'Nanny REIT' must be avoided
In January, the German Ministry of Finance reached a landmark decision on the introduction of REITs (Real Estate Investment Trusts). The ministry is now drafting a bill for the launch of a “D-REIT”. A successful D-REIT would benefit Germany as a financial centre in several ways:
German and international investors would have a new and attractive investment vehicle on the local market. For private investors, it is particularly suitable for long-term capital accumulation. It provides an additional investment medium for institutional investors and international investors with easy access to German property markets.
Property companies could generate new equity, something that is often urgently required.
Companies in other sectors and public authorities could transfer their property portfolios into REITs, thereby mobilising dormant capital that could then be used in their respective core markets. This will also add to the stock of ‘investable’ real estate.
Tax revenues for public authorities would be increased both directly and indirectly. The critical factor here is that the total tax charge (REIT and shareholders) of ongoing taxation, and the taxation of hidden reserves, does not become prohibitive. Were this to happen, the REIT would not be accepted and nobody would benefit.
For REITs to be successful in Germany, they must offer a clear distinction to existing property investment products. A REIT should not be a “share-based investment fund”, but rather it should have its own profile so as to be accepted on the capital market.
The REIT business model should not be overly restricted by legal provisions. For institutional investors, eligibility for use as collateral and imputation as part of the investment share in property are key characteristics.
A central issue is the obligation to distribute profits. This varies widely in international practice. The majority of countries provide for a distribution of between 80% and 90%.
A high compulsory distribution benefits shareholders and public authorities. Nonetheless, excessive compulsory distribution makes it more difficult for the company to generate internal financing, thereby limiting fast, entrepreneurial operations on property markets and company growth. This weakens the company and therefore harms mid-term investors and public authorities.
In our opinion, a feasible solution would be to have a D-REIT distribute 80-85% of its profits to its shareholders. A critical factor in this is the precise and workable definition of the basis for calculating the distribution. Two key points here include appropriate consideration of depreciation, or restrictions on distribution owing to the difference between the REIT’s IFRS consolidated balance sheet and the single entity balance sheets of investment companies.
Market listing is a REIT qualifier, as this is the only way that a REIT can become a liquid investment. Furthermore, listing forces a greater capital market focus and more transparent conduct. However, there should also be the option of a non-listed ‘pre-REIT’, subject to the same taxation as a REIT. If this vehicle does not go public after, for example, five years, it loses its REIT status as of the end of this period.
Also, from a capital market perspective, a high free float should be the aim. At the same time, however, the way the capital market operates should not be hampered by restrictive regulations on the concentration of share ownership: corporate takeovers must be possible.
There must also be transition periods for the new entity – it should be possible for REITs to be initially founded by a single shareholder. This is the only way to enable the intended integration of, for example, large industrial property portfolios. An IPO within a period of five years would then allow more widespread ownership.
Internationally, there is some variation in the level of borrowing permitted. In the key markets of Australia, France, Canada, Japan and the US, there are no restrictions. Entrepreneurial freedom must also take priority in Germany. The appropriate level of gearing should then be determined by the degree of demand on the capital market.
If designed in a sufficiently liberal way, REITs can effectively supplement the range of property investments possible in Germany. Different yield/risk profiles can be achieved according to the strategy of the respective REITs in term of geographic focus (Germany, Europe, global), property segment (office, logistics, residential, and so on) and activity mix (holding property portfolios, buying/selling and project development). These profiles can then be adjusted to increase efficiency in the individual asset structure. If the intention is not to create another “property savings book” but rather a business investment opportunity on the property market, then freedom of choice must prevail.
Over-regulation will create a ‘nanny REIT’. A key factor will be creating sufficient legal certainty for REIT status. This means developing regulations that are both clear and calculable with a grounding in the modern property business. Nothing would disable a REIT more than if its management were forced to operate under constant fear of risking its REIT status.
This would create a completely new product: the ‘nanny REIT’. Ultimately, regulations must allow competition between two different supervisory regimes: in addition to state regulation through investment law for open-ended funds, REITs are also subject to the controlling and disciplinary function of the capital market.
Dr Eckhart John von Freyend is CEO at IVG Immobilien