What is the Real Estate Investment Trusts - Case Study Example

Property investment analysis The UK has recently (2007) introduced Real E Investment Trusts (REITs). These allow property companies to pool monies from private investors to own and manage major property assets. Q.1. Review the market theory and aims behind REITs, and assess the research evidence from other countries with a longer-established REITs market. (40 marks) Real Estate Investment Trusts (REITS) in the UK began operations effective from the first of January 2007 and right now have charted their own growth momentum path with an ever increasing investor portfolio of diverse dimensions. Property investment in the UK financial markets has changed considerably since then and this paper examines both corporate strategic dimensions and organizational structural changes along with their impact on property-related and non-property-related investment vehicles in the UK since January 2007. It also makes a comparative assessment of investment outcomes which clearly indicate that UK-based REITS have adopted a market-correlated approach to increase investors’ gains with little regard for strategic-operational environment and its multifaceted regulatory bottlenecks. The conceptual framework of Real Estate Investment Trusts (REITS) in the UK has been characteristically shaped against the backdrop of an evolving unique property market investment paradigm vis-à-vis the diversity and complexity of non-property market investment vehicles that have hitherto dominated the UK investment scenario (Wyatt, 2007). While still there is a considerable amount of confusion as to what REITS are able to accomplish on their own in a highly competitive strategically diverse highly risk-prone property investment market, there is an equally formidable quantum of hope on the part of the average property investor and the market analyst that the UK property market has the potential for growth and sustainability despite a global downturn and rising pessimism among investors in general. This paper would focus on two distinct aspects of REITS in the UK. They are the more theory oriented perspective of strategic analysis which in turn would be divided into strategic competitive environment and strategic operational environment, and empirical evidence-based analysis (Booth, 2006). All forms of REITS have to face varying degrees of competition from non-REITS investment companies. Thus a peculiar characteristic of the REITS strategic competitive environment in the UK and elsewhere is that they have to compete against a multitude of competitors engaged in diverse financial operations and markets. These investment companies not only offer nearly identical investment vehicles but also actively mobilize funds towards investment elsewhere. The type of competition they have to face and the type of regulatory regime to which they are subject might be altogether different. For example open-ended investment companies have to operate under completely different circumstances. Those investment funds bank their hopes on NAV and NDY measures to reduce risk-prone speculation by investment consultancies. This conceptual framework underlies the very organizational structure of the REIT industry and thereby influences its evolving strategic shape. Though the average UK REIT is structured in the same way as a private or a public company according to the British law, there is a significant amount of variance in its capital structure and composition. For instance in the process of distribution of profits the REIT is obliged under the Finance Act of 2006 to withhold tax from profit distributions made to shareholders out of property-related investment profits. While REITS elect themselves to be rewarded with the privilege of being tax-exempted on profits made from certain property-related investments, they have little freedom by way of diversification of assets or portfolios. Real estate investment vehicles as initiated under REITS have been noted also for their strategic emphasis on tradable shares whose prices are determined by free market forces – demand and supply. Another inherent feature associated with them is the tax transparency. Indeed the latter characteristic influences both demand for and supply of such assets despite a negative corollary associated with such declarations. For instance the demand for such investment vehicles as that of properties could be attributed to a variety of causal factors ranging from constantly rising real returns to tax-exemptions. On the other hand supply factors include REITs’ ability to divert and channel risk-prone investments away from potential collapse into an attractive investment proposition that fetches real returns. The US REITs are characteristically influential in the property sector and have been in operation since 1960 (Kosnett, 2008). Australia followed the pioneering efforts of the US in 1971. Some of the biggest names like Boston Properties (BXP) and Simon Property Group (SPG) are members of the Standard and Poor’s top 500 Index. These REITs own and operate some of the world famous landmarks in big US cities like Washington, Boston, California and New York. Market volatility in less regulated markets like the US market tends to be greater thus driving demand and supply forces off their track at times. Bigger gains are followed sometimes by equally bigger losses. Unlike the British REITs the US REITs sector has expanded into a variety of niches including those of high yielding smaller segments (Mullaney, 1997). The strategic competitive environments in the two countries do not differ substantially though the operational environments are divergent in many respects. In the first place the US REIT sector is less regulated than the British one. Thus British REITs have a lesser degree of freedom to operate in the way they would desire. However it doesn’t mean that the US REITs have all the freedom to engage in competition to achieve profit targets. The