Originally developed in the US in the 1960s, Real Estate Investment Trusts (REITs) were launched in the UK in 2007 and have become a popular way for ordinary investors to gain access to the physical commercial property market. More than 80% of British property companies, which either own land or trade in land, have so far converted to REITs.

The British Property Federation (BPF), the membership organisation for the UK real estate industry, played a key role in the creation of the companies. “We were one of the key bodies that persuaded the government to introduce legislation allowing property companies to convert to REITs,” says Melanie Leech, the BPF’s chief executive.

Conversion carries substantial tax benefits. REITs do not pay corporation or capital gains tax on their property investments. They are essentially companies that manage a portfolio of real estate to earn profits for investors. Their special tax status means that they also pay no corporation tax on the profits of their rental business.

Aisling Colgan, a director in Deloitte’s real estate tax group, says that REITs seek to apply tax “as if the investor holds the bricks and mortar themselves”. This means many classes of investors enjoy enhanced investor returns when they invest in a REIT versus a typical corporate structure – this particularly includes pension funds, investors who use tax-free individual savings accounts (ISAs), and sovereign wealth funds. 

For example, a traditional UK property firm earning income of, say, £100,000 would pay 19% or £19,000 in tax, leaving £81,000 for investors, who would be liable for tax on that dividend according to their tax status. The higher rate is 32.5%, so leaving them with £54,675. A REIT is exempt from the tax on the income and so can distribute the full £100,000. Investors pay tax on that as an income at 20%, 40% or 45%, depending on their status. An investor liable for 40% tax would keep £60,000. However, the biggest beneficiaries from REITs are ISAs and pensions funds, where rental income is not taxed.

In exchange for these tax advantages, REITs must obey strict rules. To qualify: 

• at least 75% of profits must come from property rental
• they must pay out 90% of their rental income to shareholders
• they must be primarily engaged in property investment, rather than in development or other non-property related activities.

How REITs workUnlike other property investments, REITs shares are traded on the London Stock Exchange. “As REITs are all listed property companies, trading shares in REITs is very liquid,” Melanie says. This is because investors can sell shares in REITs, making them a liquid investment – even though the assets in the fund itself are less liquid.

These are the UK rules. Some 34 other countries from Australia to Turkey allow REITs, and the rules vary across the world. In the US, REITs are not required to list their shares on a public exchange.

But Deloitte’s Aisling says there are many common features of REITs that make them a globally-recognised brand. “Even though there are slightly different rules in different jurisdictions across the world, they share fundamental principles: they invest in property, are widely-held, and distribute regularly.” They also have the advantage of paying a dividend, which means investors receive an income on their investment.

One feature of REITs is that their shares often trade at a discount to their net asset value (NAV). There are several reasons for this. First, the share price may suffer from general falls in the market that will pull the price below the value of the assets. Second, investors may be sending a signal that they believe the assets are overvalued. Last, investors may believe that while the assets are valuable, the management is unlikely to produce future growth. This offers a potential reward to investors who can buy the shares at a discount and sell at a premium when the share price rises above the NAV, so narrowing the discount between the price and the NAV.

How discounts to NAV work

The net asset value (NAV) is one of the most important concepts investors in close-ended funds need to understand. Knowing how to use the NAV to determine a fund’s fair value will give an investor a tool to help identify funds with the potential to outperform.

NAV measures the value of a fund’s assets, minus its liabilities. The formula is the market value of all securities held by a fund, plus any cash and equivalent holdings, minus any fund liabilities. Dividing that figure by the total fund shares gives a per share figure. If the NAV is, say, £10 but the share price is £9 then an investor is buying an extra £1 of assets and will receive income on £10 worth of assets.

However, an investor can only sell the share at the prevailing share price, so if buying a REIT at £9, they will have to wait to see if the price catches up with the NAV. In the meantime, they will focus on the daily price and dividend payments. 

All markets are likely to rise in value over the years, so there should be a natural increase in the share price. Even if the discount were to remain at 10%, in time we would expect the share price to rise as the value of the underlying assets rise. If an investor sold at 10% discount, it would be 10% of the new (higher) NAV and that monetary amount is likely to be higher than the £9 they paid at the outset. Many academic studies have looked at why shares in REITs and other property-based funds are sometimes priced below their NAV – referred to as the closed-end puzzle. One of the most-cited explanations is simply that the NAV has been miscalculated because the assets are illiquid and therefore hard to value. A connected reason is similar but is based on the fear that the NAV does not account for future tax liabilities. Another is that investors are worried that poor performance in the management of the fund or an overcharge of management fees will give them lower returns (even if the value of the assets is correct). Closed- vs open-ended fundsThe NAV is an important metric because a REIT can be a ‘closed-ended’ or an ‘open-ended’ fund. Both pool the resources of many investors to be able to invest on a larger and wider scale, but operate in very different ways. 

Shares of open-ended funds, such as mutual funds, are bought and sold directly from the fund manager. The number of shares is not fixed, and the fund creates and cancels as many shares as investors wish to buy or sell. However, fund managers have to keep funds in cash to meet demands from investors suddenly wishing to sell.

