An Injection of cash that won’t hurt a bit

Probably the hottest topic over the past couple of years within property has been the introduction of Real Estate Investment Trusts or REITs. Yet this landmark event has largely seemed to slip by, with column inches instead being devoted to prime minister Gordon Brown's housing pronouncements and the possibility of a property market crash.

As a result, less attention than expected has been focused on one of the most interesting and innovative changes in the property market to appear in the last two decades.

REITS are investment vehicles that benefit from certain tax advantages (normally reduced corporate income tax). Listed on the stock market, they own, and sometimes manage, income-producing property – either commercial or residential – and have existed in the US since the late 19th century. By the time the legislation making REITs possible was signed into law in the UK last year, they also existed in Australia, Japan, and several other European countries.

However, life has not been easy for the nine companies that converted to REIT status on 1 January this year. The share price of Brixton, a specialist owner of warehouse and industrial space, fell from 529p last October to 348.5p by August. Likewise, British Land’s share price peaked at £17.21 last December but by

15 August had fallen to £12.41. There are a number of possible reasons for these slumps, including uncertainty over the commercial property market, caution over a not-yet-mature type of investment and, recently, the market volatility triggered by the “sub-prime” crisis.

Despite this, REITS are unlikely ever to collapse. As property owners, they are underpinned by hard assets, and the yield is essentially tax-free rental income. So unless the property market collapses completely, a REIT should ride out any potential storm.

Even though stocks are currently underperforming, it is rational to think ahead beyond the current dip, and ask what will happen to UK REITS as the market moves upward. It has been generally assumed that REITs will focus on commercial property – shopping centres, offices, industrial units and so on. However, in more mature markets, particularly the US, much wider specialist REITs covering the public sector have been set up. There is no reason why a second generation of UK REITs cannot expand into new property sectors and provide wider opportunities for growth.

Arguably, the most obvious growth sector is also the most overlooked. UK REITs could easily expand into the public sector, with mutual benefits for both. Because of the long leases involved with government property, investing in a hospital, prison or government office building could be seen as a very secure investment. From the government’s point of view, REITs could be a way of fulfilling political objectives without having to lobby for additional central funding.

Unless the property market collapses completely, a REIT should ride out any potential storm

This model would have particular significance at a time when the government is focusing on building new homes. For example, REITs could strike a deal with local authorities, agreeing to build the houses for them, in return for rental income as their fee.

Indeed, recent reports confirm the likelihood that procurement for hospitals, schools and keyworker housing will use REITs, particularly as they already exist in the US. John Fraser-Andrews, an analyst with HSBC, has said that there is particular scope for public sector assets becoming REITs.

This route might be seen by some commentators as replacing existing capital funding structures, namely PFI/PPP. However, there are crucial differences between PFI and REITs. For instance, PFI is long-term whereas REITs are much more immediate; PFI is often very complex, REITs are much simpler. Rather, both REITs and PFI are mutually compatible and just provide differing funding options.

REITs complement PFI as a way for the private sector to help the public sector meet its targets. REITs are a much simpler way to raise money – they have instant cash available waiting to be spent, and the returns are annual, rather than 10-30 years away. Crucially, tax is not payable on any income, unlike PFI.

Overall, the future of REITs appears solid. Admittedly many property companies prior to

1 January this year profited handsomely from the introduction of REITs (share prices among FTSE 100 property companies rose 45% in anticipation of the new regulations), yet the current flattening of profits and yield appears to be re-balancing more sustainable market levels.

The government can actively help achieve some of its political objectives by supporting private companies spreading out to become public sector REITs. In this context, REITs are to be applauded as they will deliver immediate regenerative benefits while providing cost-effectiveness to the pub lic sector. So while REITs might have dropped off the property radar so far, do not be surprised if they start to make a much louder blip over the next six to 12 months.