Real estate investment trusts (REITs) are a tax-efficient way to invest in commercial property. REITs were only launched at the beginning of 2007 in the UK (see box, right), but the investment structure has been established all over the world for many years. REITs are popular investment vehicles in 23 countries, providing a means for investors to diversify their property holdings on an international basis.

In the UK, the Government first talked about introducing REITs back in 2003, the idea being to allow average UK investors to make money from property more tax-efficiently and flexibly, as well as encouraging expansion in the private rental sector. Gregor Logan, joint chief investment officer of the New Star International Property Fund, argues that REITs offer an easy way for the average investor to get exposure to some of the biggest and best property funds. But instead of taking a risk on single companies, investors are more likely to put money into a property fund that invests in
UK or international REITs.

Doubling the risk element
‘The drawback with a REIT investment is that you’re exposed to two risks when you invest,’ comments Logan. ‘You’re exposed to the net asset value (NAV) of the commercial property in the REIT and to the value that the market chooses to place on that REIT.’

In addition, REITs can be highly leveraged, which means they can also be very volatile. So they can do well in a rising market, but, as with all leveraged assets, losses can be amplified when the market falls.

For those with a lower risk appetite, an unleveraged commercial property fund – which has a mix of physical properties, cash and other investments –
could be a more stable option.

The advantages of REITs
According to REITA, the organisation tasked with raising the investment’s profile, REITs were introduced to get the UK into line with the rest of the world. They offer a way to diversify investment in property, and give access to commercial property funds, which previously had such high minimum investments they only attracted large institutions.
REITA spokesperson Dave Butler says that whatever the size or shape of your portfolio, property should be in there somewhere. ‘There’s increasing interest from fund managers in the sector and the average investor is more likely to access REITs through the fund route,’ he says.

Butler adds, ‘What you will tend to see are global REIT funds that are more liquid than commercial property funds, and which buy and hold properties themselves. REITs can move faster than straight property funds and the total returns haven’t been at all bad.’

The drawbacks
However, for all their benefits, it’s undeniable that UK-based REITs have performed poorly since launch (see chart on page 36). After a glorious 2006, the bottom fell out of the commercial property sector in 2007, which means that all the hype has come to very little.

‘UK property shares have been slammed,’ says Mark Dampier, research director for IFA Hargreaves Lansdown. ‘The commercial property sector has been caned this year, partly because of the credit crunch.’

Logan says that property companies had been doing well, in anticipation that many companies would convert to REITs. But he adds, ‘As with many things in the stock market, it was much better to travel than to arrive.’

Chou Chong, head of pan-European equities at Aberdeen Asset Management (which offers the Aberdeen Property Share Fund), explains, ‘The dramatic 35 per cent decline in the FTSE Real Estate Index since the beginning of the year (to the end of November) was the result of a combination of factors – including profit-taking, particularly after the eventual introduction of more tax-efficient REIT structures, and fears about the impact of rising interest rates on commercial property valuations.’

The Aberdeen Asset Share Fund, which holds over 88 per cent of its portfolio in the UK, is down nearly 20 per cent to November this year, despite a return of nearly 47 per cent in 2006. But plenty of high-profile funds are having problems, including M&G’s portfolio, which reportedly applied a 90-day notice period on institutional investor withdrawals in November.

A spokesman for F&C, Jason Hollands, says that ‘Investment in property funds should always be about the attractiveness of the income, or the solidity of the tenants helping to guarantee secure returns’. He adds, ‘In 2007, a lot of hot money came into the market, with people investing in property for all the wrong reasons, and they have been disappointed.’

Why invest?
So UK REITs may be in the doldrums, but with REITs trading at a 30 to 40 per cent discount to their underlying asset value, is this a good time to invest?
The truth is that UK REITs, and the properties that underpin their portfolios, may still fall further. They’re still quite low profile, and without a lot of market and consumer education they’ll remain a relatively unknown quantity. Consumers are still far less interested in UK REITs than institutional investors, something that’s unlikely to change for the foreseeable future.

At Standard Life Investments, assistant fund manager Svitlana Gubriy thinks that investing in REITs on a global basis is the only option right now, with Asian and US REITs offering good prospects. 'Japan is looking very interesting,’ she says . ‘There are some very high-quality office buildings in Tokyo where the rental yields are high, in contrast with the UK where returns on commercial property are negative. Sterling rate investors also have an advantage, as the currency exchange adds three per cent to your total return.’

Hong Kong and Taiwan are also strong markets, she says, but Singapore, which launched REITs six years ago, has been the real success story. Gubriy points out that ‘rents have been growing at 30 per cent a year for the last three years’.

Don’t overdo it
Mark Dampier cautions that the problem with REITs for the average investor is the risk of overweighting in property, because the average unit trust portfolio will already have property investments through other holdings.

But Dan Looney, investment liaison manager at Towry Law, maintains that REITs can still be useful as a diversification tool. ‘As no-one can time the markets 100 per cent correctly, we give our clients a blend of asset classes, but that blend will depend on the client’s goals and risk appetite.’

He adds, ‘This offers clients a mix of commercial property investments within all our client portfolios because the bottom line is you can’t predict the future. The success of the REIT probably rests on further interest rate cuts right now, but our theory is to always avoid the hype, keep a diverse portfolio and ride through any market problems.’