In our introductory article on REITs, we looked at how the underlying property rental business is taxed, and how the tax position of the fund is effectively transferred to the investors.
In particular, we saw that there is no tax, both on income profits and capital gains at the fund level. The profits are taxed as property income when distributed to the shareholders, while capital gains accrue in the fund, and are only taxed when the shareholders realise their investment.
But what does it take to be a REIT and to qualify for the tax breaks? This is the topic that we explore in this article.
How to understand the conditions
Recall that a REIT is a company that invests in real estate on behalf of its shareholders. It provides investors with access to opportunities that might not otherwise have been open to them individually. By acquiring a single equity holding, an investor is supplied with a ready made property portfolio. The best way to understand the conditions is to ask the following questions:
- How do these conditions ensure ease of access for the retail investor?
- How should the portfolio be managed on sound investment principles?
The main conditions fall into three distinct classes, which we shall look at in turn. These are:
- Structural conditions which are about what the company “looks like” from the outside;
- Portfolio conditions – what are the conditions that apply to the property rental business?
- Residual conditions relating to the balance of the business – how are the non-rental activities structured?
During the course of the following account, we shall mention some of the historic conditions that applied when REITs first came on the scene, but were recently abolished. These modifications have been made in order to lower the barriers to entry for companies wishing to convert to REIT status.
Before we start, it should be pointed out that REIT status is not automatic, even though the conditions are satisfied. The company must actually make an application to HMRC to join the regime1. Likewise, a group of companies that satisfies the conditions for a group REIT, is not a group REIT unless and until it gives notice of its intention to convert.
Structural conditions – what does the company “look like”?
These conditions deal with the way in which the company is structured, and have no bearing on the way the underlying business is run2. There are six conditions:
- The company must be tax resident only in the UK3;
- The company must not be an open ended investment company (“OEIC”)4;
- The company must be admitted to trading on a recognised stock exchange5;
- The company must not be a close company6. Broadly this means that it cannot be controlled by five or fewer persons;
- The company can only issue one class of ordinary share. The only other securities that it can issue are non-voting restricted preference shares7;
- The company can only borrow on terms that are considered to be “commercial” for tax purposes8. For example, it is not permitted to borrow on terms where the interest exceeds a reasonable rate of return, or is linked to the profits or asset value of the company (“results dependent interest”).
We shall now look at some of these conditions in more detail.
Structural conditions – recognised stock exchange
When REITs were first introduced to the UK property market, they were required to be listed, rather than admitted on a recognised stock exchange. What’s the difference and why is it so important?
In a nutshell, being listed means that the shares must not only be admitted to trading on a recognised exchange, but also be included in the Official List of the UK, or an analogous list in a country outside the UK. This would be the case with shares trading on the London Stock Exchange. However, this doesn’t include junior markets such as AIM – while the latter is a recognised exchange, it is not included in the Official List9.
The consequence was that a company intending to operate as a REIT was faced with the compliance burden of a full listing, which can be quite expensive. Since 2012 however, it has become possible to trade on AIM and comparable markets, which are more lightly regulated.
This change in the rules has come about as the requirement for full listing had been perceived as a significant barrier to entry especially for start-up REITs.
Take the example of London and Stamford, which subsequently merged with another company to become LondonMetric. London and Stamford started life as a normal company in the aftermath of the credit crunch, and was set up specifically to take advantage of the slump in property prices. Initially the company was a cash shell, and was AIM listed before moving up to the main market – once on the main market, it was able to convert to REIT status. The effect of the rule change means that companies like London and Stanford can start as a REIT on AIM and stay there as long as they like.
The requirement to be admitted on a recognised stock exchange provides retail investors with the means, not only to buy into the real estate market, but also to make an exit. It is worth comparing the position with direct property investment, and all the attendant hassles involved in buying, managing and selling the assets making up the portfolio. All that a REIT investor needs is an online brokerage account, one click of a button and that’s it!
However, the fact that there is a market for REIT shares doesn’t in itself guarantee ease of access – it will depend on the particular stock that the investor wishes to buy or sell. For example, the shares of a blue chip company such as British Land will have a higher degree of liquidity than those companies at the smaller end of the market, especially AIM listed companies. This is one factor to bear in mind for investors who wish to explore more specialist sectors as opposed to general REITs.
Structural conditions – close company requirement
This requirement reflects the intention that ownership of the property vehicle should be diverse –an investment for all, not just for the more sophisticated investors.
