01/12/04

Global REITs – Development and Outlook

"Discuss REITs from a global perspective, including the US, Asia and Europe, examine how they have developed, and the general outlook for them".

The Global Real Estate Investment Trust, or REIT, market has grown exponentially over the past few years. More and more countries have embraced a tax efficient property listing structure to encourage private commercial property investment. There have been several key factors driving this growth. Global investors have become increasingly disillusioned by poorly performing equity markets and have been eager to access investments offering lower risks and steadier returns. The world's major economies have also experienced lower investment returns in a generally low inflation and low interest rate environment. Investors are also slowly becoming acutely aware of the growing need to save for longer and increasingly underfunded retirement periods. More and more countries are discovering the benefits of REITs. They offer tax transparency, liquidity, improved corporate structures, simpler tax structures, easier access to all forms of capital including unsecured debt, and greater overall property market efficiency, and are altering their laws to create REIT-like vehicles to realise these benefits. However, the main disadvantage is that one of the key benefits of owning direct property, that of lower volatility, is reduced through the use of a directly listed vehicle such as REITs. The chart below illustrates the relationship between risk, as measured by standard deviation, and returns per annum for direct property markets, stock markets and listed REIT sectors. The US and Australian markets are used for comparison purposes, as these markets are the most mature of the global real estate markets and provide the best comparison of how the potential UK tax efficient regime will look.

The chart shows that although direct property exhibits lower risk than the listed markets, the REIT sectors in the US and Australia infer that higher returns can be achieved for investors by sacrificing some of this lower risk. Another compensating factor, and indeed the crux of these tax-efficient investment vehicles, is the increased liquidity and lower transaction costs that they offer investors.

One of the key advantages of REIT structures has been observed in markets where REIT systems have been introduced, where discounts to Net Asset Value (NAV) have reduced substantially, removing the tax overhang from share valuations. Markets such as France have seen the average discount to NAV decrease from around 30% in early 2003, to a current aggregate sector premium of almost 10% since the tax efficient SIIC structure was introduced. In comparison, although the UK real estate sector has seen discounts narrow from around 40% in early 2003 to around 15% in anticipation of a similar structure, discounts to NAV still exist reflecting a tax disadvantage overhang on share valuations. This reduction in NAV discounts, coupled with strong aggregate performance of the underlying property markets in most countries since the early 1990's, has driven comparatively strong REIT performance globally. The chart below illustrates the strong and stable performance of the US REIT sector over the past ten years compared to the other main US equity market indices.

The EPRA/NAREIT Global Index includes the main constituent real estate stocks listed across the world and currently has a market capitalisation of some US$460Bn. However, the index does not include all listed stocks and is calculated on a 'free-float', or investible total basis, so care must be taken when comparing it to full market capitalisation totals used elsewhere. The largest markets that currently enjoy a tax transparent commercial property investment vehicle are the USA and Australia, followed by a plethora of smaller REIT markets. Recent years have seen Japan, France, Singapore, Korea and Hong Kong join the REIT bandwagon, while the UK, Germany, Italy, Taiwan and even Mexico appear likely to be next to join the revolution. Various other countries, especially in Asia, have also intimated their willingness to consider a similar structure.

Europe

The Belgian 'SICAFI' structure was introduced in 1995. The sector now has five listed companies, with the three largest and most liquid constituting a total market capitalisation of around US$3.0Bn. Belgian SICAFIs cannot invest offshore and have a current gearing limit of 50%, although they only have to distribute 80% of net profit in the form of dividends annually to shareholders.

The Netherlands has enjoyed one of the oldest REIT type systems in their BI structure which was established in its current form in 1969. The structure allows offshore investments and restricts gearing to 60% of property assets, although all earnings must be distributed to shareholders. There are currently seven main listed BI stocks with a market capitalisation of around US$16.5Bn.

France introduced the 'Société d'Investissement Immoblier Cotee' (SIIC) regime in 2003 with reasonably lenient rules including the allowance of both developments and non-prescribed gearing limits. The SIIC sector currently has four large and liquid stocks with a combined market capitalisation of around US$18.5Bn, although there are several smaller listed companies and more planned in the near future. The conversion charge that the French Government imposed on converting French real estate stocks is broadly seen as a potential precursor to any UK conversion charge. The final exit amount was settled at 16.5% of any unrealised capital gains, payable over four years in equal annual instalments.

In the UK, the publication of the Government document “Promoting more Flexible Investment in Property” was delivered in March 2004. Following a broad industry response, it is widely expected that some kind of UK system will be made available in the following couple of years, with Morgan Stanley explicitly expecting its introduction by April 2006. The property industry has argued for maximum operational flexibility while acknowledging the need to protect private investors. Many factors are yet to be decided, but the detail of the structure will be the key to how successful these tax transparent commercial property vehicles are in the UK.

Asia

The Asian Real Estate market enjoys the strongest growth prospects of all the regional property markets. UBS Warburg estimates that the region, including Japan and Australia, contains approximately US$1.3Tn of investment grade property, approximately the same as the US. The current total market capitalisation of the REIT sector in Asia is around US$80Bn. The Australian REIT market is estimated by JP Morgan and UBS to own around 45% of the investment grade real estate available in Australia, while the US market owns around 12.5%. Applying these numbers to the investment pool available in Asia infers the huge growth potential of the market.

