REITs: a smarter way to invest in property?

REITs offer tax attractions and income averaging 5%. We run through the pros, cons and outlook for property investing.  

Is now the time to get back into the property market? If so, a real estate investment trust (REIT) could give you a highly tax-efficient route into the sector. For income-seeking investors in particular, the structure of a REIT has real attractions.

First things first, however. There is no getting away from the fact that large parts of the UK’s property sector have really suffered during the Covid-19 crisis. It is not much fun owning a shopping centre when all the shops are closed; and if you’re the landlord of an office block, predictions of the permanent demise of the workplace are not what you want to hear.

That said, it hasn’t all been bad news. Industrial properties – factories, manufacturing facilities and so on – have been less badly affected by the crisis, as the return to work was quicker in industries where people can’t easily work from home. And the retail warehousing and logistics sector has been a big winner from the boom in e-commerce, which has seen retailers scrambling for space.

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Moreover, some property specialists are convinced the sector is now in a position to bounce back, pointing to high demand from larger investors for physical assets such as real estate.

“Despite the adverse knock-on effects from Covid-19 on real estate, there is still a lot of dry powder waiting to target real estate once the dust settles,” says Rasheed Hassan, a director at the real estate adviser Savills. “While logistics and residential will continue to be top picks over the course of the next 12 months, alongside offices, we anticipate activity will return to most sectors of the market.”

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Leaving aside the merits, right now, of investing in property for a moment, the crucial point to understand about REITs is their unusual tax status. Since 2007, when the UK first introduced a REITs tax regime, these vehicles have been taxed in a different way to other property businesses.

To qualify as a REIT in the UK, the company must own commercial or residential property and rent it out; it must also distribute at least 90% of the profits it makes from this business to shareholders. REITs pay no corporation tax on their profits; instead, shareholders pay income tax on the distributions they receive. These are technically known as “property income distributions” but they do not count as dividends in the same way as payouts from other listed companies.

This makes REITs a potentially tax-efficient way to invest in property. First, they leave you free to use your dividend tax allowance – the amount of dividends you can earn tax-free each year – on other investments. This allowance is worth £2,000 in the 2021-22 tax year.

In addition, if you hold your REIT shares in an individual savings account (ISA) or private pension, which both shelter investments from tax, there will be no income tax to pay on the distributions you receive. So not only will the REIT have a bigger pool from which to pay out income, since it pays no corporation tax, but also, you won’t have to pay any tax when you receive this payout.

Nor are ISAs and private pensions the only options for investing in REITs while maximising tax efficiency. Shares in REITs can also be held in tax-efficient insurance wrappers, including life insurance and capital redemption policies, and life annuity contracts.

One other tax wrinkle is worth mentioning. REITs must be incorporated in the UK or in a small number of other locations, such as the Channel Islands. Wherever they are incorporated, they are treated for tax purposes as if they were based in the UK, with one important exception: there is no stamp duty to pay when buying shares in non-UK REITs. This is why many REITs are incorporated in the Channel Islands.

Broadly speaking, REITs in the UK fall into two categories. First, a number of traditional property businesses have opted for REIT status since the regime was introduced 14 years ago. Segro (LSE:SGRO), British Land (LSE:BLND) and Land Securities (LSE:LAND), the UK’s three biggest property developers, are all structured as REITs.

These businesses might be described as property trading companies. They buy land with a view to developing it, often have large workforces, and may be managing major construction projects as well as maintaining a portfolio of properties that are rented out.

By contrast, some REITs are collective investment vehicles – funds, just like an investment trust that holds UK equities, say. They may have only a handful of employees, and typically outsource the day-to-day running of their property portfolios to a specialist management company.

Both types of REIT look attractive to income seekers, for whom low interest rates make it difficult to secure attractive yields elsewhere. The average fund REIT currently offers a yield of 5% according to the Association of Investment Companies (AIC). Trading REITs tend to offer slightly lower yields, but Land Securities, for example, currently offers 3.8%.

This level of income compares very favourably to cash savings, which typically offer less than 1% today, but also to corporate bonds, where you would be lucky to get much more than 3% outside of the more risky high-yield issues.

All of which brings us back to the question of whether now is the moment to put your faith in property. Dzmitry Lipski, head of fund research at interactive investor, is in the optimistic camp.

“Despite challenges, the long-term fundamental case for property as an asset class remains intact and it remains a key part of the alternative assets mix,” he argues.

“Yields and valuations still look attractive relative to other asset classes, and property remains a solid option to generate income and diversify an investor’s portfolios.”

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Certainly, data from the Investment Property Forum (IPF) suggests many in the property industry believe the sector is now bottoming out. Last month, the IPF published forecasts for 2021 and 2022 based on predictions from around 20 leading property investors. This year, it sees a total return – income and capital growth combined – of 4.4% from the sector as a whole, rising to 6.9% in 2022.

The IPF does point to significant variations from different sub-sectors. Its total return forecasts in 2021 range from a 12.7% gain for industrials to a 9.8% decline from shopping centres. But its forecasts for 2022 are in the black across all areas.

Many commercial property trusts are preparing to exploit emerging opportunities, argues Christian Denny, EMEA capital markets research and strategy director at real estate specialist JLL. “Investment vehicles that are able and willing to invest directly in real estate assets or debt, as well as companies, are clearly having no difficulty in attracting capital,” he says, pointing to a number of large institutional investors and private equity funds that have raised money for investment into the sector in recent months.

For retail investors thinking of joining them, it is worth pointing out that the REIT sector offers both generalist and specialised opportunities. Traditional property companies with REIT status include giants of the sector including Segro, which focuses on industrial assets, and UNITE (LSE:UTG), which is a student accommodation specialists, as well as Land Securities, British Land and Derwent (LSE:DLN), which have broader portfolios.

Among the fund REITs, the generalists include BMO Commercial Property (LSE:BCPT), one of interactive investor’s Super 60 choices, and Custodian REIT (LSE:CREI). But there are also specialists such as Tritax Big Box (LSE:BBOX), which offers a pure play on the logistics sector, and Supermarket Income REIT (LSE:SUPR), which is effectively an investment in the groceries industry.

What about US REITs?

The US is the original home of the REIT, having launched the world’s first REIT tax regime in 1960. Today, there are around 200 REITs listed on US markets – potentially providing international diversification opportunities if you have significant existing UK REIT investments.

As in the UK, US commercial real estate suffered during the Covid-19 pandemic, although the US government’s fiscal support packages provided some relief to the sector. There has been some evidence of a bounceback during 2021, particularly in major cities and in the industrial sector.

US REITs are structured very similarly to their UK counterparts; they pay no corporation tax, with income tax payable by investors when they receive distributions. These distributions are typically paid after 30% withholding tax has been deducted, but UK investors, in theory, benefit from a double taxation treaty with the US, which can reduce this to 15%. However, you may need the help of an accountant to ensure you receive this relief.