A close company is a company that cannot be controlled by five or fewer persons or “participators”10. The tax definition is a lot more complicated, as it has to cater for a number of situations to ensure that the rules work properly. For example:
- A company with six shareholders who all belong to the same family is still a close company11;
- A company that is a 100% subsidiary of another company isn’t close if the parent isn’t close either12.
The second example makes sense – one looks to the ultimate owners of the company to see whether control is concentrated or widely spread. So subsidiaries of blue chip companies whose shares are traded daily on the London Stock Exchange, are unlikely to be close. The parent company has too many shareholders
For the purpose of the REIT legislation, the close company definition has been recently modified to ensure that the presence of certain types of institutional investor will not adversely impact the company’s status. The list includes pension schemes, life insurance companies, authorised investment funds, as well as charities, social housing associations and sovereign wealth funds13.
Again, this makes sense, on two counts:
- These fund vehicles themselves have wide ownership. To disqualify a REIT because it has only one investor which happens to be a pension fund would be bizarre, when one considers who the ultimate beneficial owners are;
- Furthermore, the purpose of a vehicle such as a pension fund is exactly the same as that of a REIT – to provide retail investors with a savings wrapper. Prohibiting a pension fund from investing because it makes the REIT a close company would defeat the very purpose for which REITs were introduced in the first place.
The close company requirement has also been relaxed by allowing a REIT to take up to three years to become “un-close”14. This will make it easier to start a REIT from scratch, as with the London and Stamford case, or even to spin out an existing property portfolio which is privately held. For example, a number of investment trusts such as Hansa Trust, or Caledonia, started life as simply being a vehicle for a wealthy family’s equity investments – could we see something similar happening in the property world?
Portfolio conditions – how is the property rental business managed?
These conditions deal with the actual business itself – what does it involve and how is it run? The conditions are15:
- The business must involve at least three properties16;
- No single property may represent more than 40% of the total value of the property rental business (valued on a fair value basis)17;
- Property that is owner occupied is excluded from the tax exempt part of the rental business18;
- At least 90% of the rental profits must be distributed to shareholders each year (subject to the legal right to distribute). There are in fact two strands to this:
- All profits that originate from investments in other RIETs must be distributed19;
- For profits from the remaining part of the rental business, the minimum payout ratio is 90%20.
The distribution requirement does not however extend to any capital gains made on a property disposal.
- There are restrictions on paying out a distribution to a corporate shareholder who holds an interest of at least 10%. If such a distribution is made, the company must pay a one-off tax charge21.
Let us look at the first three conditions.
The requirement for three properties is consistent with the need to keep the investment portfolio diversified – investing in a single property means that all the risk is concentrated in one asset. Admittedly, this begs the question whether three properties are sufficient for diversification purposes – but three eggs are certainly better than one.
However, it is still possible for a REIT to own a single building, provided that the property is split up into separate units that are individually let22. For example, a shopping centre or a block of flats, would count as multiple properties – as long as there are at least three units, the condition is satisfied. Of course, a single building still concentrates risk, especially in insurance terms – what if the building burns down? However, the risk that the rents will dry up, has been spread by the fact that there are multiple tenants.
Given that one can split up properties, owner occupation is possible in one sense. The condition is satisfied if an office block split is into several floors, with the owner occupying one floor and letting the rest. This is because the other floors are all treated as independent, provided that they are effectively sealed off from each other.
The “40% condition” is also consistent with the idea that risk should be spread amongst the various assets in the portfolio. One investment principle is that when a holding becomes overvalued, or makes up a substantial part of the portfolio, it is best to sell. However, there are arguments against such a policy. This illustrates that other principle of investment, which is to “run your winners”.
One should note that the valuation is on a fair value, rather than a historic cost basis. What this means is that although the condition may have been satisfied when a property was first acquired, it can still fail if the property appreciates in value, to the extent that it dwarfs all the other assets in the portfolio. In other words, one can have a wildly successful investment, but be forced to sell it simply because it has become too successful.
What would be the position if there were five properties, all, except one of which has proved to be a dud? It makes more sense to sell the duds and keep the cash cow, not the other way round. But the more duds that are sold off, the greater does the breach of the “40% condition” become. One could always buy more properties to compensate, but what if there are no suitable investment opportunities available?
Residual conditions – the balance of the business
REITs are permitted to have a certain level of “residual” activities, such as trading, or property development as opposed to letting. Furthermore, certain types of indirect property investment such as holding shares in other property companies and authorised funds fall into this category.
