Should you buy into the Reit revolution?

published 26 July 2006

One group had a pleasant surprise from last week's Budget. Property companies were given an incentive to convert themselves into real estate investment trusts (Reits) and become tax-efficient property vehicles, says Ian Watson in The Business. Reits are pooled property vehicles, listed on the stockmarket, which buy up property and then lease or sell it. The Inland Revenue has finally removed several restrictions that were seen as stumbling blocks to their introduction in January 2007. The news sent the shares of leading UK property firms "soaring" and the reaction from the firms themselves, which had previously described the first draft legislation as unworkable, was "positive".

The Reit revolution: lessons learned from the Sipps fiasco

After the Sipps "fiasco", when investment property was at first going to be included in personal pension schemes and then not the Chancellor was keen to get Reits right the first time, says Edward Simpkins in The Daily Telegraph. So what are the details? Although Reits will be tax-exempt, they will have to distribute 90% of their profits in the form of dividends; the shares must be listed in the UK; and no single investor can own more than 10% of the firm. At least 75% of the vehicle's assets must be in property and 75% of its income must be in the form of property rentals. Borrowing will be restricted so that earnings cover interest payments by 1.25 times and firms that want to become Reits will have to pay a "conversion charge" of 2% of the market value of their property.

This is the beginning of what could turn out to be a Reit revolution, says Simon Watkins in The Mail on Sunday. It's not only the big property groups such as British Land, Land Securities, and Hammerson that have seen their share prices respond. Large retailers could also benefit, and Tesco's shares rose too. The supermarket could "demerge" its property business to take advantage of the tax break and split itself into two separate companies Other sectors pubs or hotels, for example with chunky property assets might also consider the Reit option.

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The Reit revolution: M&A activity in the property sector

But beware, says Jim Pickard in the FT. Although the property sector is now heading for a "vigorous period of mergers and acquisitions" as firms jostle for position, this is on the basis of the widely held belief that tax-free UK Reits will trade at a premium to net asset value (NAV). Across Europe, for instance, premiums to NAV have reached as high as 30%. But there is no "golden rule" that says this is necessarily the case. The main point of Reits is that income, not NAV, is likely to become the new reference point. Elsewhere, Reits may trade at a big premium because they can offer dividends of 5% or more, but in the UK, where yields are lower, this looks "unlikely".

Reits don't change the property industry's fundamentals, agrees John Waples in The Sunday Times. They don't fill empty buildings, increase rents or change the industry's basic cyclicity. Property shares are already trading at premiums to NAVs and without capital growth they "can't go any higher". When they were introduced in America in the early 1990s, Reits were designed to rescue a property industry that was "on its knees". In Britain, the exact opposite is the case. So there is a real danger that when Reits are introduced in January, retail investors will be encouraged to buy in at the peak of the cycle. The excitement is already "in the price".

The Reit revolution: the best property plays

We would urge caution, but if investors do want to invest in UK property, Reits offer diversified holdings and yield attractions. If you can't wait until January, have a look at shares in property agents Savills (SVS, 1,268p) and DTZ Holdings (DTZ, 659p), which were both upgraded to buy' from hold' by Panmure Gordon after the Reits announcements. The broker said it has raised its earnings forecast and target price for Savills on the expectation of "strong long-term growth", due to the transfer of property to Reits vehicles, says Afx News. For DTZ, rising European profitability is also good news. Savills yields 3.5% and trades on a p/e ratio of 18 times, while DTZ yields 1.5% and its p/e is a hefty 32 times.

Slough Estates (SLOU, 654p) shares posted one of the biggest gains in the sector following the Budget. Slough, too, is likely to qualify to become a Reit, says Michael Jivkov in The Independent, and the shares were also boosted by better-than-expected results. On a price/earnings ratio of seven times, the shares have "underperformed" the sector and, on a longer-term view, they will "go higher": "buy".

Reits have "taken the world by storm", says Citigroup. It is "overweight" UK property stocks in a global portfolio, favouring Land Securities Group (LAND, 1,914p) although it already trades at an 8% premium to net asset value and yields just 3%.