law which created the US REITs is not less stringent than the law which created the British REITs. A particularly striking aspect of the US REITs is that they have been yielding very high returns since they were first crated except during a few years. Despite the current global economic meltdown the US REIT sector has shown some remarkable resilience that has little parallel elsewhere. This is particularly so with regard to the average yield or NPV. According to reports the US REITs have enabled investors to gain an average of 14% historical compound return on their investments in comparison to most of the other investment vehicles (www.usreitinfodesk.com). While the US REIT sector has been operating with greater ease due to a liberal operational environment, the British REITs have been subject to an ever increasing regulatory framework (Imperiale, 2006). Outside the US, the Australian REIT sector is the largest with a market capitalization above A$ 100 billion (McMahan, 2007). In comparison to the British, Australia’s REIT market structure is more or less patterned on the US REITs. This variability is particularly striking when profit distribution is factored in. In Australia profit margins are distributed subject to the same 90% limit of earned profits by the REIT as in the US. In the UK though this ceiling is applicable, REITs are not open-ended investment trusts that could earn their profits not only through renting out but also as the traditional property investment companies. The US laws were changed from time to time in order to enable REITs to operate in a freer environment. Thus in 1999, US REITs were allowed to own subsidiaries (Brown, 2008). This outcome is associated with the current spurt of growth in the US REIT sector particularly against the backdrop of global economic slowdown. Australian REITs have also been recording higher growth rates that have little parallel elsewhere. According to recent research findings, Australia’s REITs have successfully weathered government policy-related impact on their strategic operational freedom by diversifying into a variety of areas including niche markets (Cruickshank, 2007). Q. 2. Assess the UK REITs sector over the two years since it was launched, and present and discuss a particular UK REIT in the form a case study. (40 marks) Although a number of investment vehicles exist in the non-property sector of the economy, there is very little strategic freedom for the average REIT to channel funds into diverse investments thus expecting a real but constantly growing return (Acharya and Dimson, 2007). While the company is a normal corporate entity with a listing on a stock exchange there is something unusual about its strategic focus, viz. the way and manner in which it conducts itself in distributing profits. Potential investors would have the assurance of getting some profits but nevertheless how much profit is determined by a number of other endogenous organizational variables and exogenous environmental factors. The latter invariably include strategic environmental factors which in turn are divided into competitive and operational factors. For example the following interim income statements of Segro Plc show how the company has been performing up to 2007 and after. The rationale for the tax exemption of such investments can be understood on the ground that government financial authorities are more or less inclined to believe that such exemptions have an automaticity – to be better understood with statistical analysis – by way of cumulative investment effect (Knight, 2006, p.282). In the UK REITS market, such expectations are based on the relative stability gains such as reduced market volatility and fluctuations in price differentials. Financial authorities are less focused on the eventual finance-related outcomes but more concerned about the probable outgrowth of market imperfections (Stubbs, 2009, p.581).. Segro Plc is a property investment and development company with a sizeable share in industrial and office property renting business in 10 countries. As the above table of Segro illustrates all forms of REITS had to face varying degrees of competition from non-REITS investment companies. Portfolio management firms especially employ such highly complex extraneous metrics to quantify market-performance ratios on the basis of a mutual gain-loss pay-off. Mutual funds do the same. Practically REITs operate in a similar strategic environment where competition is stiffer and determined by market forces of demand for and supply of a product. Yet strategic investment proposition on which they operate is not the same as that of other investment firms’. REITS superimpose their entitlement to tax exemption as the most desirable advantage associated with any form of investment. In the eyes of the potential property investor the greater the margin of profit earned through rentals the greater the strategic credibility of the organization (Baum and Devaney, 2008). During the period under review almost every REIT in the UK market made a net positive return on property related investment that brought cumulative gains to the investor. However, many firms failed to make an appreciable gain either through tax-exempted rental income or other investments. This is illustrated by profit declarations made by REITS in the UK after one year of operations. There were a lot of hopes that almost bordered on an unrealistic estimate of market forces. After two decades of lobbying LEITS in the UK became a reality but nevertheless economically the time was not appropriate for them to benefit from the tax-free revenue gains. The anticipation of a huge turn-around in the property market was negated by the level of competition that happened to take place despite a negligible market concentration ratio of big firms. The market concentration ratio gathered momentum after some time towards the end of the year though. While other non-REITS investment companies responded to the unfolding