I was
recently invited to join a team to study the economic implications of a
proposal to set up Real Estate Investment Trusts in the
How does REIT work?
In general, REIT is a legal entity that owns income-generating properties directly or through a subsidiary, and passes on the rental income to its share holders on a regular basis. It is usually set up by the owners of an existing income-generating property, who will initially transfer the title of the property to a separate legal entity, either a corporation or a trust (referred to as a REIT), and then list the REIT in the stock exchange by offering part of the ownership of the REIT to the public in exchange for equity infusion. The animated graphics at the bottom of this page provides a simplified example of the process of setting up a REIT.
What is in it for REIT sponsors
The property owners of the initial properties of the REIT are called its sponsors. Why do property owners want to set up a REIT, instead of, say, directly selling the property to a third party? First, the legal framework of REIT usually provides some tax benefits to the sponsors (companies that want to convert their real estate into a REIT) in exchange for the REIT’s meeting certain conditions in the types of properties that it holds and the distribution of its income. Second, instead of an outright sale, the sponsors can maintain partial ownership of the income-generating property, which is often not possible in the case of a property sale, or may have to be sold at a deep discount in the case of a partial sale. Third, a REIT set up allows the sponsor the flexibility of selling additional ownership of the REIT if the market condition is favorable, or buys back some or all of the ownership of the REIT at a lower price if the market condition is temporarily unfavorable. Fourth, the setting up of a REIT can help the sponsors develop a new business, namely, that of an asset manager, whose income comes from managing assets for all the share holders of a REIT, instead of just the sponsors, and the expertise so gained can be used on managing other assets for investors.
What is in it for investors
The difference between investing in a publicly listed REIT and in a publicly listed real estate holding company is that a REIT is usually mandated to own mostly income generating properties, whereas a real estate holding company can be holding a lot of properties under development, which are yet to prove their income generating capability, or may be developed mostly for the purpose of sale rather than for income, which means that the company’s income is less smooth or predictable. The real estate holding company can also own other assets, without any restriction on the proportion of the other types of assets that the company holds, which, again, makes the company’s income less certain. Second, a REIT is required to distribute most of its income to share holders. A real estate holding company is not under any obligation to distribute dividends to shareholders, even when it is making a lot of profits. These differences mean that REIT has a more definite risk/return profile than a generic real estate holding company.
Third, REIT usually is taxed in a
more favorable way to investors. In the
Why would government want to promote REIT?
If a REIT usually entails tax revenue loss, why would any government support its establishment?
First, the lower cost of financing and liquidity provided by REIT investors (as against financing through bank lending or bond issuance, which is particularly high in the Philippines) will promote investment in real estates in commercial, industrial and residential sectors. Such investments will create jobs in construction, real estate management, and finance. Hopefully, the jobs so created will feed back into the demand for real estate development, and thus sustain a virtuous circle. Without the incentives given in a REIT set-up, potential investors may simply keep their savings in deposits, or worse, use it up in consumption. Hence, REIT can be seen as a means to stimulate economic growth by encouraging real estate investment, using savings from individuals, instead of say, government financial resources.
Second, the establishment of REITs can
contribute to the development of the local capital market, especially when REITs
are listed on an exchange that allows easy purchase and sales of REIT shares.
Not only can a REIT framework provide an additional source of financing (direct
public participation) for real estate development, the listing and trading of
REIT shares, as well as the management of assets in a REIT, will generate demand
for financial professionals, which means the creation of high income jobs.
Listing of REITs on the local stock exchange, for example, is likely to increase
liquidity of and interest in local stocks. Stock transactions will generate
income for the government in the form of stamp duties. In fact, in financial
centers such as Hong Kong and
Third, REIT can be used as a means to promote home ownership. If directed at residential housing development, REIT can provide liquidity for the financing of such developments by developers. From a government’s point of view, it would be an effective means to encourage savings, which can be particularly important in economies with a low savings culture. Savings in the form of equity in housing will provide a cushion when the residents retire, thus reducing the economic impact on individuals as well as society.
There are also tax benefits to the government on a long term basis from new real estate developments resulting from REIT policy. Additional real estate taxes could be collected from new real estate developments by the local authorities on a recurring basis (versus VAT on consumption which is one-off) and can be used to pay for better public services.
However, it is by no means a certainty that the overall benefits to the government can offset the immediate tax revenue loss arising from the tax concessions to REIT, which can be substantial. In addition, while many tax concessions available to REITs are applicable to existing real estates, the long term benefits of REITs, such as the promotion of real estate development and capital market growth can only be estimated and may not be immediately apparent to officials responsible for public finances. Several of the tax concessions contained in the current proposal to the Senate are particularly contentious. These are :
Mitigating these tax revenue losses directly would be stamp duties to be collected from the trading of listed stocks of the REIT, the exact amount of which would depend on the number of stock transactions in a particular period of time. The more frequently the shares are traded, the more the stamp duties that would be collected. Income tax may also be collected from the original owner when the REIT delivers the sales proceeds from the sale of some of the shares that the original owner used to own to the investing public. Further down the road, the economy will benefit from faster and cheaper property development, as well as the jobs created in the construction industry.
The direct beneficiaries of the tax concessions to REIT would appear to be the REIT investors. However, the original property owner also stands to gain substantially, since the investors will take into account the net value of their investment before accepting the selling price of the REIT shares. Hence, the direct tax concession benefits would most likely be received jointly by the investors and the original owner, while the indirect benefits would be spread to the whole community over time.
The question that policy makers will have to ask is, what is the minimum tax concession that the government would have to make to induce sufficient interest from investors and sponsors to REIT? It is a question that is nearly impossible to answer. If we look at economies in the region that have introduced REIT, the prudent approach seems to be for the authorities to start with a moderate level of tax concession, and use the market response to consider whether further concession is required. It is always easier to give more than to take away concessions later.
In considering the moderate level of concession sufficient to attract the interest of local investors, one has to figure out the existing investment tendency of, and opportunities available to, local investors. Their perception of real estate investment, would also be useful. As regards foreign investors, it would be necessary to assess the attractiveness of Philippine real estate as compared to real estates in other Southeast Asian countries to foreign investors. The strength of the currency would also be an element in this consideration. Of course, the higher the level of attractiveness, the less concession will be needed, and vice versa.
As a global investor currently residing in the Philippines, I certainly would welcome more diverse investment instruments being introduced here.
Article by : Chiu-ying Wong, CFA, 15 January 2008.