A new consultation paper on U.K. property funds, similar to the concept of U.S. real estate investment trusts (REITs), was released last week as part of the U.K. budget statement. However, many issues will need to be ironed out during the consultation period that closes on July 16 of this year.

"This has been a long-term thing; we've been looking at the possibility of developing this market since 1985," said one market source. "Establishing this vehicle paves the way for a new source of permanent capital for the real estate market, and the government hopes to establish a housing REIT that opens up investments in residential property to draw more investment capital into the residential sector. The idea is that it will help establish a more stable private rented sector."

In the latest U.K. housing supply review, Kate Barker argues that a flexible housing market will expand the role for the private rented sector and establish a better balance of housing tenures. Improving provisions in the private rental sector could be achieved through investment vehicles along the lines of U.S. REITs, she added.

"When we started looking into this we were ahead of the curve but there was nothing to compare it to, and I think the idea was that the Treasury would have to foot a loss in revenue," said one market source. "But the industry has been able to show with all other jurisdictions set up, that the U.K. has been missing out. It's easier for the government to understand what the advantages are when they have something to compare it to."

From the government's point of view, establishing a U.K.-based equity vehicle means keeping the equity onshore. For investors, REITs would present the opportunity to combine the tax treatment of direct ownership with the liquidity that comes from something listable. "It allows pensions and savers direct access to the real estate market. At the moment, there is no real vehicle to do this," said one market source. "The nature of the market is big and lumpy."

Establishing REITs is a way for smaller investors to invest in commercial properties that are deemed more suitable for long-term savings and provide a sort of halfway house between the bond and equity markets.

According to Fitch Ratings, property companies making the conversion to REITs are likely to transfer their existing debt into the new property vehicles. "As capital structure criteria for REITs are made clear, it will be interesting to see how the rationale for highly leveraged, tax-efficient securitizations for a corporate stack up against REITs as a funding route," said analysts, adding that at this preliminary stage, it is to difficult to gauge the long-term impact.

Fundamentally, a REIT is an equity play rather that a debt play. A REIT pays out dividends as they are earned and distributes all of its incomes and gains. REITs are not required to carry any debt to optimize profits. But for companies incorporating securitization vehicles within REITs, Fitch said it would continue to regard the equity portion of the structure, as subordinated equity. Some in the investment community are concerned that investing in REITs who hold their assets in securitization vehicles means that the holding company capital is, in effect, subordinate to the securitization debt, a position which is consistent with Fitch's methodology for assessing equity on securitization vehicles.

However, the agency added that as long as the maximum consolidated level of gearing is in line with that set for REITs, property companies that are heavy users of securitizations should still be able to convert to REITs. "Its worth U.K. regulatory authorities investigating whether they should limit the inherent volatility and subordination of interest for unit/equity holders in such REIT vehicles," said analysts. "This will be the case where the securitization involves a large single trophy asset such as Canary Wharf, exposing investors to concentrated geographical and sectorial risk."

At this stage, the general election could push the REIT issue far into the 2005 agenda. "Although there will be some levels of conceptual similarities between the U.K. market and other established markets, we still need to iron out the detail and that looks likely to be a long-term process," added one industry source. "People have over-anticipated that the government would move quickly on this, and property shares have been re-rated in expectation of REIT treatment; but it's important to note that this is not just around the corner."

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