Offshore PICs - the first wave
With an ageing population, the demand for reliable income-generating vehicles is likely to increase. Recent stock market volatility and high-profile corporate scandals have contributed to deteriorating investor sentiment towards the longer-term savings and pensions markets. Investors have tended to maintain a relatively low exposure to commercial property over the past decade, despite its consistent absolute returns, a high-yield, low-risk profile and strong long-term performance. High trading costs, poor liquidity and a lack of suitable investment vehicles, particularly for smaller pension funds and retail investors, proved major obstacles.
In addition to strong outperformance of other asset classes over most periods, absolute returns have been recorded in 29 of the past 33 years, illustrating the less volatile nature of commercial property returns. Given this background, we believe that the new offshore property investment company (PIC) sector represents the first wave of UK REIT-type vehicles and will answer most of the aforementioned concerns. These vehicles offer investors the opportunity to participate in commercial property in a transparent, cost-effective and tax-efficient manner.
The investment rationale for commercial property is a compelling one in today’s economic environment. Given the low correlation to equities and bonds and historically lower overall asset volatility, commercial property has a natural role to play in reducing the risk profile of a diversified investment portfolio. The development of the UK property investment market was boosted this year when the government, conscious of the need for lower-risk savings options, announced a consultation process on an appropriate tax-efficient structure.
The proposed introduction of a UK REIT, following years of lobbying from the property industry, shows the government’s acceptance of the need for a structure to promote and regulate indirect property investment in the UK. These vehicles will in all likelihood be conservative in nature and aimed at smaller private investors to encourage the widest possible ownership of property. The consultation paper, Promoting More Flexible Investment in Property, was launched in April to garner the opinions of a broad representation of bodies concerned with commercial property. Responses were requested by June, and it is expected that following industry feedback, the government could introduce REIT status to the UK property industry in the latter part of 2005.
REIT-type vehicles, in the form of PICs, are however already established in the UK, albeit in an offshore environment. The launch of this new offshore registered and fully listed UK property sector over the past couple of years has created little press or broker coverage given the distraction posed by the REIT debate. These vehicles offer most of the advantages of a REIT system with the added benefit of a simplified Guernsey-registered tax structure. They provide exposure to UK commercial property for investors across the wealth spectrum as they are fully listed on the London Stock Exchange, as well as the Channel Islands Stock Exchange, therefore investors can buy as small an exposure as required. They also enjoy increased liquidity and a high-income yield.
These vehicles provide a natural diversification of investors’ income away from traditional gilt yields, equity dividends and cash. Given property’s natural illiquidity, fully listed vehicles allow cost-effective access for smaller investments. Trading in direct property assets is expensive, as an average direct commercial property transaction costs around 7.5% for a round trip. However, trading costs in these vehicles is limited to the average for equities, which is usually less than 1% of the total value of the trade. Another key benefit is that, historically, UK listed property companies tend to be more highly correlated to the stock market than their underlying property asset performance. Offshore PICs offer investors the advantage of a fully listed vehicle, but one which more closely tracks the underlying commercial property market performance and associated risk characteristics.
The defining characteristic of these funds is a Guernsey-registered closed-end investment company structure, investing directly in UK commercial property listed in London and the Channel Islands. They benefit from simple tax-efficient structures with one class of listed ordinary shares. Due to their Guernsey listing, they pay no capital gains or corporation tax so most, if not all, of the income can be distributed as dividends.
A key benefit of their closed-end structure is that liquidity does not need to be held within the companies to facilitate any potential redemptions which would normally trigger the need to sell assets. The companies are highly regulated within the existing legal framework covering listed and fully incorporated legal entities and also enjoy a reassuring corporate governance framework with a fully independent board of directors and external property investment managers. They are eligible for UK taxed advantages vehicles, such as SIPPs, ISAs and PEPs, and typically have relatively low gearing of around 50%, most of which is fixed for an average of 10 years. Dividends are paid on a regular quarterly basis, and are highly reliable due to long and stable lease terms. The underlying property portfolios also benefit from a high degree of diversification, both geographically and at the property sector level.
The strong performance of the sector to date suggests the popularity and latent demand for these types of vehicles in the UK. They should appeal to both retail investors keen to diversify their own income streams and also to smaller institutions eager to increase their commercial property exposure but find that they are unable to so due to large lot sizes and transactions costs. These companies are also attractive to funds of funds as they provide a broad exposure to the UK market while reducing trading costs in direct property. To date, only a few such funds are available. Several more similarly structured vehicles are in the process of being launched, so the sector should gain an increasing amount of publicity and popularity. For investors seeking a low-cost, liquid and highly correlated exposure to the UK commercial property market, then these vehicles are UK REITs in all but name.
Mark Meiklejon is property investment analyst at Standard Life Investments