Real Estate Investment Trusts (REITs) could distort the characteristics of property for investors. Property has provided excellent returns for many people over the last 10 years, and while REITs are not expected to produce the same returns as direct property ownership due to additional charges and costs, they will permit investors to diversify their investments by providing a low entry level.
The ins and outs of REITs
Unlike investment in an individual property, which requires large amounts of capital as well as time and expense, REITs allow investors to share the benefits of property investment without the overall risks and costs that accompany property ownership through a small portfolio.
Investors will purchase shares in the REITs of their choice, which itself owns a selection of property. It will focus on property in the residential or commercial sectors in the UK or overseas markets depending on its purpose, so the investors can choose the sector they want to put their money into, but they will not have any say on the particular properties that are purchased. REITs will be managed by property professionals who will handle the day-to-day running of the property portfolio, making any decisions about the purchase, sale and management of its contents.
Changing characteristics
People generally understand direct bricks and mortar investment, but not the characteristics of property change when it is put into a fund. Direct property is time-consuming and expensive. It can also be hard to sell in a slow market and difficult to purchase against competing buyers in a strong market.
Creating new issues
In theory REITs address a number of these issues, but at the same time they create new ones. For example, they have the potential to be large diversified portfolios of property giving the investor a spread of investment, but the tax treatment of REITs makes a bias towards UK-only property quite likely, in order to minimise tax on rental income that is likely to occur in overseas holdings.
The requirement for REITs when they launch in January 2007 is for them to have a full quotation on the London Stock Market or another major overseas listing such as in Dublin, not on AIM or OFEX directly. Being on a major exchange means they provide liquidity to the investor, should they wish to buy or sell their share in the fund on a given day. The downside is that if many people want to sell their shares at the same time, the price of the share will naturally drop through the excess supply, and the price achieved could be below the asset value of the company. Equally, if there is excess demand for the REIT, it could drive the share price above the asset value of the property within the firm. This is different to directly held property or property within closed funds, where the valuation is directly related to the property value.
Clearly changes in investor sentiment that cause fluctuations in the share price of a REIT are not directly changing the value of the underlying property assets. It is for precisely this reason that REITs will have the effect of distorting the characteristics of property somewhat, making this type of property fund act more like an equity investment. This will increase to some degree the correlation of REITs to the performance of equities, particularly in periods of short-term market disturbance and for most investors this is the opposite of what they are seeking when diversifying into property.
An illiquid asset
As property is an illiquid asset, the provision of liquidity through a full listing could be seen as a great benefit, as the investor has an exit route by selling their shares to another investor, without forcing the company to sell its property. If a significant number of investors wished to exit a traditional open property fund at the same time, as happened in Germany a year ago, the fund would have a crisis if it could not return enough cash to the investors. It would be forced to try to sell its underlying property assets to create liquidity once it had used up the cash available on account, which may not be possible in a timely manner, creating significant asset value loss at fire-sale prices. In all likelihood, as property is a slow asset to sell, the fund may well need to revert to being a closed fund as happened in Germany, or significantly delay the sale date of the units for the investor.
