LEGAL ANALYSIS: [2008] J.LB.L.R. 489
LEGAL ANALYSIS
LEGISLATIVE DEVELOPMENTS
& CASE REVIEWS
The EU REIT: Levelling the Playing
Field with the United States
JONATHAN LAWRENCE
Partner, K&L Gates, London
{_IJ/EC law; Real estate investment trusts; United
States
A recent report^ (the "Report") has provided an
important contribution to the debate on whether a
European Union wide Real Estate Investment Trust
(the "EU REIT") should be created. The Report
provides a detailed analysis of the diverse REIT
regimes in operation throughout the European Union,
the problems this diversity causes and a preferred
structure for the EU REIT. This article summarises
the Report and offers its own view on the viability of
the proposed EU REIT.
What is a REIT?
A REIT is a type of real estate company that is subject
to a specific tax regime which aims to avoid taxing a
rental income stream at both the corporate level and
the shareholder level.
Why create an EU REIT?
Of the 27 members of the European Union, only 13
currently allow a version of these tax transparent
1. Pier Eichholtz and Nils Kok, "The EU Reit and the Internal
Market for Real Estate" (Maastricht University, 2007).
vehicles. In turn, each of these vehicles has their
own specific national criteria. The Report argues that
this lack of cohesion causes problems for the EU
real estate market. By contrast, the United States
has enjoyed a common REIT regime since 1960.
The Report identifies six disadvantages for European
Union property companies, investors and lenders due
to the lack of an EU REIT.
Distorted competition
Investors from Member States without a REIT regime
are at a disadvantage to investors in other Member
States and those, for example, in the United States.
Domestic and foreign shareholders in listed property
companies are treated differently under the various
regimes in the European Union. For example,
investors in Luxembourg pay no withholding tax,
as compared to a 22 per cent withholding tax
rate in the United Kingdom. Many countries not
only discriminate between domestic and other EU
investors, but also differentiate between the countries
of origin of EU members, due to double taxation
conventions concluded between Member States.
Impediments to specialisation in the
European Union
A company can diversify by investing in more
than one type of real estate or by investing in the
real estate of more than one country. The Report
contains evidence that in listed European real estate
companies with a market capitalisation exceeding
US$50 million, almost three quarters invest in more
than one real estate type but less than a quarter
invest in more than one country. For US REITs,
it is possible to diversify across state borders and
thus be geographically diversified. In addition, there
are many "super-specialised" US REITs which only
invest in a single real estate segment, for example,
regional shopping malls. The authors argue that the
cohesion of a single REIT regime has allowed the
US REIT to concentrate on building expertise in
specific parts of the property market and to grow
new categories, for example, self-storage facilities.
Effects on investment performance
The relevant literature demonstrates that larger real
estate companies benefit from economies of scale.
US REITs have increasing growth prospects and
lower costs, leading to a direct relation between firm
profitability and firm size. Real estate companies in
the United States mainly obtain a larger scale by
investing in one property type while diversifying
across states and regions.
The authors argue that a lack of a single property
investment vehicle for Europe prohibits European
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real estate managers investing cross-border in a
coherent fashion. The ease of investing across state
borders in the United States results in sufficient scale
to focus on one real estate type. Country borders in
Europe are forcing real estate companies to invest
locally and to diversify across types. Companies that
execute a pan-European strategy have to deal with
a wide range of rules and regulations which are
detrimental to performance.
Disadvantages to individual Member States
Portfolio theory states that if the returns on two
assets do not move perfectly in line with each
other, the combination of both assets leads to a
higher rate of return for the same level of risk, or,
a lower level of risk for the same level of return. The
authors recommend that property companies could
create shareholder value by specialisation and their
shareholders should obtain risk spread by holding
shares in a range of property companies. Regional
diversification of real estate investments is attractive.
In smaller Member States, diversity is not available
within their borders. However, the authors argue
that even in larger EU Member States, like Germany
or France, regional differences are not likely to be
substantial enough to obtain diversification benefits.
Is there a danger that international investment, and
the intercontinental capital flows that are associated
with it, could potentially lead to synchronisation
between asset markets? Evidence gathered shows
that cross-regional diversification is still important
for real estate investors. Property markets appear to
be driven strongly by local factors.
