The Good, The Bad And The Simple Truth: Why A REIT Structure Might Be Right For Your Investment

After a slow start almost 20 years ago, REITs have grown in popularity in the UK. When the government opened the regime to private investors in 2022, the number of REITs increased by 61% in just a year. 

However, an increasing number of investors are breaching its requirements and paying the consequences. For that reason, it is imperative to ensure strong compliance procedures and processes are implemented and maintained.

This is the view of Gen II Head of Real Assets Ben Mardon and Director, Head of Real Assets in the UK Barry Hindmarch.

Bisnow spoke to Mardon and Hindmarch about which investors can benefit most from entering the REIT regime and how to ensure good governance keeps an investment on the right side of HMRC. 

Bisnow: When REITs opened up to private investors in 2022, did they immediately see the benefits?

Ben Mardon: The benefits were obvious from the beginning, as REITs are designed to encourage on-shore investment through tax-efficient structuring. However, initial uptake of the private REIT was slow. 

Many investment managers were concerned by the strict REIT annual testing and potential disqualification for noncompliance or failing one or more of the tests and resulting in the structure being fully taxable under UK law.

As managers’ understanding of the REIT regime expands, many now see past their initial concerns. They recognise that a strong governance framework supporting the REIT is essential in managing ongoing compliance and are now comfortable with the structure, which has resulted in a significant increase in their use.  

Private REITs are now being used for both direct UK investment and by European funds coming into the UK as a local master holdco where the focus is on income-producing assets. 

Bisnow: What are the main requirements of a REIT?

Barry Hindmarch: There are four main tests. First, you’ve got to have a diverse portfolio. You can’t have one asset valued at more than 40% of a portfolio, and a REIT must hold at least three properties unless it has a single commercial asset worth more than £20M. 

Second, you have to generate 75% of profits from a property business. Any investments outside property can’t generate a large percentage of your income. 

Third, the property profits must exceed property finance costs by 1.25, excluding intragroup interest. So a highly geared portfolio may not be suitable. 

And finally, you have to distribute 90% of net property-related profits to investors. Investors can keep the remaining 10% for reinvestment or development, for example. A withholding tax of 20% is deducted from each distribution for applicable investors but may be fully or partially recovered. 

Bisnow: And what is the main benefit?

Hindmarch: That you have no capital gains tax to pay when you dispose of a property. This is a significant gain, which increasingly attracts private investors. 

Mardon: While the primary benefit of a REIT and focus is income-producing assets and meeting the distribution requirements, it also offers a possible exit strategy with the sale of the shares in the REIT, which in turns hold the underlying UK investments.

Bisnow: Given the requirements, what sort of properties is the regime aimed at?

Hindmarch: A REIT is not for high-risk developments or assets that need to be completely refurbished or rebuilt. They need to produce regular income. It’s not going to be real estate-focussed on an opportunistic strategy so is better aligned to core and core-plus strategies.

Residential increasingly suits this structure. A few years ago, residential wasn’t an institutional-grade asset class because it was dominated by smaller landlords, but now institutions are creating schemes, much in the line of the U.S. model. 

Challenges do come from rental properties with a high turnover of residents and short-term leases, however. 

Other asset classes that suit a REIT structure include logistics and industrial, as well as retail parks. We have one client based in Singapore who invests in data centres in Europe and uses a REIT structure in the UK.

Bisnow: How can an investor make the most of using a REIT structure? 

Mardon: You need to manage cash flows, make sure you meet the distribution requirements and be organised to look ahead to what you will need to declare.  

What’s critical is to have good governance in place. HMRC only requires an annual test, but our recommendation is to perform soft testing quarterly. This enables you to monitor ongoing compliance and reduces the need for last-minute corrections at the year-end to ensure compliance with the requirements. 

Bisnow: What risks does a REIT structure pose?

Mardon: Managing a REIT does require a different asset management approach to other funds. For example, we’ve seen investment managers undertake a build-to-rent scheme where they may be tempted to sell some units at practical completion, which is not in accordance with the regime, where assets are to be held as longer-term investments rather being actively traded. 

In general, the risks are minimal if you stick to the core strategy and actively monitor ongoing compliance, which is underlined by the fact around 10% of REITs have been disqualified. This is above the level people expect and underlines the need for strong governance by both the manager and the administrator. 

Bisnow: Can you give an example of poor management?

Mardon: One of the most common errors comes with rent-free periods. From an accounting perspective, you amortise the rent-free over the length of the lease and account for adjusted income from Day 1, but in reality, the tenant will not pay rent over the rent-free period. 

This creates a mismatch between distributable income and cash available to meet the distribution.   

The biggest challenge, however, is an investment manager who is being overly aggressive with their strategy, including early disposal of assets, which could be classified as trading rather than investment. 

Bisnow: How can a REIT ensure good governance?

Hindmarch: First, everything has to be documented. You have to hold the right board meetings and run them in accordance with regulations. 

We carry out a full suite of services to support our clients using UK REITs within their investment structures, including full support of the underlying propcos, the REIT and, as required, the entities above. That could be a UK fund in the form of a limited partnership or a Luxembourg fund with a pan-European investment strategy.  

Our services include accounting, administration, company secretary, local directors and tax services, including ongoing REIT compliance testing.

Bisnow: What would you say to a client considering entering the REIT regime for the first time?

Mardon: That it is surprisingly simple to enter. You can set the structure, make an election, and HMRC will then come back fairly quickly to confirm you have been accepted into the regime. 

Hindmarch: HMRC’s Leeds office streamlines applications because it is a structure that the government wants to encourage. They will guide investors, as long as you follow the rules. 

Once you’re in, the best approach is to partner with an administrator who understands how to maintain good governance. Each time we carry out quarterly tests, we go through the result with the client and see how sensitive it is to movement. 

But once you’re in, if you’ve bought the right kind of real estate and follow the rules, it’s a really good structure. I think we’ll see a lot more REITs in the future, particularly with the pooling of local government pension schemes.

This article was produced in collaboration between Gen II and Studio B. Bisnow news staff was not involved in the production of this content.

Studio B is Bisnow’s in-house content and design studio. To learn more about how Studio B can help your team, reach out to studio@bisnow.com.