Reforms to the Real Estate Investment Trust regime: comments on the consultation document released on 4 April 2012 Grant Thornton UK LLP (Grant Thornton) has considered the questions raised in the consultation document setting out the possible reforms to the Real Estate Investment Trust (REIT) regime, published by HM Revenue & Customs (HMRC) on 4 April 2012. Grant Thornton welcomes the opportunity to comment on the consultation on reforms to the REIT regime, to explore the potential role social housing REITs could play in supporting the social housing sector and to consider the tax treatment of REITS investing in REITS. Grant Thornton is one of the largest accounting services firms in the UK. We act for some 130 housing associations and other providers of social housing including 50 of the top 200: more than any other professional services firm. As a professional services firm with extensive experience of the social housing sector we are well placed to comment on the technical aspects of the consultation, in particular as regards to the suitability of the REIT regime. We also comment on the investment and commercial aspects of the consultation based on our experience of dealing with social housing sector clients, and have taken their comments into account in formulating this response. Specific comments We set out our comments on the specific questions raised in the consultation document below. Question 1. Does a financial constraint exist for social housing providers? If so, please elaborate In our view, there is currently a financial constraint for social housing providers. The reduction in the availability of grant funding for social housing has created a considerable financial constraint for those associations wishing to develop. This is at a time when long term debt financing is no longer being made available by banks, and the shorter term financing options that are being offered by the banks have significantly higher interest rates. The other financial constraint relates to rent levels. Rents are predominantly set at social housing levels, which may not provide sufficiently attractive returns for commercial investors. The new affordable rent regime, which allows rents to be set at up to 80% of market rate, may provide more scope to move to a different funding regime in the future. Question 2. What sources of finance are housing providers currently using to support affordable housing development? The traditional forms of financing are bank financing and grants, as set out in question one above. Question 3. What new sources of finance are housing providers exploring to support future development? An increasing number of housing providers are issuing bonds to raise funds, either in their own name or as part of a consortium (such as through The Housing Finance Corporation Limited). These bonds are typically issued in the open market and bought by a range of investors, such as UK and overseas institutions. However other options are also being taken up, such as sale and leaseback of properties, lease and leasebacks, joint ventures and alternative models, depending on investor requirements.
Question 4. Does the size of the housing association impact the financing opportunities available to it? If yes, please explain In our view the size of the housing association does impact the financing opportunities available to it. Smaller providers generally have fewer options available to them as the administration costs of some of the financing options are only feasible if larger funds are required. The stock held is also relevant because it affects the ability of the provider to deliver a certain level of return, hence their attractiveness to investors. Question 5. How attractive is affordable housing as an investment for institutional investors? What, if any, are the barriers? Institutional investors have traditionally not been significant investors in UK residential property. This aspect was explored in some detail in the Government's consultation on investment in residential property. The key issues identified were that: small unit sizes make it difficult for institutions to build up sufficiently large portfolios to make investment worthwhile small unit sizes involve, relatively speaking, more administration and management than larger commercial properties (for example a single office block) the lower yields available compared to commercial property mean that some churn in the portfolio is required to increase on-going returns. Residential property also typically has a larger gross to net yield difference, often requiring significant on-going expenditure to keep it updated. This is normally a landlord cost, while for commercial property such costs are borne by the tenant (under full repairing and insuring (FRI) leases). These issues can apply equally to social housing. There are other issues that would affect the attractiveness of equity investment in social housing beyond those applying to general residential investment as follows: The purpose of social housing is to provide accommodation at below market rents (highlighted in paragraph 2.1 of the consultation document). This can mean that providers of social housing do not have a sufficient