The people who are running a significant portion of South Africa’s commercial properties are going REIT mad.
As such, the next time you walk through the V&A Waterfront, Hemingsway Mall, Umlazi MegaCity, Hyde Park or Canal Walk you might want to take a moment of pause and reflect on this thing called REIT. It is coming to shake the very core of South Africa’s commercial property sector.
In the short term, only the JSE listed property funds will be rated. These funds are invested in some of the most prestigious properties in the country, including the ones listed above. The sector is currently valued by the market at more than R200bn. As such, while sounding like the normal corporate gobbledygook, the introduction of the Real Estate Investment Trust (REIT) regime in South Africa will be very much in your face. It can be described as a special tax regime for property funds with far reaching consequences.
If you have missed the phenomenal returns delivered by the listed property funds, watch this REIT development closely because it is likely to trigger another good run from the JSE hosted queer asset class. “While the sector has already had a good run and is not expected to top last year’s performance, we think the introduction of the REIT structure will further support valuations,” says Thabo Ramushu director and analyst of property equity fund manager Meago. It is an exciting development, says Ramushu.
As an offshoot of a broader movement to flush out tax dodgers in complex financial structures, the REIT thing is huge. Big operators who move money from different corners of the globe to engineer tax havens will certainly be watching this development as it is also coming to rock their world.
Expected to take off at the beginning of April, the REIT regime is being carefully constructed to keep money flowing into bricks and mortar. However it has been crafted to flush out those seeking to create “thin capitalisation” opportunities, a practice where investors present what should have been equity as loan investment to derive the tax benefit attached to interest income.
Well Deserved Tax Benefit
The sleek thin capitalisation creators came close to spoiling the party for property funds. These funds have a legitimate case to style a portion of their investment as loan types, debentures with no maturity date, but still draw interest income tax benefit. South Africa has two types of these property funds which run on a hybrid capital structure mixing equity with debt as part of a single tradable unit. The oldest type is the Property Unit Trust and the Property Loan Stock was added later to create further flexibility.
The primary purpose of this financial creativity was to create an asset class that offers the benefits of listed equity, mainly liquidity, and advantages of fixed property, mainly consistent rental income. By mixing equity and debt within the same unit the asset class creates a space where consistent distribution is mandatory. Bear in mind that equity pays dividends as and when such is available from attributable profits but interest on a loan has to be paid no matter what. As such, property funds have traditionally been favoured by investors chasing income which mainly consist of pensioners. The tax authorities understood the logic behind these structures and they let them be.
Financial engineers spotted the gap in this arrangement by styling what could have been pure equity to mimic loan capital. The exploitation of this gap has been significant enough to cause tax authorities across the globe to declare it as a scourge of sort. Thin capitalisation is most prevalent within private equity deals where operators engage in complex reorganisations to exploit tax gaps. They do this by diverting what could have been profit into carefully crafted interest payments. This has caused temperatures to boil in the UK with politicians like the Prime Minister David Cameroon, fanning the issue. “There are some forms of avoidance that have become so aggressive that …. it’s time to call for more responsibility and for governments to act accordingly,” said Cameroon recently. “Companies need to wake up and smell the coffee, because the customers who buy from them have had enough”. The UK division of US fast food giant Starbucks has found itself on the receiving end of this wave. Faced with a public backlash, the company made an extraordinary decision of volunteering tax that is technically not due. Other global giants like Google and Amazon have also witnessed the wrath of UK politicians for more or less the same practice.
The UK “terrorism” is absent in South Africa but the recent relent of US private equity giant Bain Capital which owns Edcon makes for space to watch. Bain surrendered in a fight against SARS over the treatment of interest around the Edcon transaction. Details are scarce but the case smells like a failed thin capitalisation attempt.
With former taxman Pravin Gordhan now seating as finance minister the tax noose is also tightening up around complex structures in South Africa which brings us back to the REIT talk. The REIT regime comes as part of a broader package, the Draft Taxations Laws Amendment Bill. An explanatory note of the bill released last year identified complex structures as “problematic”.
National treasury came close to throwing the baby out with the bath water through the 2011 version of the bill before sections of it were suspended. It featured a section which threatened to blow the property funds out of the water by shutting down the tax benefit of interest type income. Careful consideration saw this move suspended which then allowed for creation of a REIT structure.
“Had it not been willingly suspended by National Treasury, this section would have resulted in the debenture interest distributed out of PLS companies being taxed as a dividend,” noted Estienne de Klerk, REIT Committee Chairman of the Property Loan Stock Association (PLSA). “This would have destroyed significant value in the listed property sector.”
The PLSA notes that the proposed amendment was never intended to have a negative effect on the sector and was designed to prevent tax leakage in other structured finance transactions.
What does it mean?
The National Treasury has completed its work and has handed the button to the JSE which is designing listing rules for REITs. The JSE closed its public submission process on the 25th of January and is now busy finalizing the rules. The REIT regime is expected to be ready to accommodate JSE listed property funds at the beginning of April.
South African listed property funds which choose to convert into a REIT will join a globally dominant design of property funds. Property funds in countries like the US, Australia, Hong Kong, Singapore and the UK are largely organized as REITs. This has created a globalised investment appetite because of the consistency in rules governing them across country borders. Property which pass the REIT test will not pay capital gains tax when disposing buildings.
While the South African listed property funds sector has grown in leaps and bounds over the past decade or so, it is yet to fully tap into global institutional investors. These investors shy away from the sector because they don’t understand its unique rules and its uncertainties over tax issues.
JSE listed property sector has grown from about R10 billion in total market capitalization to more than R200bn in about ten year. The sector has outperformed other asset classes in the past four years and posted a total return on investment of 36% in 2012 compared to the 22% scored by equities and bonds 16.0%. This year’s performance is expected to cool down but still remain at respectable levels.
Nobert Sasse the CEO of the largest property fund in the country, Growthpoint, expects returns to be between 10% and 16% this year. Marc Wainer CEO of the secno0d largest Property Fund Redefine expects returns to come in at between 14% and 18%.
The head of Listed Property Funds for Stanlib Keillen Ndlovu is a bit conservative but expects the sector to post decent growth numbers matching or above inflation. “Listed property income should grow by over 6% in 2013 and improve to 7% in 2014. Our base case for listed property total returns in 2013 is 9%. Our bull case forecasts 16% total returns and our bear case only forecasts 2.2%”
The REIT alignment is likely to see global fund managers take a second look at local property funds boosting liquidity of the sector and growth prospects. Sasse who doubles as chairman of the PLSA, says “Together we are shaping a solid base for South Africa’s listed property sector to grow with tax certainty”.
Wainer says the introduction of the REIT regime will be a positive catalyst for the sector in the coming year. “Apart from the many benefits of the new REIT legislation, including tax certainty, it should result to more international investors in our sector. Interest from international investors remains high and this is where growth will come from.”
Ensure not to miss this REIT train.