Time to go closed-ended?

In a recent survey from the Association of Real Estate Funds (AREF), it was found that, while 79% of advisers use open-ended property funds, only 26% use REITs, and only 22% property investment trusts.

That makes me sad. I think advisers – and most importantly their clients – are missing out.

But before you accuse me of being crassly opportunistic, I’m not saying this just because some open-ended property funds have closed to redemptions.

There’s enough hysteria surrounding this already without me adding to it, so let’s be fair and acknowledge that these funds have done the right thing to protect their long-term investors. In fact they have done the only thing they can do when faced with the prospect of mass redemptions.

The problem with these funds is not that they are in a crisis now – it’s that they don’t work too well at the best of times. In order to try and maintain liquidity, they need big cash buffers – as much as 20%. With interest rates near zero and likely to stay there, this is a drag on both capital returns and yield, as well as a very inefficient way to get exposure to an asset class.

The other usual benefit of open-ended funds is the near-certainty that you can trade at NAV. Physical property funds, with their arbitrary price swings and tendency to close to redemptions in jittery markets, don’t offer that certainty.

But what about discounts?

Investment companies have their own problems, of course. We’ve seen discounts widen sharply in our Property Direct UK sector post-Brexit, to 18% as I write. As a result of this, yields are up to 5.6% (see table).

But several analysts have been inclined to view this as a buying opportunity, pointing to the good track records of many companies in the sector, and the fact they are going into this downturn (if that is what it is) with lower gearing than the sector did in 2008.

This sector is for long-term investors, whether you invest in open-ended or closed-ended funds. Being a forced seller is always awful. But long-term, closed-ended funds are quite simply the better structure for illiquid assets, because managers will never have to sell assets to meet redemptions. In fact, they can take advantage of downturns to buy properties at knockdown prices, even as open-ended funds are having to sell.

Investment companies investing direct in UK property.  UK REITs are marked with an asterisk. Source: AIC (18/07/16)

REITs vs offshore investment companies     

One thing that does confuse people is the difference between a REIT and an investment company that invests in property. It may be helpful to make this clear.

For our purposes, a REIT is an investment company that is tax-resident in the UK and invests in property. It has a special tax status granted to it by HMRC that allows it to avoid paying corporation tax on its profits from rental income, provided that income is distributed to shareholders.

There are investment companies that are not REITs. These are registered offshore (typically in Guernsey or Jersey) so they don’t have to pay corporation tax anyway.

There are two important differences for shareholders between UK-incorporated REITs and offshore property investment companies – both to do with tax. First, you pay stamp duty of 0.5% when you buy shares in a REIT, but you don’t pay stamp duty on purchases of funds that are registered offshore.

Second, when you receive what’s called ‘property income distributions’ from a REIT (basically rents) they are taxed at income tax rates, as if they were property income, not as dividends. The original idea behind this was that REIT shareholders should be taxed as though they owned the properties themselves. With offshore property investment companies, however, dividends are simply taxed as dividends.

Of course, if you hold the shares in an ISA or SIPP, the latter difference is irrelevant – you pay no tax on your income anyway.

One potential source of confusion is that a company can be UK tax-resident and a REIT, but still be registered offshore. Four companies in the Property Direct UK sector fall into this category. For historical reasons, they have chosen to keep their registered office in the Channel Islands, but decided to opt into the UK tax system to take advantage of the REIT regime. No stamp duty is payable on their shares.

The table above shows which investment companies in the Property Direct UK sector are structured as REITs (marked with an asterisk) and which are not. But unless it’s going to make a big difference to a client whether distributions are taxed as income or dividends, it’s not worth getting hung up on the differences between the two.

Whether REIT or not, any closed-ended property fund offers the obvious merit of matching an asset that takes weeks or months to sell with a pool of permanent capital – rather than trying to cram the square peg of an illiquid asset into the round hole of the open-ended structure.

Source: AIC