REITs: A taxing problem for pubcos
Shares in a number of pub operators, notably those expected to make the move to REIT status in the near future, rose sharply at the end of last year. Investors were anticipating the gains to be made by groups splitting the ownership of their assets, the pubs, from the operational side of things.
Such anticipation was overdone, to say the least, and shares in the companies concerned have edged off somewhat in the first few weeks of the new year.
While no groups have yet taken the plunge, REIT or real estate investment trust has become the buzz acronym of the sector, for now. Everyone's looking at its potential, but no-one's committing themselves, and are unlikely to in the coming months.
Among the key issues to deal with are the benefits of debt restructuring; finding an upside to counter the loss of control and dealing with the costs involved in conversion. As observers have pointed out, factors driving the interest in this area are the opportunity to hand back capital to shareholders, together with a clearer vision as to the value of the assets involved.
The costs of conversion would certainly be significant. The taxman is proposing to slap down a charge based on two per cent of the market value of properties entering a REIT. Added to which one would need to absorb the cost of renegotiating existing debt finance, so the likes of Punch Taverns, Enterprise Inns and Mitchells & Butlers (M&B) face bills running into hundreds of millions of pounds.
Such are the sensitivities surrounding the issue of opting to become a REIT that companies are quick to quash speculation that they are or are even rumoured to be lining up to do so before they are ready.
Punch, for example, was quick to shoot down recent press reports that it was about to ask the taxman for permission to become a REIT, stressing that while the group was looking at its options it was still "very early days".
Meanwhile, other operators are currently considering their position.
Enterprise Inns is examining the pros and cons, although Ted Tuppen, the group's chief executive, wonders whether it is an appropriate structure for a pub operator.
Another possible, M&B, similarly reiterates that it is looking at what becoming a REIT would do to its business, but that no decision has yet been made.
As for the City, opinion is divided. In a recent sector note Nigel Parson of Evolution Securities argued the case for conversion was compelling. He said: "The potential to split out rental income into a REIT structure will prompt the market to appreciate the valuation of the underlying asset and split out the separate valuation of the earnings capability of the operating company," regardless of whether a company opts to become a REIT.
"It makes traditional earnings-based valuation metrics redundant. The opportunities are too compelling to ignore," he added.
But loss of control of the assets would be a key hurdle for companies to negotiate, as Parson acknowledges. As is the '75 per cent rental income' criteria, although some operators could proffer the 'wet rent' argument discounted rents in return for a beer tie and so qualify, while tenanted pubcos can circumvent the 'no owner occupation' rule that is required in an opco/propco structure.
James Ainley of JP Morgan believes the stock market got ahead of itself in the run-up to 'REIT-Day', and that some assessing the situation were "putting two and two together and coming up with five". He says that in most cases the tax benefits net of the costs involved in converting are "negligible".
Deutsche Bank's Geof Collyer suggests that there would be some "significant potential short-term upside" for the likes of Enterprise Inns. But he argues that the company's board "has a duty to its investors to adopt a corporate structure that is capable of generating long-term value, not just a short-term adrenalin rush of a big capital payment upfront".
Collyer believes better value can be created by managing a tight balance sheet and returning funds to investors via share buybacks.
Like anticipating the next deal, second-guessing who'll be the first to 'jump' is no easy task. In the short term the only people with a smile on their faces will be those investors who took profits on December 31 last year with a few well-placed share disposals.
Why bother becoming a REIT?
A number of pubcos are looking at the options, weighing up the financial benefits against the costs. Being a REIT won't affect the day-to-day running of a pubco's operation, although it might see an operating arm pushing even harder against its landlord's rent rises.
PROs: it splits pubcos in two, dividing the property owning arm from the operating arm and offering tax breaks to the property company which distributes profits as dividends. REITs allow a greater assessment of a company's worth: cashflows and underlying asset value.
CONs: it is very costly to set up in terms of re-financing and government fees, which could offset the start-up costs.
REIT rules
A REIT's structure means a company is exempt from paying corporation and capital gains tax as long as:
It is UK resident and listed on a recognised stock exchange
At least 75 per cent of a REIT's pre-tax earnings derive from rental income
At least 75 per cent of gross assets are in rental property investments
It distributes at least 90 per cent of profits from its property rental business
It has interest cover of at least 1.25x
No shareholder owns more than 10 per cent of the entity
No owner occupation allowed
The converting company pays two per cent of the market value of the properties entering the REIT.