Examples of the ways in which cross border
property investments in the European Union are
obstructed:
• A tax transparent REIT-like structure is not
available in every EU Member State and therefore
cross-border property investments by REITs in
Member States without a REIT structure are
taxed. For example, a French citizen who owns
shares in a French real estate company that
invests in Romania will incvir double taxation—at
the investor level and at the fund level in
Romania—even though the property company in
France has a REIT structure.
• An institutional investor from one Member State
who buys shares of a listed property company in
another Member State with a REIT-like structme
is often subject to a withholding tax.
Investors in small Member States are particularly
affected—these countries partially miss out on
international capital inflows into their property
sectors and cross-border real estate investments are
more beneficial if the local property market is small.
Poor allocation of capital
The authors argue that listed real estate companies
without a tax-exempt regime trade at a valuation that
is lower than the value of real estate assets minus
debt, i.e. at a discount to Net Asset Value (NAV).
Investors in the shares of non-REIT regime companies
will not be willing to pay exactly the asset value of
the property company, as the double layer of taxation
makes the company less valuable than its assets.
A pan-EU REIT structure would give non-real
estate companies the possibility to pool their
properties in different geographic areas into a
property investment company, thereby obtaining
sufficient scale to enable a sell-off of assets,
rather than be owner-occupiers of their real estate.
Companies can then focus on their core non-real
estate business.
Market safety and security
The current patchwork of regimes incentivises
property companies to incur a high level of debt in
countries that do not have a REIT structure, since
these non-REIT companies can use their interest
rate expense to reduce their tax bill. The Report
analyses the situation in Belgium, Canada and
France just before and after their respective REIT
regimes were introduced. The level of debt of the
relevant companies decreased substantially after a
REIT structure was introduced—from a debt ratio of
between 50 and 60 per cent before the regime, the
ratio started to decrease in the year of introduction
and stabilised at 20 per cent three years later.
• Correlations between the performance of EU
Member State residential real estate markets are
very low. Investors in residential property can
therefore benefit from geographical diversification.
• As REITs are obliged to pay out the majority
of their annual net earnings, they have to turn
to the capital markets to obtain funding for new
acquisitions. This obligation means that REITs
are regularly subject to external scrutiny.
• An EU REIT ^ructure is likely to diminish the
use of tax havens as jurisdictions of incorporation
for property companies.
The proposed EU REIT structure
The Report proposes a structure for the EU REIT
which the authors believe provides an ideal model
for the new entity.
Cash distribution request
The authors advise an obligatory payout of net
earnings by the EU REIT of between 80 per cent
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and 100 per cent, with equal treatment of earnings
from rental income and from capital gains. This
measme ensures sufficient tax income is generated
through taxation of profits at the shareholder level.
In addition, this obligation means managers do not
retain too much free cash flow. In turn, REITs are
forced to go to the capital markets for funding on
a frequent basis—ensuring scrutiny by investment
banks and new investors.
491
requirements regarding their shareholding structure.
This is a rare example of the US REIT regime
being relatively restrictive. US REITs need to have
at least 100 shareholders, with the five largest
shareholders holding not more than 50 per cent of the
shares (institutional investors are exempted from the
rule). The rules lead to dispersed ownership which
makes it more difficult for shareholders to band
together to oppose takeovers. The authors believe
that these types of ownership requirements hinder
the monitoring role of large shareholders.
Corporate governance structure
The authors prefer internal management of an EU
REIT which they say creates management incentives
for the company. The current trend in the real
estate world is for property companies to be
incorporated in tax havens while investing in nonlocal real estate markets. This has lead to increased
use of external management for these companies,
whereas externally managed property companies
have virtually disappeared in the United States.
A year 2000 report showed that REITs managed
by external advisers underperformed internally
managed REITs by seven per cent each year. In
addition, externally advised REITs have higher
interest expenses due to higher debt levels and higher
debt yields. Compensating managers based on either
assets under management or on property level cash
flows creates incentives for managers to increase the
asset base by issuing debt, even if the interest costs are
unfavourable. The vast majority of US REITs manage
their own real estate portfolios and are internally
advised.
Leverage
The authors advise against imposing any leverage
restrictions on an EU REIT. The current restrictions
on leverage under the various EU regimes vary from
a maximum leverage ratio of 25 per cent in Belgium,
to no restrictions in France. The risk of high levels
of debt needs to be weighed against the risk of a
debt ceiling distorting the competitive position of
a REIT. Restricting access to debt makes property
companies very vulnerable to takeovers. From a free
market perspective, why should regulatory bodies
govern how much debt a company acquires? Studies
show that US REITs had an average debt ratio of 65
per cent during the period between 1992 and 2003.
