In the 2019 Budget Speech presented by the Minister for Finance in Parliament on 22 October the minister stated that discussions surrounding an initiative about financial instruments, known as Real Estate Investment Trusts, which provide investors with the opportunity to invest directly in the property market, are close to conclusion. It is planned that from 2019, the administrative, fiscal and regulatory framework will be completed, so that REITs can start being traded on the Malta Stock Exchange markets.
Malta is one of a very few countries in the developed world not to have a REIT regime and the announcement made by the minister is indeed a very positive development and REITs will be a welcome addition to the local universe of securities.
A REIT is an investment vehicle for real estate that is comparable to a mutual fund, allowing both small and large investors to acquire ownership in income-producing real estate assets that may include office buildings, shopping malls, showrooms, hospitals, hotels, storage facilities, and so on. Such investment vehicles could equally be called Real Estate Investment Funds because essentially that is what they are.
On the local front one would assume that government's intention is to establish a REIT regulatory framework for income-producing commercial real estate assets and real estate related assets excluding residential assets. This would certainly be the more sensible approach. One would also assume that it will be mandatory for all REITS to be listed on the Malta Stock Exchange and their shares traded publicly. This is normally a requirement in all jurisdictions where REIT regimes exist.
What distinguishes REITs from other listed real estate companies is that a REIT must acquire income-producing real estate properties to operate them as part of an investment portfolio, as opposed to either developing or reselling those properties after the development is completed.
One may ask what the real benefits of REITS are when there are already a number of property-related equites listed on the Malta Stock Exchange. REITs provide a way for individual investors, small or large, to earn a liquid share of the income produced through the ownership of commercial real estate, without actually having to buy commercial real estate. REITs provide income-seeking investors with an extremely liquid stake in real estate, allowing both small and large investors to acquire ownership in certain real estate assets that individual private investors cannot usually access.
REITs normally receive special tax treatment. A REIT is normally income tax and capital gains exempt, but shareholders will have to pay tax on the dividends. To ensure that a regular flow of income is subject to tax at the shareholder level, in most jurisdictions, REITs are required to distribute between 85% and 90% of their profits. This distribution requirement does not include capital gains which can be retained within the REIT, however, shareholders are normally also taxed if they receive exempt capital gains. Most REITS offer Dividend Reinvestment Plans that allow investors to reinvest their cash dividends by purchasing additional shares, at a discount of between 1% to 10%, of the current share price.
REITs often have a competitive advantage on corporate acquisitions, as other non-REIT bidders may have to discount their purchase price for latent capital gains. The benefit can potentially be shared between the buyer and the vendor to increase their post-tax proceeds and reduce the REITs purchase price. REITs are therefore able to make decisions in a tax-exempt environment, based on the commercial performance of individual assets (without having regard to which assets would give rise to taxable capital gains on disposal).
On entering the REIT regime any latent capital gains on rental properties are effectively eliminated. The REIT tax regime removes the traditional "double-layer" of taxation, where profits are taxed at both the company and shareholder levels. Instead, tax is generally only payable at the shareholder level, giving improved after-tax returns to shareholders. There are normally restrictions whereby a penalty tax charge is payable by a REIT if it pays dividend to significant shareholders who may be beneficially entitled to a substantial share of the REIT's dividend payments.
One of the most important economic benefits of REITs is that they enable owners of pristine commercial properties to unlock and release equity on what is generally considered to be a very illiquid asset thus providing an alternative source of funding to owners of commercial real estate.
The commercial property market in Malta has some very particular characteristics that place it at the higher end of the illiquidity scale. An asset is illiquid when it cannot be sold easily or exchanged for cash without the lapse of time or without incurring loss in value. This can cause holders of illiquid assets to experience losses, especially when the investor is looking to sell quickly. Illiquid assets also typically lack depth of market.
It is mainly the shallow market that makes the Maltese commercial property market particularly illiquid.
Firstly, the number of local institutional investors who have an appetite for holding commercial properties in their investment portfolios are few. Those that exist are often constrained to the extent of their investment allocation to this asset class by the size of their balance sheet or by regulation.
There are no local pension funds or family offices which are normally the typical investors in commercial real estate assets. Furthermore, the few local institutional investors such as insurance companies and investment funds that have the resources to invest in commercial real estate in Malta may already be close to or at their maximum permissible allocation.
Not to mention, that over the years increased regulation and capital requirements have not been kind in their treatment of this asset class and have made it increasingly difficult for regulated institutional investors to increase their investment allocation to commercial properties.
Secondly, the number of foreign investors who put their money in local commercial property can only be very small. This is due to a number of reasons foremost being that international property investors prefer investment in properties in major cities and Malta is often not on their radar.
Another important reason why foreign investors are often discouraged from investing in local commercial property is because the market does not offer an effective exit route in the event that an investor wishes to liquidate a commercial property.
Thirdly, it has become increasingly costly for institutional investors to hold physical properties with the result that, more and more institutional investors are now looking at accessing investment in commercial properties through property funds or REITs.