income stream to support the level of funding required to develop new housing. Historically this gap has been met by the provision of government grants. It is difficult to see how sufficient return would be generated for investors investing in vehicles developing new housing unless grants were maintained, at least at their current levels For existing housing, the position is different. Where housing has been developed some time ago and rents have risen (albeit at below market levels) while interest rates have been fixed, there will typically be a margin between rental income and interest expense. This margin offers a potentially attractive return for investors, and if it continues to grow, would mean attractive capital growth as well as income. Whether such an income stream is attractive to investors will depend very much on the pricing; investors will compare risks and rewards on other investments in deciding whether the price justifies investment. Social housing providers can use proceeds from sales to reinvest in new housing development. As vendors, they will need to ensure the price is not set too low to avoid accusations of enriching investors Social housing rents are often paid directly or indirectly by local authorities, which may be perceived as a lower credit risk investment than large numbers of ordinary residential tenants. We note the comments at 3.11 of the consultation document which state that social housing tenants typically having longer tenures which are more likely to be renewed and thus offer a lower risk of void periods. This benefit may go some way to compensating for the lower levels of rent, although investors may require guarantees from Local Authorities or Registered Providers to fully bridge the gap
Question 6. What role is there for REITs to play in social housing for either low cost rental or affordable home ownership accommodation? The REIT is one of a number of possible vehicles which are suitable for property investment. Limited partnerships, offshore unit trusts and Property Authorised Investment Funds are other vehicles which provide similar tax benefits to the REIT, in particular tax 'transparency', being the absence of a tax charge at the level of the entity itself; the taxability being transferred to the investors. REITs are unlikely to represent a complete solution to the financing needs of the social housing sector. However, the equity finance will, in effect, be a long term source of funding for the social housing stock; this is likely to be beneficial for housing associations as it enables them to make long-term decisions about the socio-economic needs of particular areas of the UK. A REIT represents a tax efficient way of reducing the risk of direct ownership for institutional investors and is a well-known investment vehicle on the international markets. Much of the debate, so far, has been around assessing whether REITs will work for low cost rental provision. It is possible that the characteristics of shared ownership may be a better model for the REIT structure. Shared ownership will fit better with the risk/reward concept attaching to equity investment and provide a chance to make a return on both the capital value of the property as well as the rental element of the arrangement. We have not modelled a possible scenario for shared ownership but, in our view, the success of such a model would depend on: acceptance that shared ownership arrangements are investments rather than trading the demand for shared ownership in meeting the needs of (what are increasingly seen as) the 'squeezed' middle income earners attempting to get on the housing ladder the extent to which lenders are prepared to provide mortgages for shared ownership properties. Question 7. In what circumstances might REITs be an attractive means of accessing finance compared to existing financing options? REITs represent a long term source of funds which makes them attractive compared to the financing currently available from banks. A number of social housing providers have recently issued, or explored whether to issue, bonds on the financial markets. The price that a bond achieves is a reflection of the market's assessment of the risk associated with the entire association and can be affected by any smaller elements of the business plan or perceived issues with the governance or wider organisation (for example a recent change in chief executive). REITs will be attractive if: set up costs are reasonable. Therefore the listing requirements on smaller markets need to be possible if they work for some of the mid-tier housing associations as well as the very largest. This means that the REIT rules need to be flexible in allowing smaller associations sufficient time to meet the REIT conditions there needs to be an allowance for 'churn' in the portfolio. The churn will allow some tenants to exercise their right to buy but, crucially, also allow the REIT to capitalise on uplifts in market prices in some locations to fund upgrades or new developments of social housing in other areas of the country. We consider this to be a crucial element of a Social Housing REIT as their investment will be required particularly in disadvantaged areas.