Debt-holders serve as an additional monitor to the
soundness of US REITs.
Ownership requirements
They recommend no shareholder restrictions on an
EU REIT regime. Under some REIT regimes in the
European Union and under US REIT regulations,
property companies are obliged to meet certain
Mandatory listing
Mandatory listing of the EU REIT should not be
prescribed. Of the 13 EU Member States with
REIT-type companies, six require that the shares
of these companies be listed on a stock exchange.
However, neither the long-standing Netherlands REIT
nor the US REIT require mandatory listing. Listed
and unlisted REITs co-exist. The fashion for one
type or the other varies as market circumstances
dictate. Companies should themselves decide how
they should be financed.
Operational restrictions
(a) Diversification: There should be no compulsory requirement for an EU REIT to diversify
its real estate holdings. Evidence indicates that
shareholders should diversify, while companies
should focus. Why should tax-transparent companies have diversification prescriptions, where
other companies do not?
(b) Trading and development: There is no
economic reason for restricting the activities
of the EU REIT. However, the authors agree
that there is the need to create a level playing
field between tax-exempt property investment
companies which also develop properties and
pure development companies which also pay
corporate tax. The proposed solution is to allow
EU REITs to perform development activities but
to tax them under the prevailing corporate tax
regime if, for example, the developed property is
sold within three years of completion.
(c) Asset base: Purchasers of shares in the EU
REIT should decide on the merits of the asset
holdings, not the regulators. Provided investment
policies of EU REITs are transparent, potential
investors are able to make decisions about where
they invest.
Open-ended versus closed-ended
schemes
The authors recommend the EU REIT should be
closed-ended. When crises hit, an open-ended
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structure (under which investors are allowed to
buy or redeem shares at will) is unstable and
leads to loss of investor confidence in the market.
Open-ended structures offer high liquidity and
low volatility of returns for investors. However,
timely and accurate valuation of properties is an
issue. Property valuations suffer from lagging and
smoothing. Lagging occurs because buildings are
only sold infrequently and the current value of a
specific property cannot be directly observed in the
market. Smoothing occurs when property valuers use
old information in a new appraisal. These inherent
problems in valuing real estate mean that property
companies which engage only in annual valuations
are at a disadvantage as their investors are able to
predict that the share price is going to suffer a
massive decline at the end of the year. This leads
to massive capital outflow prior to year ends, which
forces companies to buy their own shares. Openended property company share regimes amount to
the financing of illiquid real estate assets with equity
that is callable on a daily basis.
structures. Therefore, the national arguments have
been played out in these jurisdictions—albeit they
all reached a slightly different end product.
The European Union may not respond kindly
to following the US model and the Report's
recommendations for a loosely regulated EU REIT
may not be to everybody's taste. However, the Report
makes an extremely interesting case for reform and
should be considered by real estate companies, their
investors and their lenders.
Analysis
The Report is persuasively argued. It sets out a
landscape where the differences in REIT regimes
across the European Union (if the vehicle exists at
all) make for a minefield of rules and regulations that
are difiicult to manoeuvre. Where the regimes share
similarities, they are overwhelmingly negative—for
example, inherently discriminating against capital
flows from other EU Member States. The authors
point to the expansion of the use by European
property funds of tax havens such as Jersey,
Guernsey, the Isle of Man and Luxembourg. The EU
REIT could fight back against the loss of tax revenue
due to the use of havens.
The Report was published in November 2007 and
does refer to the credit crunch. The authors argue
that the REIT often maintains a lower level of debt
than other types of property company. When a REIT
structm-e is introduced in a jurisdiction, the leverage
of the property fund decreases rapidly. This decrease
is caused partly by the restrictions on debt imposed
in some REIT regimes and partly by the fact that
interest paid on debt is applied as an expenditure
and is therefore tax deductible. A tax-exempt REIT
means that interest is no longer deductible and it is
more profitable to use equity to support the business.
The difficulty of launching an EU wide regime
is not to be miderestimated. Each Member State
will have its own national sensitivities. The EU
REIT would be an option that only certain property
companies would want to consider. The individual
REIT regimes in each Member State would remain
unaffected. However, they may well be adapted
if the EU REIT proved attractive. All the major
Member States, such as France, Germany, the United
Kingdom, Spain and Italy, have their own REIT type
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