The introduction of REITs in Malta will therefore go a long way to address the challenges and barriers inherent in the local commercial property market and to an extent will also provide the liquidity that is currently lacking.
REIT Regulatory Regimes differ from country to country but in most jurisdictions a REIT must normally
- Be a listed entity with shares traded daily
- Distribute a very large part (normally between 85% and 90%) of its annual profits in the form of shareholders' dividends
- Be managed by a Board of Directors or Trustees
- Have shares that are fully transferable
- Have a minimum of 100 shareholders after its first year as a REIT
- Have no more than 50% of its shares held by five or fewer shareholders during the last half of the taxable year
- At the beginning of each tax accounting period, at least 75% of the REIT's gross total assets must relate to real estate income generating assets or be held in cash or cash equivalents
- Derive at least 75% of its gross income from real estate assets
- Hold more than one property and, of these, no single property can exceed 40% of the value of the total properties owned by the REIT
- REIT must not hold owner-occupied properties
- The REIT can sell property holdings, in which case, the realised capital appreciation is reflected in the dividends.
REITs also offer a number of benefits to private investors, particularly small investors, namely:
1. Access: REITs facilitate access to investment in certain real estate assets that individual private investors cannot always access
2. Diversification: Over the long-term, REIT returns have shown little correlation to the returns of the broader stock market
3. Dividends: REITs provide a stable income stream to investors through the payment of high dividends
4. Liquidity: REITs listed on a stock exchange can easily be bought and sold
5. Performance: Over most long-term horizons, REIT returns outperformed the S&P 500, Dow Jones Industrials and Nasdaq
6. Transparency: Listed REITs operate under the same rules as other public companies for regulatory and financial reporting purposes.
Another important benefit of REITs to an individual investor is that REITs are not allowed to be developers. By investing in businesses that own the real estate assets one would be eliminating the risk of development which is often regarded to be the highest risk when investing in real estate. Also, shares of property development companies are normally much more volatile than those of REITs. In more efficient markets investors looking for diversification in the REIT sector can get exposure in REIT ETFs.
Every investment comes with benefits and risks. REITs can only reinvest a maximum of between 10% to 15% of their annual profits back into their core business each year. This may cause some of the REITs to grow at a slower pace than a normal company. Although the dividends paid by REITs are backed by long term rental streams, these are never guaranteed. Cyclical downturns in the commercial real estate market could make REITs business less stable and more volatile. Governments have the right to increase property taxes over time to increase their budget revenue. Such measures normally reduce the earnings of REITs.
The high dividend pay-outs made by REITs may lead management to go for higher leverage to expand real estate holdings. This would result in higher interest being paid if financing is obtained from banks or through fixed income securities. This would in turn reduce earnings. In contrast, expansion in real estate holdings may create additional sources of income for leveraged REITs.
Against the backdrop of a rising interest rate environment, REITs can be one of the obvious losers. This is because REITs are asset-heavy investments that require high levels of leverage, borrowing substantial amounts of money to purchase properties that they subsequently rent out. With rising interest rates, REITs will have to fork out more in interest payment, potentially reducing the distributions they can pay to investors. A high debt to asset ratio can therefore be a concern. In Singapore for example, on average, REITs have a debt to asset ratio of just under 35%. It is normal for regulations to prescribe a threshold for the maximum leverage that a REIT can have at any time.
However, REITs have the advantage that they can raise money from public offerings and private placements rather than from banks or through bonds. In fact REITs globally have continued to favour follow-on equity offerings, which accounted for 61% of capital raised in 2017. Private placements of common stock have contributed a further 11% of all capital. It is of course highly important that REITs are properly managed by highly skilled and experienced managers and must be regulated by a regulatory regime that is robust, stable and sustainable and which ensures the highest levels of prudential supervision and consumer protection.
On the international front, there is an opportunity for Malta to attract foreign REITs to be established in Malta and managed from Malta. This will depend on the attractiveness of our regulatory framework compared to that of the principal jurisdictions such as the UK, Singapore and Hong Kong. In this regard it is hoped that government will emulate and improve upon the regulatory framework of the leading jurisdictions. Tax legislation remains a fundamental requirement to create an effective REIT market.
REITs have been around for around 60 years. While certain countries have unique value propositions, many of the key attributes are indeed common. According to EY's latest Spotlight on REITS, there are currently around 37 REIT markets in the world with a total market capitalisation of approximately $1.7 trillion. While the US is clearly the world leader there are several nascent and emerging countries that have developed attractive regimes. The number of countries offering REITs as an investment vehicle has almost doubled in the last 10 years.
It is hoped that government and the Malta Stock Exchange will embark on as wide a consultation process as possible with all the stakeholders prior to defining and articulating Malta's REIT regime. Government would also do well in engaging one of the leading international advisory firms who have significant experience of REITs in other jurisdictions.
The announcement made by the Minister of Finance in the 2019 Budget Speech is most welcome and long overdue.
David G. Curmi
The author is Chief Executive Officer of Mapfre MSV Life plc, the leading provider of life insurance protection, long term savings, investments and retirement planning in Malta