Question 8. What would the social housing REIT business model need to look like to generate attractive returns? In addition to the comments above, the small unit sizes typical of residential investment, and the lower levels of rent, may mean that administrative costs of dealing with individual tenants make an investment in an entity which deals directly with the tenants unattractive. We consider that a model where the REIT has an overriding lease, or a number of leases, with one or more housing associations, would overcome these concerns. The housing association would still deal directly with the tenants (under existing or new leases) and therefore significantly reduce the administrative burden as existing arrangements can be utilised. This arrangement would also lower the barriers of entry for new REITs into the market. Question 9. What level of return would be considered attractive to your investors? Grant Thornton does not manage investments and cannot, therefore, respond to this question directly. However, based on our significant general commercial experience, any investor would expect a competitive return that was comparable to other investments with a similar levels of risk. The level of risk can be managed by adopting the head-lease/sublease structure we refer to in our response to question eight. Question 10. What reforms would be needed to enable REITs to support a social housing business model? Recent relaxations to the REIT rules have meant that barriers to the attractiveness of REITs identified at the time of the residential consultation process have, to some extent, been removed. In particular the proposed abolition of the conversion charge makes the use of REITs a more feasible proposition. The introduction of the multiple dwellings relief rules for Stamp Duty Land Tax (SDLT) removes an SDLT disadvantage for large investors acquiring portfolios of properties, compared to smaller investors buying single properties, which will be especially important for social housing. However, in our view, some technical issues remain, as follows. A REIT is required to distribute 90% of its taxable property business income. This reduces the amount of cash available for reinvestment and expansion in the REIT. For REITs owning commercial properties, taxable property business income is reduced by capital allowances which effectively reduces the distribution requirement. Capital allowances are not available for residential property. Therefore, a 90% distribution requirement could require commercially unacceptable levels of distribution to be made (possibly to the extent that distribution requirements exceed the level of cash available to the REIT) As noted above, to compensate for the typically lower yields on residential property, some churn of the portfolio is often made. The technical issue which arises is that, if such profits are trading for tax purposes, they are not tax free in the REIT. To make the REIT regime more attractive for residential property, a relaxation of the classification of such income as 'harmful' for the REIT would be required. This relaxation would also enable a social housing REIT to participate in the 'right to buy' schemes currently being operated by a number of Local Authorities. Private investors may consider the gearing ratio test of existing REITs too onerous and limiting the attractiveness of a REIT as investment vehicle for residential property A further issue which arises in respect of social housing sales is that, in certain circumstances, a sale of a property can trigger a requirement to repay grants previously paid, which could further reduce commercial returns A REIT has to be listed and therefore the costs of the listing have to be weighed against the benefits. The REIT also has to comply with a number of detailed conditions, which, in some cases, can impact on the commercial operation of the REIT
Because of the issues identified above, REITs are not always the vehicle of choice for property investment, and in many cases a partnership or unit trust structure may be preferred. The same could apply to investment in social housing. However, if there is investor appetite for investment in social housing then REITs would certainly be among the vehicles to be considered. In our view, the attractiveness of REITs could be greater if: there were to be some relaxation to the 90% distribution requirement to compensate for lack of availability of capital allowances there were a relaxation of the trading restrictions in relation to the churn of properties the regime were to be extended to private companies, possibly with a diversity of ownership test. As noted above, for new housing it is likely that grants would have to be maintained to be attractive to investors. In our view, a possible alternative might be to tax social housing REIT dividends at a lower rate than other REIT dividends, thereby offering a partial subsidy in a form other than a grant. This would not be of benefit to non-taxable investors such as pension funds and would, in fact, deter such investors from this sort of investment unless they could make a reclaim of notional tax to compensate for the lower commercial return. The benefit to the Government of such a structure would be to divert the Government subsidy from initial grants to fund tax incentives over the life of the project. Tax also needs to be considered in respect of transfers of housing portfolios from existing housing providers to the REIT. SDLT at rates up to 4% could arise on the transfer, and even if multiple dwellings relief applies to give lower rates, this would still be a significant cost. Housing associations often have charitable status and, therefore, direct taxes should not normally arise, although social housing providers who do not have a charitable status could face a tax charge on transfer. Relief from or deferral of the timing of these taxes on transfers to a REIT could encourage greater take up of the REIT regime for social housing. Question 11. What benefits and risks should be considered as a consequence of changing the REIT regime? In our view, the benefits could be: a stable source of long term funding for the housing sector which should support other sources of funding for affordable housing and increase capacity for building more houses ability for retail investors to invest into UK residential property, albeit through fractional ownership of a REIT portfolio. UK public opinion and view of the economy is often linked to home ownership; in the absence of being able to own a home outright, owning shares in a REIT may be a suitable alternative less reliance on government grant for affordable housing. The risks may be that: properties are not well-maintained as the REIT tries to maximise profits less funds are raised on the back of the properties transferred so that the housing association could, in fact, have raised more loan or bond finance on the basis of providing housing assets as security in the long term the loss of tax revenues may outweigh the shorter term initial public subsidy, ie the government subsidy is a one-off payment whereas the loss of tax revenues will be in perpetuity currently housing associations can reinvest surplus funds into the provision of new services and homes. Some of the surpluses from a REIT will be lost for good to the sector in the form of dividend payments changing the REIT rules for social housing without also changing the rules in the same way for other investments would make the regime more complex, and may also create a disparity between the available types of investment, benefiting social housing at the expense of other types of investment.