The residual part of the REIT’s business is ring-fenced from the property rental part, and subject to corporation tax in the normal way23. The consequence of the ring-fence is that taxable profits and gains from the residual part cannot be relieved by losses from the rental business24.
But while non-rental activities are permitted, they must not take up a significant portion of the company’s profits and balance sheet25. This means that:
- At least 75% of the company’s total income must be derived from the property rental business;
- At least 75% of total value of the assets must relate to the property rental business, (valued on a fair value basis).
One of the most important of the recent changes is to include cash, together with investments in other REITs as an asset relating to the property rental business – even though technically, they might not have this status in other parts of the legislation.
This is a very fundamental and important modification, especially in the case of cash. If one takes a start-up situation, the company is likely to be flush with cash from share subscriptions, but may take time in building up a portfolio. Furthermore, although the company has plenty of cash to spend, there may not necessarily be suitable investments available at the right prices. In the case of Stamford and London, there was a one year waiting period before the first property was acquired.
Two other conditions
The above are the basic conditions that should give some idea what a REIT is about – how it is structured, what the boundaries are on its rental business and to what extent it is permitted to go beyond these boundaries.
There are of course, lots of other conditions, which we shall come across in later articles. Two conditions worth noting:
- The entry charge – which is really a non-condition. Until 2012, any company intending to enter the regime had to pay an entry fee calculated at 2% of the market value of the underlying rental properties26. This charge has now been abolished, thus removing another barrier to entry to the REIT regime;
- There are borrowing limits whereby the company’s interest cover cannot be less than 1.2527. If this requirement is breached, a tax charge is payable28. Recently the rules were relaxed so that borrowings now cover only loan interest and don’t extend to other types of finance cost29. This constraint on gearing relates only to interest cover and doesn’t affect the company’s debt/equity ratio.
That completes our overview of the basic conditions. We shall come across these conditions and the concepts behind them in later articles in this series.
- CTA 2010 s 523. ↩
- CTA 2010 s 528. ↩
- CTA 2010 ss 521(1), 528(1). ↩
- As defined by the Financial Services and Markets Act 2000 s 236. There are in fact, OEICs that can invest directly in property. In particular, there is a special class of property OEIC, called a Property Authorised Investment Fund, that is the counterpart of the REIT in the regulated funds market. ↩
- CTA 2010 ss 528(3). ↩
- CTA 2010 s 528(4). ↩
- CTA 2010 s 528(6). ↩
- CTA 2010 s 528(8). ↩
- CTA 2010 s 528A, which states that REITs may either be listed or traded on a recognised stock exchange. For these definitions see CTA 2010 s 1137, ITA 2007 s 1005. HMRC has a table of recognised stock exchanges, where they also make the distinction between those that are “listed” such as the London Stock Exchange, and those that are not. ↩
- CTA 2010 s 439. ↩
- CTA 2010 ss 448, 450, 451. ↩
- CTA 2010 s 444(2). ↩
- See CTA 2010 s 528(4A) for the full list. ↩
- CTA 2010 s 527(6). ↩
- CTA 2010 ss 529, 530. ↩
- CTA 2010 s 529(1). ↩
- CTA 2010 ss 529(2), 529(4)(c), (d). Furthermore, in valuing the properties one disregards any debt that has been secured against the assets – CTA 2010 s 529(4)(e). ↩
- CTA 2010 s 604(2) Class 3 ↩
- CTA 2010 ss 530(1)(a), 530(4)(a). ↩
- CTA 2010 ss 530(1)(b), 530(4)(b). ↩
- CTA 2010 ss 551-553. This charge cannot be relieved against any tax losses of the residual business – CTA 2010 s 551(7). ↩
- CTA 2010 s 529(4)(b), see also the HMRC Guidance at GREIT02030. ↩
- CTA 2010 s 534(3) – note however that the small profits rate and marginal relief do not apply. ↩
- CTA 2010 s 541(4). ↩
- CTA 2010 ss 531(1), 531(5). ↩
- CTA 2010 s 538. ↩
- CTA 2010 s 543. ↩
- CTA 2010 s 543(3) – this cannot be relieved by any tax losses from the residual business – see s 543(6). ↩
- CTA 2010 s 544(3)-(5). Prior to the changes, finance costs included “other costs that under generally accepted accounting standards are considered to arise from a financing transaction.” –see the old CTA 2010 s 544(5)(e). ↩
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