Punch Taverns took a step back from the U.K. real estate investment trust frontline and joined other U.K. pubs that remain sidelined on the benefits of converting to REIT status.

Since their launch in the U.K. at the beginning of this year, REITs have been well received by the traditional listed real estate companies, the ones that own properties with a number of different tenants operating in different industries. Rising immigration and higher house prices will continue to bolster the U.K. rental market, sources said. "For an operating company that also owns real estate [namely pub chains], in order to comply with the criteria to become a REIT, there would be a need to separate the property from the operations by using an opco/propco structure," said Michael Cox, a property, corporate and infrastructure securitization analyst at the Royal Bank of Scotland.

Most U.K. pub operators have securitized their cash flows under long-term bonds. These structures need to be unwound under a separation of the assets, which can prove costly for pub operators. According to Morgan Stanley fixed income analysts, unwinding securitization cash flows would cost a company such as Punch Taverns an estimated GBP630 million ($1.25 billion). "There are also other costs paid to create the REIT, such as the conversion tax, fees, additional central costs, and any pension obligations," reported Morgan Stanley analysts.

Recent talk pointed to Punch Taverns becoming the first pub operator to convert to REIT status, but the company has cooled its interest and now looks more likely to adopt a similar wait-and-see approach as its competitors have done. "Punch is not interested in converting to REIT right now," said Sarah Barton, lead analyst at Morgan Stanley. "The entry charge didn't look efficient right now - that's not to say they are ruling it out forever. We wonder whether a partial sale leaseback to unlock property value or a partial de-merger with REIT conversion may be a more likely option." According to Barton, a sale and leaseback with propco REIT conversion could offer a one-time gain of up to 40% over current share prices.

Smoke rings the issue

The looming smoking ban that comes into effect across England on July 1 seems to be adding pressure against REIT conversion. Bans in Scotland and Wales have prompted profit drops for pubs over the first few months of the year, and it is expected that their English counterparts will in general experience the same down trend, with the real outcome of the ban not completely appreciated until well into 2008. Removing these assets held under securitization structures at an uncertain time could mean their value drops in a new REIT. "Timing is probably the biggest issue," Barton said. "The trouble is, waiting until 2008 might mean a window of opportunity has gone if interest rates and property yields rise further."

But despite the listed shortfalls for conversion, pub companies are likely to keep the option under review. Shareholders are expected to lean on the pubs to look for other ways to raise profits in the wake of the smoking ban, and it is believed REITs would help fill this gap. Although Punch may be downplaying the prospects of a portfolio conversion for now, all eyes have turned to chain Mitchells & Butlers, which is expected to announce its plans vis-a-vis the REIT structure on May 22.

For M&B, there are four potential announcements to be made on May 22. The first is, of course, to do nothing, and the second is the sale and leaseback of the entire estate, according to an assessment from the RBOS. The third would be the company's separation into an opco/propco and the listing of the propco as a REIT (unwinding the securitization would cost M&B an estimated GBP150 million). The final and potentially most advantageous option would be a joint venture with a property investor for a portion of the estate. This last option would allow M&B to retain some control and upside potential from the properties, and would still enable it to demonstrate what a third-party investor would be willing to pay for the property assets.

The sticking point to all of this is that the two entities under the opco/propco structure could not fall under common ownership. With these pub companies, it is important to consider how large a portion of its value is derived from real estate, therefore many landlords are slow to give up total control of the land. "This is a management issue, the question being whether or not the two sides can operate with a single common interest, particularly in the long term," Cox said. "Most pub management teams seem to have concluded that keeping the properties and the operations under one umbrella offers the best structure for long-term value creation."

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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