Laith Khalaf, senior analyst at investment management firm Hargreaves Lansdown, says open-ended funds keep 10% or more in cash in case investors demand the immediate return of their money. Open-ended funds may also take advantage of purchase opportunities or because an investment has recently been sold.

For open-ended mutual funds, NAV is a useful factor for tracing share price movements. However, it is not useful for assessing overall fund performance, which is measured by the share price. 

A closed-ended fund has a fixed number of shares in issue, offered by an investment company. It typically has a lock-in period and share value is determined in the secondary markets, which are formal exchanges, where the shares are traded. 

The NAV of a closed-ended fund is the price per share multiplied by the total number of shares. The value of such funds changes continuously throughout the trading day and trading cycle.

Another difference from an investor’s perspective is that open-ended funds can suspend trading if the market turns particularly negative. As well as preventing other investors encashing their funds, it means bargain-seeking investors cannot acquire assets cheaply. This is especially the case for illiquid assets such as property.
Pros and cons of investing in REITsWhen looking at REITs, investors need to realise that although they are buying a share, they are gaining exposure to the property markets. This comes with pros and cons, according to Laith.

“There are a couple of reasons why you want that exposure,” he says. “Property can deliver a reasonable income stream for investors. Then there is diversification – more traditional investments include equities, bonds and cash and this is a good way to have a fourth string to your bow in the form of property.”

As a REIT is a property investment company, it can be easily traded on the stock exchange. However, the way your investment is calculated depends on whether it is open- or closed-ended, which is something stock market investors in REITs need to consider. In an open-ended REIT, share values are calculated once per day after the stock market is closed. Share prices for a closed-ended REIT are based on what investors are willing to pay for them at any given time.

Why do REITs hold cash?

Although REITs are commercial property funds, they are allowed to hold cash, which may be unappealing to investors who are paying management fees and who could invest cash themselves. 

Deloitte’s Aisling Colgan says the cash allowance stems from a problem with the original REITs legislation in the 2006 Finance Act that did not consider cash as a ‘good asset’ for the purposes of meeting the conditions to qualify as a REIT. It particularly caused issues on launch when the cash balances were disproportionately higher than the property assets held.

This was resolved with reforms in the 2012 Finance Act in the UK that allowed cash to be included as a good asset for REIT condition purposes as well as abolishing a 2% charge on assets that companies introduced into a REIT. “The REIT legislation recognises that holding cash on launch or following a capital raise should not impede a group’s ability to qualify as a REIT. It’s not as if property companies will sit on shedloads of cash; it will be invested in property to generate returns for investors,” Aisling says.

So, while REITs can hold cash as part of a sensible investment strategy, they are likely to do this to take advantage of purchase opportunities or because an investment has recently been sold, rather than for investor redemptions. REITs are likely to keep 1%–2% in cash for those reasons, says Laith Khalaf, of Hargreaves Lansdown. 

Unlike other property investments, REITs shares are traded on the London Stock Exchange, allowing investors to exit their investment by selling shares. One particular issue is the difficulty in valuing the underlying assets. The valuation of real estate assets held by REITs is undertaken on a periodic basis by the Royal Institution of Chartered Surveyors (RICS) Registered Valuers. Philip Parnell, a partner at Deloitte, says that although frequency is at variance to the ‘real time’ movement of equity prices, it is generally regarded as more practicable and realistic given the less liquid nature of physical real estate as an asset class and the relatively fewer observable comparable transactions upon which valuers can form their opinions. “Nonetheless, the time between valuations can inevitably lead to notable adjustments – up or down – upon each valuation, particularly in the aftermath of major market events such as the EU Referendum and the 2008 financial crisis,” he says. “The premium or discount to NAV can provide an important indicator as to investor perception regarding the potential direction of value of the underlying real estate ahead of the next valuation.”

A REIT must include in its annual financial report formal valuation of its portfolio by an external valuer. There is no universal method or basis of valuing assets and liabilities for the purposes of calculating the net asset value used throughout the world.

The widely accepted International Accounting Standard 40 (IAS40) for investment property applies to the accounting for property (land and/or buildings) held to earn rentals or for capital appreciation (or both). It allows valuers to choose between a fair value model and a cost model.

According to IASplus, a central news repository curated by Deloitte, fair value is the amount for which the property could be exchanged between knowledgeable, willing parties in an arm’s length transaction. The best evidence is normally given by current prices on an active market for similar property in the same location and condition and subject to similar lease and other contracts. In the absence of such information, the valuer may consider current prices for properties of a different nature or subject to different conditions, recent prices on less active markets with adjustments to reflect changes in economic conditions, and discounted cash flow projections based on reliable estimates of future cash flows. Under the cost model, investment property is accounted for in accordance with the cost model as set out in IAS 16 Property, Plant and Equipment – cost less accumulated depreciation and less accumulated impairment losses.Investment risksWhen to invest in REITs is hard to know as there are always risks going into the property market. The key is to invest in a planned manner as part of a wider strategy that considers all assets. An investor’s objectives, time horizons, attitude to risk and capacity for loss should also be considered before any investment decisions are made. 

The original version of this article appears in the Q4 2018 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.

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