Real estate funds: origin, types, peculiarities of legal regulation
REITs originated in the USA more than a hundred years ago and now operate in many countries of the world. The predominant object of investment of such funds is real estate, the share of which in the value of the fund's assets, as a rule, is not less than 75%. The standard REIT model assumes deriving income from two main sources – the growth of real estate prices and leasing out real estate. The term REIT itself was first mentioned in 960 when the so-called REIT Act was adopted in the USA, though funds similar to REITs existed before. This document established the basic principles of REITs as they exist today and significantly impacted the spread of real estate funds in the US and worldwide. For example, in 2007, only in the USA there were about 1,000 such funds and 14 of them were included in the calculation of the S&P 500 index of the 500 largest-capitalized public companies in the USA. The features that distinguish REITs from other investment organizations can be divided into several categories.
The principal advantage of REITs, as compared to other investment organizations, is a special preferential taxation model. According to this model, that part of the income of the fund, which is distributed among its investors, is not subject to corporate income tax. Income tax is imposed directly on the investor's (depositor's) income distributed by the fund. To qualify for these terms of taxation, a U.S. real estate investment fund must meet the following requirements:
- distribute at least 90% of its profits to its investors;
- invest at least 75% of its assets in real estate (investments in mortgage-backed securities, government securities and interests in other funds are also considered real estate investments);
- At least 75% of the fund's total income must be from rents, mortgage payments or proceeds from the sale of real estate. These sources of income, together with gains from the sale of securities, dividends, and other regular payments, must account for at least 95% of total income;
- the fund should have at least 100 investors, with the five largest investors holding no more than 50% of the units.
This implies that the real estate investment trust model is designed firstly to develop the real estate market and secondly to support private investors. In other countries, the REIT model looks approximately the same, with some differences in the amount of distributed profits, the volume of investments in real estate, and several investors. For example, in Japan, to obtain J-REIT (Japanese real estate fund) status and relevant tax benefits, the fund must have at least 1,000 investors, and the three largest of them may not jointly own more than 50% of the units.
2. Investment restrictions.
Real estate funds are strictly limited to investments in existing real estate to minimise risks. With few exceptions, REITs do not invest in unfinished projects and share construction. This provides a degree of protection for the fund's investments against the risks associated with unfinished construction projects. Typically, REITs can acquire completed properties, which, by the way, is an additional incentive for the development of the real estate market in those countries where the REIT regime exists. Another limitation concerning investment by real estate funds is the limited use of leverage. For example, H-REITs in Hong Kong can borrow no more than 35% of their net asset value. This restriction was caused by the desire to reduce potential risks, taking into account the specifics of the real estate market as such. The absence of borrowed funds means that there are no encumbrances on real estate, which gives the real estate funds more flexibility in disposing of assets. Moreover, under the conditions of a declining market and difficulties with the recoupment of projects, as the existing experience has shown, repayment of borrowed funds becomes the main problem of construction market participants. Of course, such an approach may appear to be largely conservative and impose certain limitations on the amount of potential profit; however, in the context of risk protection, it is certainly justified. Dynamics of prices for REIT units traded in the U.S. stock markets shows that first of all those funds whose share of secondary and mortgage securities in assets exceeded 40% suffered ("Navigating the Credit Crisis" by Dees Stribling, December 2008, Real Estate Portfolio).
3. Fund Management.
When investing, classic REITs do not manage real estate on their own. Originally, The REIT Act required U.S. funds to employ third-party managers to manage fund assets. Later on, this rule was relaxed and funds were allowed to set up subsidiaries independently, intended for real estate management and, depending on the demand, for rendering services to persons who directly use real estate - as a rule, to tenants.
In most countries where real estate funds operate, there is a requirement for a separate management company. In addition to such a general requirement, there are also separate requirements for the management company itself. For example, in Singapore (S-REIT), the management company must have at least five years of experience in property management.
General restrictions on the number of investors and the number of units owned by an individual investor have already been mentioned in the "Taxation" section. However, there are also restrictions related to the affiliation of individual investors to certain groups of investors. As a general rule, investors in real estate funds may be both individuals and legal entities, both REIT residents and non-residents. Non-residents' participation in real estate funds is subject to several restrictions, primarily tax ones. For example, at the exit from Japanese funds (J-REIT) foreign investors pay a lump-sum tax at the rate of 7% of the withdrawn funds. Such a rule was introduced to limit the withdrawal of capital by foreigners from REITs and the economy as a whole. In turn, in Hong Kong funds (H-REIT) foreign investors registered as taxpayers in Hong Kong do not pay tax on income derived from investments in H-REIT. In this case, there is a fact of the same protectionist policy but aimed not at restricting the withdrawal of capital, but at encouraging investment. Institutional investors, for example, pension funds, also can invest in real estate funds. In the United States, for example, this was allowed in 1993.
As a rule, the funds' units are freely tradable on the leading American and world stock exchanges, but to be admitted to trading on a stock exchange, the fund must be registered with the Securities and Exchange Commission (SEC). REIT units are subject to the same requirements and have the same features as other types of securities - credit purchases, short sales, etc. Of course, such securities are subject to general, recently often unfavourable securities market movements, but their volatility is less since the real estate price underlying the value of such securities is not as subject to fluctuations as the securities market. Therefore, real estate fund securities are often used to create diversified loan portfolios.
According to The REIT Act, REITs in the USA are divided into three main groups: real estate funds (equity REITs), mortgage funds (mortgage REITs) and so-called hybrid funds (hybrid REITs). Real estate funds invest their assets directly into real estate objects. As a rule, when we talk about REITs, most often we talk about real estate funds. The income of such funds consists of the major components mentioned above: income from renting out real estate properties and income from the change in their value. The majority of such funds are more than 90 % of their total number. Mortgage funds invest assets in various mortgage products and are usually of two types according to the type of property financed - residential and commercial. It was the mortgage funds, whose combined assets have grown more than 15 times through explosive growth in the U.S. real estate market, that were hit by the collapse of the U.S. subprime mortgage product market. However, the overall reliability of REITs was not much affected - the share of mortgage funds among REITs is small and does not exceed 6 per cent. Hybrid funds combine the characteristics of the two groups mentioned above, primarily about income sources. Their difference from real estate funds is a larger share of mortgage products among investment objects. There are few such funds - only about 2 per cent.
7. Distribution of real estate funds in the world.
The REIT regime is common in many countries of the world. As a rule, when adopting relevant legislation, they try to use the term REIT to make the local terminology consistent with the world one. That's what they do in Japan (J-REIT), Hong Kong (H-REIT), Singapore (S-REIT), Great Britain (UK-REIT), Germany (G-REIT), they plan to change terminology in Australia (change from LPT (Listed Property Trust) to A-REIT). But many countries prefer to use their terminology. In Belgium, such funds are called SICAFI, in France - SIIC, in Netherlands - FBI. The Netherlands pioneered real estate funds in Europe, where the FBI regime was presented in 1969. It should be noted that for many European countries, the real estate fund – is a fairly new phenomenon. For example, relevant legislation was adopted only in the UK in 2007. However real estate funds are developing very fast - in France, the regime was introduced in 2003 and already in 2006, the number of funds exceeded 30. The general requirements regarding the objects of investment, the composition of investors and the distribution of income remain the same when new REIT regimes are created, only the relevant values change. The tax exemptions applicable to the activities of the funds are the same general rule. Even if corporate tax is applied to REIT activities (as, for example, in France), it is at much lower rates than those provided for in the general tax regime.