Until recently, the discussions, analysis and political debate surrounding real estate investment trusts (REITs) and their impact on the property market have focused on the traditional residential and commercial property sector.
This is reflected in the fact that the current REIT market at the time of writing consists of nine 'mainstream' commercial property companies, who were already listed on the London Stock Exchange and who own mainly commercial offices, shops and industrial buildings.
What's the government's policy position on pub REITs?
REITs were introduced by the UK government for a number of sound policy reasons.
One of the key objectives was undoubtedly to provide a vehicle that allows a range of different investors, (including pension funds and individual investors), to collectively invest in property in a manner which provides similar tax efficiencies to the more risky and illiquid alternative of investing in property directly.
There has never been any clearly stated government policy position as to what type of property should be allowed within the REIT regime. The fact that a portfolio of pubs is not what initially sprang to mind when the concept of UK REITs was initially discussed at government level does not, in principle, mean that they shouldn't form an important part of the future UK REIT market.
An investment opportunity that is difficult to ignore
Looking at the pub industry specifically, we can see a huge portfolio of property, with the net assets of the top five asset intense pub companies - Marston's, Punch Taverns, Greene King, Enterprise Inns and Mitchells & Butlers - in the region of £18bn.
The attractions of putting this portfolio into a tax efficient investment vehicle cannot be ignored. Pubs are a cornerstone of society in the UK; I think it is safe to assume that they are here to stay. A pub REIT could offer exactly the sort of asset intense, low-tech, cash generative business that the government has been trying to make available to the "man on the street" through the introduction of UK REITs. It is this investment potential that is beginning to attract the interest of the private equity markets.
The challenges for industry and government
So what are the challenges that need to be overcome by industry and government to create a pub REIT market? The challenge for the industry is to find innovative ways of isolating the element of a pub portfolio that fits into the REIT regime and package that up in a way that gives rise to a minimal amount of 'pain' in terms of changes to the operational management.
Of course, the ultimate step is to sell the property to a REIT and enter into a leaseback - although persuading shareholders that this is the right step to take will clearly be a challenge.
Either way, I have little doubt that the demand for new asset classes from investors, the tax incentives available from REITs, and the ability of the market to find solutions, will mean that in time we will see a pub REIT sector develop in the UK.
The catalyst for overcoming these hurdles may come from private equity buyouts or defence strategies in response to takeovers.
The challenge for the government is to determine whether it needs to intervene and change legislation in the short term to encourage the healthy growth of the UK REIT market in an increasingly competitive global property market.
How/when will we see a 'pub REIT sector'?
Unfortunately, the answer to this could lie partly in the intricacies of tax legislation so at this stage you will have to forgive me for delving into a bit of detail.
A fundamental concept of the REITs legislation is based on the principle that the 'tax break' is afforded only to income that arises from "..the exploitation, as a source of rents or other receipts, of any estate, interest or rights in or over land…" Although this would appear to be a fairly broad concept, it creates problems for property related activities that do not fall within the tax authority's traditional strict analysis of property income.
Pubs fall into this category largely due to the fact that there are generally a range of different services that a pub owner provides, such as wholesaling beers, wines and spirits, food, gaming/vending machines and these services are integrated into the discounted 'wet' rents that a tenant will pay the pub owner.
There are also other pitfalls presented by the REIT legislation including the restrictions on owner occupied property (and the resulting implications on control) that are likely to require some significant restructuring in order to comply with the REIT legislation.
We think it is unlikely that the UK government will change the REIT legislation in the short/medium term to enable pub companies to be able
to convert to REIT status as easily as the traditional listed property companies have, other than minor tweaks for new REITs already flagged up in the pre-Budget report in December. Consequently, it could be unwise for these pub companies to evolve strategies on the expectation of such improvements in the legislation.
Gareth Lewis is director of finance & investment at the British Property Federation