With a huge underlying property base, U.K. REITs are off to a fast start.

By Sarfraz Thind

After waiting nearly four years filled with speculation and debate, the U.K. property sector finally saw a REIT framework implemented on Jan. 1, 2007. The legislation received an immediate seal of approval as ten of the country's largest property companies converted to REIT status. With a large underlying property base and strong interest in domestic business, industry experts are hoping that these 10 companies are just the beginning of a strong U.K. REIT platform.

		The Starting Line-up As of May 2007, 10 U.K. real estate companies had elected REIT status. Here are 10 industry representatives who will become more familiar in the pages of Portfolio.

The 10, which consist of Big Yellow Group PLC (LSE: BYG.L), The British Land Company PLC (LSE BLND.L), Brixton PLC (LSE: BXTN.L), Great Portland Estates PLC (LSE: GPOR.L), Hammerson PLC (LSE: HMSO.L), Land Securities Group PLC (LSE: Land.L), Liberty International PLC (LSE: LII.L), Primary Health Properties PLC (LSE: PHP.L), SEGRO PLC (LSE: SLOU.L) and Workspace Group PLC (LSE: WKP.L), have £65.9 billion ($128.96 billion U.S.) in assets under management, approximately 71 percent of the total £91.9 billion ($179.84 billion U.S.) of the U.K. property listings in the FTSE EPRA/NAREIT Global Real Estate Index. Analysts expect an additional seven or eight companies to convert to REITs later in 2007, boosting the REIT total to 80 percent of the overall listed U.K. property market.

All Systems Go

Larger property companies such as British Land, Land Securities, Liberty International and Hammerson have benefited from deferred tax write offs of approximately £1.3 billion ($2.6 billion U.S.) and £850 million ($1.6 billion U.S.), respectively. Hammerson and Land Securities also will receive savings of £300 million ($600 million U.S.) and £1.6 billion ($3.2 billion U.S.), respectively.

"This is the holy grail of property investment products," says Mike Prew, property analyst at Lehman Brothers in London. "Real estate professionals have been waiting for this change to see equity capital marshaled more carefully into the industry."

A report published by the investment research firm Ibbotson Associates showed the Sharpe ratio (historical returns divided by volatility) of U.K. property stocks over the last 10 years to be 0.48, whereas the equivalent figures for REITs in the United States and Australia were 0.73 and 0.97, respectively.

"This is clear evidence that REITs have a better risk/reward ratio than non-REIT property shares," says Patrick Sumner, head of property equities with Henderson Global Investors. "It is reasonable to expect an improvement in the U.K.'s Sharpe ratio with the arrival of REITs, because the relatively dependable dividend will make up more of the total return."

Ironing the Wrinkles

Despite its overall warm welcome, the REIT legislation is not without its wrinkles. Not all in the industry share the outward mood of optimism. The major stock market reaction to the government's REIT proposals occurred in March 2006, when investors swamped the property sector and created an 8 percent jump in share prices in one day.

In contrast, January 2007 has seen a 4 percent decline in property share values as investors worry that U.K. real estate growth could subside in 2007. This means that retail interest in the market could be a gradual affair. "Retail investment in REITs will come out of regular savings," Sumner says. "People won't move wholesale from bonds to property in a drastic fashion."

U.K. REIT Rules On balance, most market participants have welcomed the government legislation as having delivered a solid and workable REIT framework, as well as having created a new way for investors to tap into the underlying property market. Under the new rules, REITs are regulated by the amount of borrowing they can carry due to the stipulation that income must cover borrowing interest by at least 1.25 times. Furthermore, at a minimum, 75 percent of REIT earnings must come from rental sources, a rule which is designed to provide a stable cash flow to investors. Additionally, REITs are required to distribute 90 percent of income as dividends, so that earnings are delivered in a manner similar to direct property investment. The legislation should attract more dedicated REIT-focused investors, as in countries such as Australia and the United States.

Furthermore, there are key gaps in the legislation that need to be addressed, industry experts say. "There is still some way to go in order to make it easy for new companies to come to market," says Dave Butler, program coordinator at Reita in London, an organization that raises investor awareness of the benefits of REIT investing in the U.K. "The stipulation under the rules is that you need to lease a minimum of three properties. This can be a difficult rule to satisfy for new companies converting to REITs."

Some also feel that the laws have not done anything to improve the passive style of property management seen in the United Kingdom. Martin Barber, chief executive at Capital & Regional PLC has been one of the most vocal critics of the government legislation in recent months. "For companies with large historical capital gains liabilities, it has been a no-brainer to convert," he says. "However, for others, there remain some serious operational restrictions for U.K. REITs. The laws prevent any form of internal management, which means that U.K. REITs can't operate their own companies as they can in the United States. Even if you have a subsidiary company managing properties, it will breach self-occupation rules."

However, some U.K. REITs' performance was undoubtedly boosted by the REIT conversion, such as British Land, which was FTSE 100's third-highest performer in 2006. Companies electing to convert averaged more than 48 percent, according to Lehman Brothers data. This was marginally less than the balance of the FTSE 350 property index1, which registered more than 50 percent.

"There was an 11 percent discount in late January when U.K. fund managers sold out of the sector. Then U.K. REITs were rated to a 10 percent premium to NAV and now trade on a 3 percent discount," Prew says. "However, global REIT fund managers are buying the sector as the 'natural owners' of REITs in the long term."

While REITs are required to pay out taxable income, the overall estimate is for a rise in the amount of dividends paid out in the first year. "Dividends would be less if companies only paid out the minimum required," Prew says. "But we think they will make higher discretionary distributions. Our estimate is for U.K. REIT dividends to rise by 30 percent to 60 percent in the first full year of REIT status."

Monitoring European REIT Traffic

With its strength as a financial hub and its huge underlying property market, analysts such as Prew are confident that the U.K. will become the center of the European REIT business. Participants already have begun to organize initiatives to open up the market further. At the beginning of 2007, the FTSE Group launched a series of U.K. REIT indexes to provide added transparency on the performance of companies involved in the business, and to support the development of REIT index-linked investment and derivative products in the future.

REIT-hungry funds from across the globe already have shown strong interest in the U.K. market, and are expected to play a big part in its future growth. Last year, the European Public Real Estate Association (EPRA) estimated that there will be some £150 billion ($190 billion U.S.) of capital inflows entering the European market in the next five years.

For property companies and financial advisors seeking to broaden the country's retail exposure to property, the U.K. legislation is a very positive step. "Financial advisors are keen to give retail investors property exposure—suddenly you have £65.9 billion of listed property in the U.K. on a level tax field which opens a new source of investment," Sumner says. "With 75 percent of the income source coming from rents, which tend to be stable, REITs could prove a strong draw for retail investors."

¹ The FTSE 350 consists of all companies in the FTSE 100 and FTSE 250, representing the largets 350 eligible companies.