Potholes on the road to REITs
Copyright: David Lawson - first published Property Week March 2007
Real estate investment trusts [Reits] are the biggest change to affect property since the modern industry emerged from past-war reconstruction, so it ironic that a critical role will be played by the most recent revolution in bricks and mortar. Landlords will focus more on income, one of the key features of managed space, while operators could be attracted by the prospects of transforming into Reits to benefit from lower taxation.
Property companies have been valued in the past on long-term net asset values. Reits will be measured on more short-term factors like cash generation. This requires a fresh approach, says Rob Hamilton, managing director of online agent and flexible space manager Instant Offices. Investors will focus on income, leaving landlords twitching about whether they are maximising returns on every square foot of space. Vacancy rates will be critical, and many are already sifting through inventories to find surplus and hard-to-let offices.
Some agents and operators anticipated these pressures and have developed a new approach, involving a more collaborative role. They work with clients, advising how to make better use of space and even create joint ventures through management agreements. For instance, Instant Offices Management is creating innovative medium-term tenancy deals that quickly place businesses into empty buildings and generate favourable cash returns, says Hamilton. He sees growing interest in such deals but also growing recognition of the merits of flexible space to maximise income.
Meanwhile, operators will be looking to follow leading property companies by transforming into Reits. But many will be disappointed, according to Richard Gill, managing director of London business space operator Landmark. Only those owning freeholds will meet criteria set by the Treasury, and even then the property will have to be transferred into a new entity separate from the business centre trading company.
Other restrictions will also influence how many can – or want to - make the transition. Single asset firms are not permitted, while the 10% limit on shareholdings means that Reits are not an appropriate vehicle for small family owned entities, writing off the bulk of smaller operators. Yet more grit in Treasury regulations which could make operators think twice includes the fact that 90% of profits must be distributed, which precludes reinvestment of profits on any meaningful scale for growth.
So, where might Reits emerge? Some names immediately spring to mind, says Gill. Regus has set up a fund to acquire freeholds of its properties, and this could be established as a Reit. Morgan Stanley could transfer the properties owned by Executive Offices Group into a Reit. He sees two potential trends:
Fund managers are already looking for an alternative foothold in the sector. Close Brothers, which specialises in tax-friendly investment, has been playing in this arena for some time after setting up Business Centre Properties (BCP) and the Romulus High Income Fund, often working in partnership with operators like Citib@se.
Fund manager Kenmore has backed Avanta, one of the fastest growing operators. Avanta managing director David Alberto says investors are keen to tap into the higher returns from managed space and points out that firms like his already separate property into distinct holdings. Highcross is another pioneer after buying Bizspace, another leading operator. But Gill believes the main thrust of new money is still waiting to happen.
‘I suspect that institutions will wish to see more transparency of pricing and profitability in the sector,’ he says. ‘There simply is not enough reliable data about the relative profitability of business centres for analysts to make really informed judgements.’
The Business Centre Association is working on initiatives to bridge this gap. These include backing an ongoing study by DTZ Research called The Flexible Managed Office Market to help educate investors, and efforts behind the scenes to persuade its members to be more open about returns and to standardise charges.
New business centres added 4,500 workstations to the London market last year, yet even this has not kept up with surging demand, according to Instant Offices. Average occupancy jumped to almost 87%. ‘The market is as strong as it has ever been and rents have shot up,’ says Rob Hamilton, MD of Instant Offices. The number of workstations has more than doubled in six years to 57,500.