not have a debt to assets ratio exceeding 60% of the fiscal book value of its assets.
Thirdly, a Dutch REIT is restricted when it comes to the amount of development activity it is allowed to engage in.
The Dutch REIT legislation is among the least restrictive in the world. As opposed to the Japanese REIT, for example, Dutch REITs are allowed to engage in non-property-related activities as long as tax is paid over the income related with these activities. The Dutch model also allows REITs to invest in foreign property holdings. This is not allowed in the Japanese and Hong Kong REIT model either.
The already mentioned financing restriction of 60% is generally viewed as non-restrictive and compares reasonably well with the financing restrictions used in other countries. Singapore and Hong Kong, for example, have been using financing restrictions in the range of 35% of the market value of the assets. The French, US, Japanese and Australian REITs, however, are even less restrictive on this point. They have no restrictions on the debt ceilings. REITs in those regions generally use self-imposed financing restrictions, which are usually not to far off from the 60% restriction used in the Netherlands.
Judging from the number of REITs introduced up until now, the introduction of the law did not immediately spark a lot of interest for this sector. It certainly did not receive the amount of attention that is currently drawn to the (potential) introduction of REITs in several Asian and European countries.
One of the reasons for this could be that the Dutch legislator did not give any additional incentives for the creation of these investment vehicles. There have been no particular fiscal incentives to convert real estate holdings into a REIT structure. Particularly not the incentives we have seen in France for example.
The French have promoted the structure by allowing property companies to convert their real estate holdings into REITs and charging only 16.5% in capital gains ‘exit’ tax instead of the regular 33% in capital gains tax. To give an even further boost to the REIT market the French government recently launched the so-called SIIC-II regime. Under this regime taxed owners of real estate that sell their real estate holdings to REITs will, for a limited period, only have to pay 16.5% in capital gains tax as opposed to the regular 34.9%. This is believed to have given an additional boost to the size of the French REIT sector. The growth of the US REIT sector in the early 1990s was stimulated by changes in fiscal policy as well. Similar incentives would most certainly boost the size of the Dutch REIT market. The introduction of REIT structures in other countries gives rise to property companies choosing their country of incorporation on the basis of the most loosely defined structure. Although the Dutch structure has its advantages, it might lose out in comparison to the new structures that are expected to be disclosed in Germany and the UK.
Therefore Dutch property companies are lobbying for changes to the structure. One point stands out in this perspective: the restriction on development activities. Investors and REITs are lobbying to allow increased property development carried out by REITs as long as it is for their own portfolio. This would greatly improve the return potential for these structures. It remains to be seen how this matter will develop.
Global Property Research has developed several indices for tracking the development of this sector since. Its research shows that the free float of the major Dutch REITs has grown from E5.2bn in December 1989 to E8.2bn in January 2005. Compared with the recent boom in the Asian REIT market this is a rather lousy track record.
An additional reason for the mediocre growth in market capitalisation in recent years is that this sector has been trading at significant discounts to its net asset value. The European listed real estate sector has been trading at an average discount in the region of 15% versus its net asset value from early 1999 until late 2003. This was a result of the dwindling interest in real estate as an asset class during the tech bubble of the late 1990s.
During those times of big discounts it proved virtually impossible to issue equity at reasonable conditions nor did any property company consider an Initial Public Offering.
As a result of the cheap valuations a significant number of companies was taken over. Between April 1999 and October 2004 the combined number of de-listings and takeovers reached a staggering 87. Eight of those takeovers involved Dutch REITs. The majority of these deals were settled in cash underscoring the low valuations of these companies. All in all these developments did not help grow the listed European real estate sector.
Since the collapse of the tech sector and the diminished return expectations among investors in general, people have started to appreciate real estate as an asset class again.
The low volatility and the generally stable returns are leading investors to increase their weightings towards property. A recent survey by JP Morgan Fleming Asset Management indicates that UK pension funds in general intend either to increase or to keep their property weightings at least at their current level. In general these pension funds seem to be aiming at a weighting towards the property sector in the range of 5% to 10%. Since the REIT sector is a good proxy for investing in real estate directly. This will most certainly lead to increased money flows towards the REIT sector.
The European listed real estate sector is currently back at the valuation levels last seen in 1998, meaning that it is trading more or less at its net asset value. According to our estimates the Dutch REIT sector has appreciated a little more and is currently trading at a premium to its net asset value. Several factors could justify this premium rating. First, Dutch REITs have a relatively high weighting towards retail assets. These assets have proved very resilient against the declining economic growth. Secondly, investors expect the net assets values of retail assets to show significant increases due to the increased interest for real estate that has led to decreasing initial yields. An increase in these historic valuations could make up for part of the premium rating. Thirdly, it has been rumoured that major overseas property funds might be interested in buying retail assets in Europe. One of the possibilities for them would be to buy a listed Dutch REIT. A final consideration behind the premium rating could be that the interests of the management teams are currently better aligned with those of the shareholders. In earlier days when the property companies where trading at premiums to their net asset values, management teams were easily tempted to issue new equity. Due to increased corporate governance this opportunistic behaviour has diminished.
A lesson we can take from the development of the Dutch listed REIT market compared to other countries is that it is nice to have relatively loose regulations. However to actively grow a REIT sector additional fiscal incentives will prove useful.
With an eye to the future harmonisation of the REIT legislation among countries would be helpful. Harmonisation could lead to a level playing field for the listed property sector. Then listed property could finally become a global sector and an even better alternative to the direct property market.
Daniel van Akkeren is a senior portfolio manager at Kempen & Co