Listed property companies could start converting to real estate investment trusts (reits) from May, but investors in listed property company shares or property unit trusts (Puts) converting to reits should not expect to see the value of their investments increase immediately.
The benefits are likely to become apparent over the long term, with the listed property sector receiving a boost from increased foreign investment, experts say.
However, some investors may find that, after the expected conversion of most listed property entities to reits over the next year, they will no longer be able to offset the tax exemption on local interest against distributions made by these entities.
Reits are entities that invest directly in property and enjoy a unique tax dispensation. These structures are recognised in a number of different countries, and provision was made for them in South Africa by way of an amendment to the Income Tax Act last year.
The effective date for the new tax regime for listed reits was April 1, but recently released listing requirements are effective only on May 1. Companies whose financial years end in March or April are expected to be the first to convert.
Other listed property loan stock (PLS) companies are expected to convert to reits over the year from May, when their financial years begin, Estienne de Klerk, chairman of the Property Loan Stock Association Reit Committee and executive director of the largest listed property group, Growthpoint Properties, says.
Any new listings in the real estate sector of the JSE will have to comply with the JSE’s reit listing requirements, the exchange has said.
Patrycja Kula, business development manager at the JSE, says that when South African listed property entities convert to reits, South Africa will be the eighth largest reit market in the world.
“The reit structure is in line with international best practice, and having a globally understood structure will make our listed property sector much more attractive to foreign investors. The tax advantages of the new structure will also make the sector much more attractive to local investors,” she says.
The JSE says more than 25 countries use a similar reit model, including the United States, Australia, Belgium, France, Hong Kong, Japan, Singapore and the United Kingdom.
Neil Stuart-Findlay, co-manager of Investec’s Property Equity Fund, one of the top-performing domestic real estate funds, says the new reit structure will create greater tax transparency and certainty. When PLS companies convert to reits, their net asset value (NAV) is expected, on average, to increase by 10 percent.
PLS companies make up the bulk of the real estate sector on the JSE.
The expected increase in NAV is because most companies will be able to reverse their balance sheet provisions for capital gains tax (CGT), as reits will not be liable for CGT. Puts are already exempt from CGT.
Stuart-Findlay says, however, that this increase in NAV is unlikely to drive a sharp increase in share prices upon conversion, as the market is far more focused on forward yields than on NAVs when determining valuations.
De Klerk says what could affect the price of listed property shares will be the higher demand for these shares from foreign funds tracking global reits indices, in which local reits will now be included. He says there will not be an immediate material increase, but over time the impact will be positive.
Stuart-Findlay says although some lesser real estate indices used by foreign investors may include South African real estate companies in future, and this will be positive for these shares, it will not result in any immediate, dramatic change in their share prices.
He says that although reits will be slightly more attractive than the current entities to foreign investors, foreign shareholdings in local reits are expected to remain quite low.
The new structure could also facilitate the unwinding of some cross-holdings between real estate companies because the tax advantages of doing so would fall away, Stuart-Findlay says. This should allow management teams to focus on their direct property investment strategies rather than being distracted by issues related to their shareholder base. Over time, this should translate into enhanced shareholder value, he says.
De Klerk says one of the negative consequences of the conversion of listed property entities to reits is that investors in PLS companies (directly or through a real estate fund) will lose the ability to offset the tax exemption on local interest against the distributions paid by these companies.
PLS companies pay their distributions as interest, but once they convert to reits, their distributions will be regarded as a taxable dividend or rental income, and the tax exemption will no longer apply.
Taxpayers who receive distributions from reits will have to include them in their taxable income and will be taxed on these payments at their marginal tax rate. They will, however, be able to deduct costs, such as those incurred in acquiring the reit shares.
De Klerk says the tax exemption on distributions from reits was removed by National Treasury because it plans to introduce a tax-incentivised savings vehicle in 2015. It has proposed that individuals will be able to invest R30 000 a year up to a lifetime amount of R500 000 in these vehicles and receive all the interest, rental or capital gains made on these investments tax-free.
If your retirement fund (retirement annuity, pension, provident or preservation fund) invests in a reit, the distribution will not be taxed in that fund.
