Brown stands up for REITs

Real estate investment trusts will help those who don't want to buy-to-let, says Chris Partridge

Real estate investment trusts (REITs) which will enable small investors to put money in property without paying tax twice are on the way, Gordon Brown announced in his Budget speech. REITs will fill a big gap in the options open to small investors who do not want to risk their whole nest egg in one buy-to-let property, but for whom shares in property companies are highly taxed and subject to the often irrational booms and busts of the stock market.

Real estate investment trusts (REITs) which will enable small investors to put money in property without paying tax twice are on the way, Gordon Brown announced in his Budget speech. REITs will fill a big gap in the options open to small investors who do not want to risk their whole nest egg in one buy-to-let property, but for whom shares in property companies are highly taxed and subject to the often irrational booms and busts of the stock market.

REITs spread the risk, building up a portfolio of residential and commercial properties that are owned collectively - a bit like unit trusts but with the added security of owning land rather than companies and also gaining economies of scale in their property investments.

The two main differences between REITs and quoted property companies are that they are not taxed, and the income is almost entirely distributed as dividends to shareholders, who pay income tax individually.

REITs have proved immensely popular in the US, where they were introduced in 1960. France, Japan and Australia have similar schemes. At present, UK tax law makes property unit trusts unattractive because the trust pays corporation tax and capital gains tax, and the investor then pays income tax on top. Despite the disadvantages, there are a number of unit trusts based on property in the UK, but they usually concentrate on office blocks and trading estates.

Investors can also buy shares in publicly quoted property companies that own and manage properties to rent; but not only do they pay tax twice but the share value depends on the whims of the stock market rather than the underlying value of the properties they own. Listed property companies are effectively valued at between 30 and 40 per cent below the market value of the properties they own, which makes borrowing more capital difficult and also makes them vulnerable to bids from asset-strippers.

David Melhuish, senior policy officer at the Royal Institution of Chartered Surveyors, believes REITs will be popular when they arrive in a year or so. Unfortunately, there are obstacles to overcome first, mainly to ensure overseas investors still pay taxes.

"It is very positive that the Chancellor intends to legislate, although there are a number of things outstanding," he says. "We have a year to close a number of tax loopholes, but not a lot of progress has been made so far."

REITs will be good for small investors who don't want the hassle of buy-to-let, says Phil Nicklin, real estate tax partner at Deloittes. "What you can't do as an individual is buy a small corner of Broadgate [the massive office complex in the City of London]. You can buy shares in the quoted property companies such as Land Securities but these shares are dominated by what shares do, rather than the value of the properties," he explains. The arrival of REITs will not mean the end of property-based unit trusts and shares in property companies, Nicklin says, but will appeal to the average investor. "REITs are a halfway house between actually buying a bit of property and current property shares," he says.

The limitation that active investors may find with a REIT will be that you will not be able to sell your holding back to the fund, but will have to sell it on the open market.

You will have to wait a while for the money, however. The removal of the requirement for unit trusts to hold at least 20 per cent of assets as shares mean that managers will need time to dispose of properties to repay unit holders.

The proportion of income that REITs will have to distribute is yet to be fixed. "At present, it is likely that REITs will have to distribute 95 per cent of rental income but that depends on how it is calculated," Nicklin says.

The impact of the new investment vehicle on established institutions will be dramatic. Unit trusts will have to be reformed to cope. "There is an anomaly in property unit trusts, where rental income is taxed at 20 per cent whereas trusts holding bonds are taxed at nil rate," says Nicklin. "We are hoping this will be straightened out."

Many quoted property companies will want to convert to REIT status, which should remove most difficulties they face as ordinary companies. The transition could give them huge windfalls in unpaid capital gains tax.

* When Gordon Brown began considering REITs two years ago, he wanted to anglicise the name. "Property investment trusts" would be the PITs, so he chose "property investment funds", but everybody began to take the PIF (even accountants have a sense of humour). So it's back to REITs.