competitive environment with strategic initiatives of their own, such policies did not go too far to accommodate variations arising from an unchartered territory of competition (Hodgkinson, 2009, p.51). A series of drawbacks during 2007 compelled REITS in Britain to reorient competitive strategy by placing emphasis on not only development finance related vehicles but also alternate policies such as residual investment in speculative activity. The causal factors that determine the extent and the nature of this reorientation of the strategic competitive policy of the average REIT in 2007 could be seen with respect to how those initially converted firms responded to NAV and NDY concepts (Sayce, Smith, Cooper and Rowland, 2006). When NAV and NDY kept on increasing, a number of firms such as Big Yellow, British Land, Derwent London, Great Portland Estates, Hammerson, Highcroft Investments, Land Securities and Liberty International, adopted a strategy of increasing the capital base. This particular development had a welcome impact on the subsequent balance sheet and profit and loss accounts of these companies. However as the Table 1 illustrates, REITS like Segro Plc. could not sustain their strategic initiative due to a number of reasons. In the first place the relative positive cash flows of these firms were reduced and operational costs began to rise against the backdrop of an unplanned outcome related to dwindling asset values. This in turn reflected in the balance sheets of these companies little later (Freiser and Frej, 2003). Q. 3. Consider to what extent the market theory behind REITs has been borne out by the market evidence in the UK to date, and assess how the REITs market may evolve in future years. (20 marks) Strategic competitive environmental impact is greatly determined by government economic policies and the external economic environment played a very significant role on REITS in the UK by shifting competition on to a relatively different sphere, i.e. foreign exchange rates were highly influenced during the first year due to a surplus of foreign funds coming into REITS. The demand for the Sterling Pound began to rise though the extent of which cannot be determined here. Such developments were interpreted by investors as the clear sign of a real estate property boom (Casey, Sumner and Packer, 2006). In fact what followed was a slow growth process of demand while supply kept on increasing at a pace. Especially commercial and residential property markets began to register higher levels of activity through a period of rapid transformation from a snail-paced real estate property firms’ supply levels to a fast-paced growth trajectory. However the euphoria was short-lived and the property markets in Britain in 2007 did not record exceptional growth trends; neither did they show extreme volatility. The following table illustrates how REITs in Britain have been performing in keeping with the theoretical underpinnings of the arguments presented here. Market capitalization figures cannot be taken on the face value as such because even the gross dividend yield does not show any considerable gain for many companies. The theoretical perspectives on strategic competitive and operational environments REITs in Britain have been borne out by these data. In the first instance the very nature of competition coupled with a global economic recession brought about a number of negative changes. Table 2: REITs’ market performance data in 2007 Company Sector Market Gross Dividend Last closing Stock market focus cap (£m) Yield* price (p) code Big Yellow Self storage 216 3.11% 187 BYG British Land Diversified 2,816.50 11.59% 330.5 BLND Brixton Industrial 64.5 50.74% 23.75 BXTN Derwent London Offices 530.8 1.88% 526.5 DLN Great Portland Estates Offices 363.9 5.71% 201 GPOR Hammerson Diversified 1,567.00 12.71% 225.25 HMSO Highcroft investments Diversified 12.6 6.50% 243 HCFT Land Securities Diversified 2,233.10 13.37% 480 LAND Liberty International Retail 1,131.00 53.61% 309.25 LII Local Shopping REIT Retail 28.3 16.08% 34.25 LSR McKay Securities Offices 46.7 13.75% 102 MCKS Mucklow (A & J) Group Industrial 125.4 8.54% 209 MKLW Offices Pineapple corporation Residential UK N/A 0.00% (enter Pineapple into search) Industrial UK Industrial Finland Primary Health Properties Health care 80.6 4.69% 240 PHP Rugby Estates Investment Diversified 14.7 0.00% 25 RUGB Trust plc Asset managers SEGRO - Slough Estates Group Industrial 423.6 28.05% 97 SGRO Shaftesbury Retail 336 4.32% 248 SHB Town Centre Securities Retail 35 12.73% 65.75 TCSC Warner Estate Holdings Retail 11.3 56.25% 20.25 WNER Workspace Group Offices 104.4 45.88% 9.98 WKP Industrial Source: http://www.reita.org/live/databank/index.html As the above table of figures illustrates the firm-centric research methodology has to be based on differentiated sub-sectoral divisions in real estate investment such as industrials, commercial (offices), diversified, residential, retail and so on. According to Brixton reports its share price hit a 52 week low on the 3rd March 2009 while almost simultaneously Segro, another industrial, lost 5th of its share value. The downslide was caused by market fears that they would have to go for heavily discounted rights issues to ensure loan agreement limits which remained under a cloud of suspicion due to an approximately 40% fall in the UK commercial property prices since the middle of 2007 (Kein, 2007). Segro is right now doing just that. Future performance of REITs in Britain would depend on the same strategic environments and their impact on them to a greater extent irrespective of what other external forces happen to play by way of a role in determining the future market outcomes. To be sure there would be a greater degree of completion in niche market segments which yield more but limit volumes to smaller size. In other words diversification would be the strategy of the firm. REFERENCES 1. 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