In an era characterised by historically low interest rates, the search for income charges on unabated across the financial world. With budgets under continuing pressure, local authorities too are seeking out higher yielding investment options and one area that has been of increasing interest – and therefore receiving increasing scrutiny of late – is commercial property. There are several ways of investing in this market but the route that has garnered much media attention is councils’ direct purchase of property for income, rather than service, purposes, both within and outside their individual borders. That much of this has seemingly been funded by external borrowing has raised concerns from several quarters.
The aforementioned scrutiny of this activity hasn’t just been confined to media reports – it’s widely believed that tighter controls will be announced by the Chancellor in the upcoming Budget and both CIPFA and DCLG are planning to bring non-financial investments made for financial returns, such as investment properties, within the scope of their Treasury Management Code and Guidance on Local Government Investments, respectively.
One of the aims of these changes will be to help ensure appropriate risk management is undertaken for these types of investments. What seems unlikely to change is that the overarching objectives of security, liquidity and yield – in that order – will apply to all investments made for financial returns. So this should be the starting point when deciding whether, for example, the purchase of a shopping centre, hotel or car showroom, stacks up in its own right and against the alternatives.
Arlingclose’s view on local authorities’ direct purchase of investment properties has remained clear and consistent – we think there are other options which offer a better risk/reward relationship and we would encourage clients to consider these first. Our preferred route of using a professional fund manager has been talked about elsewhere but are there any other viable options for local authority treasurers that have an appetite for property exposure but have, perhaps, reached their limits on pooled property funds or seek greater liquidity?
The answer is yes, in the form of Real Estate Investment Trusts (REITs). A REIT is a company which invests in income producing real estate, usually in the form of property and mortgages. There are around 35 of them in the UK (making it the fifth largest REIT market globally) and most converted from conventional property companies. There are strict rules and criteria that companies have to meet in order to qualify as a REIT. For instance, at least three-quarters of a REIT’s net profits must be generated from property rental and similarly, three-quarters of its assets must be utilised for property rental. Appropriate diversification must also be maintained but by far the most stringent rule for UK REITs is also the feature that makes them an attractive investment: 90% of property income must be distributed to shareholders within 12 months following the end of the financial year.
Another advantage for local authorities is the treatment of REITs under the current capital expenditure regime. Under the current regulations, share capital in any body corporate will be treated as capital expenditure by local authorities in England. However, REITs are explicitly excluded from this and therefore the purchase of REIT units will not come under capital expenditure rules.
Units in a REIT can be traded like a stock, on major exchanges. This provides a high level of liquidity with daily dealing available in the same way as any other listed equity investment. However, as with any equity investment, there is likely to be a high level of share price volatility associated with any individual REIT. Share prices will be influenced by a number of factors, not just the value of the underlying assets, including demand and supply, the company’s and the sector’s prospects and wider equity market sentiment. It also shouldn’t be forgotten that equity investment in a REIT is no different from equity investment in any other company – if the company become insolvent, equity investors will be at the back of the payment queue behind creditors and preferred investors.
So, there are clearly some risks to ‘security’ but a high level of ‘liquidity’. What of ‘yield’? Income returns from REITs typically range between 2 – 6%. It is this consistent payment of income that allows investors with a long-term investment horizon to sit through the swings in share price
But which REITs to invest in? REITs are companies specialising in property management, but with the income characteristics of a fund. Therefore both the financial viability of the company and the income generating capacity need to be assessed when deciding on which REITs to invest in. Clearly those REITs which pay out at the upper end of the income range mentioned above are going to be most attractive, but does this come with greater volatility? If so, are you being compensated enough for the increased risk?
Whichever individual REITs you choose, the principle of diversification that makes pooled funds so attractive still applies – you will want to select a diversified portfolio of REITs, perhaps focussing on different sectors of the real estate market, in order to spread your risk.
So overall REITs may be more of a specialist area for local authority investors but one that arguably still holds up well on a risk/reward basis compared to direct property investments. Arlingclose can assist clients in carrying out the appropriate due diligence and analysis of the UK REIT market required to make an informed investment decision.