De Klerk says another negative consequence of the conversion to the reits structure is that foreign investors in reits will pay dividends withholding tax at 15 percent, or the applicable double-tax agreement rate on the distributions made by reits.
A positive tax implication of the conversion to reits is that reit shareholders will not pay Securities Transfer Tax on buying or selling reit shares.
The listed property sector was the most active sector on the JSE over the past 12 months and has a market capitalisation of about R222 billion.
CONVERSION WILL HELP YOU TO COMPARE PERFORMANCE
The distinction between the different types of listed property entities will be maintained after they convert to real estate investment trusts (reits), but it is likely that property unit trusts (Puts) will eventually disappear.
Estienne de Klerk, chairman of the Property Loan Stock Association Reit Committee and the executive director of Growthpoint Properties, says there have been significant shortcomings with legislation when Puts have been involved in takeovers, and investor rights are limited.
There are now only six Puts on the JSE, and De Klerk does not expect that any more will be listed. Some may convert to companies after becoming reits, as a result of the corporate restructuring or rollover relief granted in the income tax amendments, he says.
When a Put converts to a reit, it will be listed as a “trust reit” on the JSE, while property loan stock (PLS) companies converting to reits will be known as “company reits”.
De Klerk says Puts will automatically be listed on the JSE’s reit board on May 1, but shareholders in PLS companies will have to apply to the JSE and meet the requirements before these companies can be listed as reits.
The main difference between PLS companies and Puts is in their capital structures, and one is a company while the other is a collective investment scheme.
Although Puts are collective investments, they invest directly in property and are listed on the JSE. Real estate unit trust funds are typically not listed and invest in the shares of Puts and PLS companies.
When you invest in a PLS company, you buy a linked unit. A linked unit consists of a share and a debenture (or loan). The debenture portion earns interest at a variable rate.
The interest comes from the net income (income less expenses and interest on debt) that the PLS company derives from rentals on the properties in which it invests.
The share portion makes up only a nominal value of the linked unit.
Puts are controlled by the Collective Investment Schemes Control Act (Cisca).
By law, all income earned by Puts must be paid out to investors. When they convert to reits they will have to distribute only 75 percent of their earnings.
PLS companies have generally distributed about 100 percent of their income, but there was no minimum requirement for them. They will, on converting to reits, also have to distribute 75 percent.
Historically, Puts were more strictly regulated than PLS companies and could not, for example, borrow money to buy more properties.
More recently, Puts’ borrowings have been limited by their trust deeds to a percentage of their assets, and the amounts they can borrow may only be changed with the approval of the unit holders.
To qualify as a reit, companies must:
* Have a minimum of R300 million in assets;
* Have a total debt-to-asset ratio of no more than 60 percent;
* Derive 75 percent of their income from property rentals;
* Distribute a minimum of 75 percent of the distributable profits (dividends);
* Have a risk policy that is monitored by a committee of the board; and
* Not enter into derivative instruments that are not in the ordinary course of their business.
The conversion to reits is expected to help you, as an investor, to compare the performance of the different listed property entities.
“The new sector umbrella body, the SA Reit Association, is compiling best-practice accounting disclosure and reporting standards. This will improve disclosure in the sector, and make it easier for accurate comparison of different South African Reit counters,” De Klerk says.
BENEFITS OF INVESTING IN LISTED PROPERTY
Listed property is a distinct asset class, and investing in it enables you to diversify your portfolio.
What makes listed property a distinctive asset class is that it gives you two ways to beat inflation: through growth of the capital investment and regular rental income distributions, Estienne de Klerk, chairman of the Property Loan Stock Association Reit Committee, says. This growth is supported by rental escalations contained in the property leases.
Neil Stuart-Findlay, who co-manages Investec’s Property Equity Fund, says listed property, like equities, enjoys growth in earnings while, like bonds, it is underpinned by a healthy yield based on the contractual rentals the properties are expected to earn.
Stuart-Findlay expects listed property to provide a yield (the distributions as a percentage of the share price) of just below seven percent in 2013, and he expects income to grow by seven percent.
“These two dynamics provide an underpin for the sector to continue to deliver real returns in the year ahead,” he says.