Overlooked way into real estate

In the UK and other countries which only recently adopted REIT structures, demand from pension funds has been reported to be weak.

Dave Butler, head of external affairs at Reita, the UK trade body responsible for promoting understanding of REITs, explained this was due in part to the relative novelty of the asset class: "With pension funds, it's a new asset class so you have to take into account investor attitudes to new vehicles - it's really only 16 months old." Steven Grahame, senior investment consultant, Watson Wyatt, said: "UK pension funds did not respond to the press enthusiasm due to the correlation to equity markets as well as the strong historical rally making their valuations look stretched - they have since fallen."

Globally, the market is down about 25% since its peak in May 2007 and demand has fallen off since summer. Since the launch of UK REITs in 2007, pension funds from the US and the Asia Pacific region increased holdings in UK REITs from 9% to 10% - an overall rise of 10%, which Leonard Geiger, senior vice president, Cohen & Steers, labelled as "not insignificant". He added, though, that it was unlikely many funds had increased their positions since then thanks to the effects of sub-prime.

"Obviously sub-prime came through the global markets. Since the second half of last year, we've seen financing dry up and start to affect the property market," Geiger said.

Jeremy Anagnos, the director of REITs for CB Richard Ellis Investors, said the effects of the credit crunch had been more of a correction than a crash: "The knock-on effect [of the credit crisis] has been dramatic, [but] the decline in pricing has really been a return to what values should have been before credit became so cheap."

Pension funds tend to allocate to real estate differently across the world. In the UK and US real estate allocations tend to be about 5% to 10% of the total portfolio. Within this, there are also differences in how much funds allocate to listed assets. Grahame said US funds tended to allocate around 20%, while Australian funds often went as high as 50%. He added UK allocations to listed real estate tended to be minimal.

Geiger explained: "REITs came out in the UK coincidentally at very much the top of the market - it was a kind of unfortunate timing."

Despite this, Geiger was upbeat about their long term worth: "Would I recommend them? Yes, absolutely. Long term it's a promising strategy that allows access to globally diversified assets."

Anagnos added: "We would suggest looking at REITs like real estate - holding assets for five to seven years. It's an asset that really needs to be held for the value to come through. You have to be willing to hold it, because in the short term REITs will be impacted by equity market volatility."

The origin of REITs

In 1994, only four countries - the US, Australia, the Netherlands and New Zealand - had REIT structures in place, the legislation for which had been passed during the 1960s and 70s and only Canada was actively considering adopting the structure. Since then, a further 12 countries have established REITs; four more (Germany, Italy, the UAE and Israel) have put the necessary legislation in place and nine are considering doing so.

Although individual REIT legislation differs from country to country, many of the basic requirements remain the same. Broadly speaking, REITs offer investors tax transparency in exchange for which a high proportion of returns (a minimum of 85% in some countries, notably Canada and France, rising to 100% in Australia and the Netherlands among others) must be distributed to shareholders.

REIT legislation also places restrictions on the provider as to the assets that can be invested in. In the UK, US and Germany, 75% of assets have to be invested in real estate, although in the Netherlands and Australia this rises to 100%.

Reita's Butler said REIT legislation changed the tax status of companies investing in this sector.

"Previously, property companies were liable for corporation tax and capital gains tax on income. Now, REIT structures are free of corporation tax, in return for which REIT investors can no longer engage in direct investments," he said.

Douglas Marvin, a tax adviser with the real estate group at KPMG, explained: "The primary principle behind the establishment of REITs was to remove the double taxation on property investment returns. For shareholders of real estate companies, their income was effectively taxed twice, at the company and shareholder level, in contrast to REITs, where the distributed property income would only be taxed at the shareholder level."

Marvin continued: "Property investment income paid to investors would be taxed as if the investor held the property directly, which is still beneficial as compared with a real estate company paying, say, 28% corporation tax and then the shareholders paying 25% tax again on the dividend, which works out at an effective rate of about 46%."

Part of the reason for the broad range of slightly different REIT structures around the world is due to the evolutionary nature of the legislation.

Geiger explained why this was possible: "Governments can and have leapfrogged each other. This means [they] have been able to pick the best or most suitable aspects of REIT legislation from their peers and implement these as they see fit. They are able to look at all the other structures and try to create the Ôbest'. A government offering a sub-optimal REIT structure is in effect putting its companies at a competitive disadvantage."

Geiger outlined some of the advantages REITs can offer to investors: "The big advantages are liquidity and the fact you can get access to professional management in seconds on a trading desk. There's also a very high level of diversification possible with listed REITs. Unless you have a large amount of money, it's difficult to put together a fully diversified portfolio by investing directly and even then there are practical limits to the level of true diversification possible. There's instant liquidity and instant diversification - you can create a totally global portfolio very quickly. Other advantages include a higher level of transparency, given the entities are publicly listed."

Butler added that REITs could give the same access as direct real estate investments, but were able to do so more cheaply and quickly due to the listed nature of the vehicle.

Anagnos said: "There has been a debate in the REIT universe for the past 15 years which asks whether exposure from listed REITs is the same as real estate. I think what everyone has decided is that REITs reduce the risk and enhance return in a mixed asset portfolio."

Diversification

From a strategic point of view, REITs can provide investors with diversification. Grahame commented: "REIT returns are linked to the underlying property market and, importantly, by selecting a manager who invests in global REIT operators, the investor can access global property markets. However, in reality, it's a listed asset and therefore subject to equity market volatility."

Although REITs are essentially equities, research by Cohen & Steers shows the correlation between REITs and other listed equities to be low over the long term. While on a monthly view, the two classes are closely correlated, over two or three years, REITs show more correlation to the property market than shares.

Butler commented that many pension funds viewed allocations to REITs as part of the overall strategic investment mix: "You have to ask what your investment strategy is. It's not really expected that pension funds see this as part of their core property investment strategy. They see it more of a core-satellite approach."

Grahame explained: "Pension funds do view REITs as a potential part of an overall allocation to property."

Geiger said REITs were a potential source of alpha generation for pension funds looking for excess returns in their real estate allocations: "There is definitely scope for alpha generation with REITs. The fund manager has many more opportunities to exploit than with direct real estate. If you have access to global property markets and can buy and sell quickly, there are fewer constraints to generating higher returns." Anagnos said: "From a global perspective, REITs offer two sources of alpha - traditional stock picking to find the best managers and allocation to regions of accelerating growth.

"A good management team can restructure and add value to improve what would have been just a pure bond-type return. From a global perspective, you have markets which are asynchronous. For example, Sydney is a definitely a landlord's office market right now, whereas in London, tenants have more power in negotiations. This variance in cycles all over the world allows an investor to go where the prospects for return are best."

However, Grahame added the caveat that investments were only as good as the management team behind them and it required skilful investment managers to identify good REITs.

Butler agreed: "From a strategic view, you can see direct investment as a way to get beta, while REITs can provide the alpha."