Secrets of Success: Real estate could be a real investment

Most investors should be taking an interest in what the Chancellor comes up with by way of a regime for the creation of so-called real-estate investment trusts in next month's Budget. It is a safe bet that there will be a boom in demand for these trusts if he comes up with a remotely sensible tax and legal framework.

Most investors should be taking an interest in what the Chancellor comes up with by way of a regime for the creation of so-called real-estate investment trusts in next month's Budget. It is a safe bet that there will be a boom in demand for these trusts if he comes up with a remotely sensible tax and legal framework.

Reits, as they are known in the trade, are a simple concept and already exist in many other countries. The biggest market, inevitably, is in the US, but they have also proved popular in Australia, France and other European countries. Their attraction is that they let individuals of modest means invest directly in a diversified property portfolio.

At present, this is not something, perversely, that it is easy to do efficiently in the UK. Nobody in the UK, where the cult of home-ownership is more extreme than almost anywhere else on the planet, needs reminding of the attractions of property as an investment. But from an investment perspective, the way most people choose to invest in property is horribly skewed.

By choice and/or necessity, most people in this country have most of their capital tied up in just one property: the house they live in.

The buy-to-let phenomenon, happily fuelled by the mortgage-lending industry in the past few years, has offered people the chance to buy further houses and flats. Their hope is that they will recover the costs of ownership through the rent they are paid and eventually realise some capital growth to fund a pension or another prudent objective.

But this has done little to dent the fact that putting the bulk of your money into just one property, even one you take extravagant care of and enjoy living in, exposes you to a high degree of specific risk.

Not only is the value of your investment tied to the particular location and features of the property, which could be affected by any number of unexpected things, such as flooding, a new road and so on, but all your money is in one type of property, residential.

While the long-run returns from housing have been more than respectable, those who see their homes as an investment are also exposed to valuation and liquidity risk.

As anyone who can remember the great negative-equity period in the early 1990s will agree, house prices do not go up in straight lines, though it sometimes seems like it at the time. And there is no guarantee that you can sell your home at the precise time you need to do so. The cost of buying and selling are not inconsiderable, either.

From an investment perspective, therefore, investing in property solely through your home is like buying one share in a single market sector, but not one that is freely traded on the stock market, such as BP or GlaxoSmithKline. What you have, in effect, is an unquoted investment that you can buy and sell only with a lot of effort and cost. In favourable conditions, this is obviously worth having, especially if you are good at picking houses, but it is far from ideal in investment terms.

The idea behind Reits is to create a vehicle through which you can invest in a wide range of property assets - offices, warehouses and shopping centres as well as residential property - and do so in a way that allows you to increase or decrease your exposure cheaply and at will.

These days, this is hard to do. The obvious route is to buy shares in a property company. This gives you the choice of a range of different types of property portfolio to invest in, plus the benefits of diversification and ease of buying and selling.

But the big drawback is that property shares are a notoriously inefficient way to gain exposure to property as an asset class. It is not just the fact that the managements of property companies have not traditionally been that dynamic, but that the returns from the underlying property portfolio are, in effect, taxed twice before they reach the hands of the investor. The company itself pays tax on its realised income and capital gains, and the investor pays tax again on any dividends that he/she receives.

Reits are specifically designed get round the double taxation problem. Because they are investment funds, they can trade assets within their portfolio without paying corporation tax. If they are investment trusts, they also have the chance to gear up investment returns through the sensible use of borrowing.

If experience in other countries is any guide, Reits will rapidly proliferate. The supply will come either from existing property companies converting to this new status (though the pace of this will depend on exactly how much of a tax penalty the Chancellor demands from companies seeking to go down this route), or through new products launched by fund-management groups.

Property funds have been quite a growth area in the past few years, because of the absence of enabling legislation to create Reits, but most of this growth has been in offshore funds, rather than in conventional onshore funds (unit trusts, investment trusts, Oeics). There is only one specialist property investment trust of any size, the TR Property Trust.

Its shares have powered ahead in recent weeks in anticipation of the surge in demand and a possible rerating of the property sector that could follow the publication of a favourable consultation document from the Treasury next month, although Reits themselves will not be created until next year. This amounts to an important and interesting opportunity for investors. A healthy Reits sector would be unquestionably be an important step in creating a new, flexible asset class for investors of all kinds.

Two questions, though: how quickly will this market grow and, more fundamentally, is this a good time to be adding exposure to the property market on valuation grounds? The commercial property market in particular looks very overblown at present, and it would not be the first time that a Chancellor has offered investors a new investment medium at precisely the wrong point in the cycle for that asset class.

I hope to return to these important questions shortly.

jd@intelligent-investor.co.uk