Question 12. What practical issues that affect implementation should be considered? Key practical issues to be considered would be the attitude of the regulator to the transfer of the properties to the REIT, in particular the treatment of any associated social housing grant. Another key issue is whether a social housing REIT will represent an attractive proposition to investors. This will be determined by the risks, pricing and underlying strength of the income stream. Question 13. Are there particular social housing regulations that might be affected by the introduction of REITs? If so, please explain. The regulatory issues we see as arising would be: the requirement to demonstrate value for money once properties have been transferred to a REIT whether the REIT will be a registered provider the rules surrounding who can invest in the REIT balancing the interests of customer service and maximising returns for investors majority ownership of REIT shares variety of regulators with slightly different interests for example the Homes & Community Agency, the Financial Services Authority, and the Charity Commission. Question 14. What role should social housing regulators play in regulating REITs in this sector? In our view there should not be a role for the social housing regulator in the direct regulation of REITs. Their role should focus on the impact of taking part in such schemes on value for money and governance, and to ensure that property which should remain regulated does so. Question 15. Given that the REITs regime applies to the UK and social housing is a devolved matter, does this give rise to particular issues that should be considered? The issues that should be considered are those noted in questions 12-14 above. The solutions to the issues raised will vary depending on the nuances of each devolved regulators specific rules. Questions 16 to 22. REITs investing in REITs We would welcome a measure to treat dividends received by a REIT from another REIT as non-taxable. The REIT dividends received would form part of the REITs profits to be distributed under the 90% test, and so an appropriate proportion would be taxed on receipt by shareholders. In theory, if a REIT dividend passed up through a chain of REIT ownership, a proportion smaller than 90% of the original REIT dividend would ultimately be taxed. Although we doubt that this would lead to significant avoidance, the distribution requirement could be changed so that a higher proportion of REIT dividends had to be distributed. Allowing a UK REITs to invest in other REITs would allow REITs with surplus cash to invest in REITs with expanding project books. Any measures which increase liquidity in the REIT share markets are likely to lead ultimately to increased investment in the sector.
Contacts For any queries in respect of our comments in this document, please contact: Kersten Muller Andrew Levene Francesca Lagerberg (email: kersten.j.muller@uk.gt.com) (email: andrew.levene@uk.gt.com) (email: francesca.lagerberg@uk.gt.com) Grant Thornton UK LLP Grant Thornton House Melton Street Euston Square LONDON NW1 2EP Telephone: 020 7383 5100 Fax: 020 7383 4715 www.grant-thornton.co.uk 2012 Grant Thornton UK LLP. All rights reserved. "Grant Thornton" means Grant Thornton UK LLP, a limited liability partnership. Grant Thornton UK LLP is a member firm within Grant Thornton International Ltd ('Grant Thornton International'). Grant Thornton International and the member firms are not a worldwide partnership. Services are delivered by the member firms independently.