It was all going so well, at least in the eyes of Ed Balls, economic secretary to the Treasury, who gave a bullish assessment to the Merrill Lynch Real Estate conference in March.
He spoke of his delight that there had already been 10 converters, and he expected more to follow. “It’s now for the industry to take the opportunities that UK Reits provide,” the minister said. “There is space for innovation in the regime, and I look forward to seeing how the industry responds to that over the coming months and years. We in the Treasury will be watching the development of UK Reits closely.”
Poor performance
However recent reports suggest that UK Reits are the worst performing in the world this year.
Their negative returns could lead analysts to downgrade the sector and foresee the end of the UK’s commercial property boom.
Only in the UK is the Reit market, as a whole, trading at a discount to the net value of the underlying property assets, the industry benchmark for valuing a property company.
Continuing interest rate rises have fuelled speculation about a downturn in the UK’s property market. Investors are therefore cutting their exposure to the sector.
UK Reits are in their infancy compared with those in other European countries such as France, Belgium, the Netherlands and Greece, as well as markets such as the US, Australia, Japan and Hong Kong.
Traditionally, Reits trade at a premium to net asset value, thanks to their tax-efficient structure. Globally they trade at about 35% average premium to Nav.
However, British Land is at a 12% discount, while Land Securities Group and Liberty International are trading at 8% and 5% discounts, respectively.
Under the tax rules, Reits must distribute 90% of their property rental income in dividends to shareholders. Investors consequently expect higher dividend yields. However, UK Reits will pay lower dividends compared with earnings than in other countries and with fears of further interest rate increases, their struggles are set to continue.
According to the FTSE/EPRA/Nareit Global Real Estate Index for April, the global benchmark for Reit performance, UK commercial property returns have fallen 8.3% this year.
High launch point
Michael Lindsay, head of real estate corporate finance at KPMG, warned at the end of 2006 that the timing of the Reits launch, at a high point in the property cycle, would make things tough for the new financial vehicle.
He is not surprised by the sector’s early struggles. “There was a clear risk that there might be some underperformance because the market had been so strong,” he says. “But it has only been four or five months so it is still early days.”
Rising interest rates will not help the market’s growth, as they are likely to hit property yields, which are already low in comparison with other countries, he adds.
Although listed property companies such as Hammerson and Land Securities were quick to convert to Reits, there has not yet been a following pack. There have been isolated examples.
Vector Hospitality, a UK hotel holding company with 78 hotels and conference centres managed by such names as Hilton and Marriott, worth a total of £2.6 billion, announced its Reit in May. The Local Shopping Reit, the first to specialize in UK retail properties, raised £160 million in the same month.
However, Punch Taverns, which was widely seen as a likely convert, says that the time is not right for a conversion. Giles Thorley, its chief executive, says market conditions are not good for its £7 billion property portfolio to convert.
Although Reits offer tax efficiency via distribution of profits to shareholders through higher dividends, Punch says its corporate tax levels are manageable and that its portfolio is too large for the current market, which Thorley says is too frothy.
Pub groups Greene King and Wolverhampton & Dudley Breweries, along with Punch and Mitchells & Butlers, have all held back from moving into Reits, despite each having sizeable property assets.
“I think there are probably a lot of people who will wait to see what the reaction is. There is some risk in being the first mover,” says Lindsay.
Reita, the organization that markets Reits in the UK, says interest is growing among UK financial advisers.