The Australian market, along with the US market, is the most developed REIT market in the world. The Listed Property Trust status was originally created in 1971, although in their current form since 1985, and is characterised as being one of the most open regimes available. There are no restrictions on developments or on gearing, as long as the LPT pays all of its earnings out as dividends to shareholders. According to the Australian Stock Exchange, there are over 800,000 investors in the Australian LPT sector of over 50 LPTs (ASX) with a total market capitalisation of around US$50Bn. Most of these have an external property manager but some have internalised their management & operate a ‘stapled security' structure, which is effectively a trust with a management and/or a development company attached. Investors therefore have exposure to both entities through their LPT holding. Further evidence from the ASX suggests that while the LPT sector is correlated to the broader stock market, the sector has been found to be approximately 40% less volatile than the market (although more volatile than the underlying direct market). The total REIT sector constitutes approximately 8.5% of the total Australian stock market, and LPTs control almost half of all institutional commercial real estate in Australia.

The ‘LINK REIT', launched by the Hong Kong Housing Authority and the first Hong Kong REIT, is due to list shortly and has attracted an astonishing amount of investor interest. The real estate sector is a massive part of the listed Hong Kong stock market, with over 50 listed property companies with a total market capitalisation approaching $75Bn. The potential is clear and the size of the listed sector augurs well for REITs in Hong Kong if current tax transparency issues within the current legislative structure can be resolved.

Japan's Investment Trust Law was enacted in 2000 to create J-REITs. There are currently 14 listed J-REITs with total assets approaching JPY 1,611Bn, or US$16bn. The yield advantage that J-REITs offer domestic investors over domestic bonds has been cited as one of the strongest factors influencing the impressive growth of the sector to date, as they offer a current 2% yield advantage over Japanese Government bonds, although this has fallen from around a 4 to 5% gap since the sector was launched in 2001. This phenomenal growth in J-REITs has resulted in the sector now trading at a breath taking average premium to NAV of around 50%. There are more restrictions placed on J-REITs than standard real estate companies, and they have limited scope for developments and for gearing. They also must pay out more than 90% of income to shareholders, thus must raise external money to invest in more properties.

Singapore currently has 4 listed REITs with a market capitalisation of approximately US$3Bn. However, given the success of the sector to date, some of the other 31 listed real estate stocks, with a total market capitalisation of some $18bn in Singapore are expected to convert shortly. The S-REIT system was created in Singapore in 2002 and allows offshore investments, some development exposure and some limited gearing.

Other Asian markets are well placed to benefit from a similar tax efficient structure. South Korea already has a structure in place (RETF and CR-REIT) although there are currently no listed REITs yet. Malaysia is reviewing the REIT rules that it set in the early 1990's, while Taiwan is finalising its regulations, as is Thailand, the Philippines and India.

North America

Canadian REITs, known as Mutual Fund Trusts (or MFTs), were established in 1994. There are currently some 24 publicly traded REITs in Canada, with a total market capitalisation of around US$12.8Bn, most of which are typically more highly geared than similar vehicles in Australia and the US.

Congress created the US REIT asset class in 1960 to facilitate public access to the large-scale commercial property market. The diversification benefits due to lower correlation with other asset classes coupled with strong relative outperformance over most time periods conspire to push REITs up the desirable investment scale. The chart illustrates the huge growth of publicly traded REITs in the US, with over 200 Trusts and total assets approaching some $275bn.

Other countries, which are officially looking at introducing similar tax efficient systems in the near future, include the UK and Germany. UBS Warburg expect that following the recent well publicised scandals in Germany, there is now a 50%-70% chance that a German REIT will be established in the next few years.

Mexico has recently introduced the LISR law, which extends tax benefits to trusts whose sole purpose is to purchase and/or manage real estate. The law now just needs to be extended to offer guidance on how these trusts can be structured and the rules for distributions, etc.

The outlook for global REIT markets in general looks very positive, as retail demand shows no signs of slowing down. Most underlying direct property market fundamentals appear intact and while a general global slowdown in property returns in widely expected, strong positive returns should still be achievable in most markets. The UK and Germany appear to be the most likely markets to launch the next REIT type vehicles, while other countries are sure to be close behind. The potential for growth in REITs worldwide is summarised in the table below which shows that both Asia ex-Australia and Europe have the largest potential to grow.

	World Underlying Real Estate (%)	Underlying Real Estate (US %Bn)	Listed Real Estate US%Bn (total assets)	Listed REIT sector US%Bn	% listed real estate	% stock market	% underlying real estate	% underlying real estate in REIT
United States	43	2,525	295	295	49	1	12	12
Continental Europe	26	1,500	50	38	8	1	3	3
Japan	12	705	58	16	10	2	8	2
HK / China	9	540	68	0	11	7	13	0
UK	8	490	80	0	13	2	16	0
Australia	2	100	45	50	9	9	45	50
Total	100	5,860	596	399	100	3	10	7

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