UK: Introduction of Hotel REITs: one step closer?

The government confirmed its aim in the 2005 Budget to legislate for UK REITs in the Finance Bill 2006. However, this is still dependent on a number of key issues being satisfactorily resolved between the government and the real estate sector. Government has requested comments to the second stage consultation paper and we are collating the views of industry to provide a response on the remaining issues for hotels.

REITs could be highly beneficial to the hotel industry but their attractiveness is dependent on how government reacts to views of industry during this consultation process. In May last year we responded to the initial consultation process on behalf of the industry and we were pleased that the majority of our proposals were included in the government consultation paper issued in March 2005 that we are now commenting on. We hope that with continued industry support and ideas we can achieve the same level of success.

To view the full article summarising the key issues to be resolved by the hotel sector and explain some of our thoughts on those issues, please see below:

Full Article

The government confirmed its aim in the 2005 Budget to legislate for UK REITs in the Finance Bill 2006. However, this is still dependent on a number of key issues being satisfactorily resolved between the government and the real estate sector. Government has requested comments to the second stage consultation paper and we are collating the views of industry to provide a response on the remaining issues for hotels. We summarise below the key issues to be resolved by the hotel sector and explain some of our thoughts on those issues.

REITs could be highly beneficial to the hotel industry but their attractiveness is dependent on how government reacts to views of industry during this consultation process. In May last year we responded to the initial consultation process on behalf of the industry and we were pleased that the majority of our proposals were included in the government consultation paper issued in March 2005 that we are now commenting on. We hope that with continued industry support and ideas we can achieve the same level of success.

• Hotels (whether in the UK or outside) will be permitted REIT investments.

• The investment must produce a Schedule A (investment) income for the REIT. The structure that we included in our initial response is likely to be adopted and this will mean that the REIT itself will own the property asset represented by the hotel and then lease it to another party or, if it is to retain a more business linked interest in the hotel asset, to a subsidiary of the REIT. The subsidiary then carries on the business or enters into a management contract with a third party. The REIT will not, as things stand, be able to let out a management contract.

• The above structure is only be possible if the REIT can show that it has at least 75% of its total gross income and the gross value of assets relating to property investment business. So for a REIT owning hotel operating company it will have to demonstrate that the operating company is not worth more than 25% of the totality of the REIT's assets. It is likely that most hotel REIT structures in the form set out above will or can qualify assuming no extreme valuation of intangibles e.g. goodwill vested in the subsidiary.

• A key point in relation to hotels is the question mark as to the level of distribution of profits required. In our responses to the original consultation we asked for 90%. The government has now decided that there will be a requirement for a distribution by the REIT of at least 95% of its real estate investment income after "appropriate deductions and capital allowances". A great deal of care will need to be taken in relation to this area, particularly for the hotel sector, and it may be this area which distinguishes the hotel sector from the rest of the property industry and causes friction between the two. The hotel sector needs to be clear on what is meant by FFE and other expenditure items in relation to hotels and also appreciate the differences between provisions for FFE/Capex on the one hand and the Inland Revenue view that distinguishes between income and Capex on the other. In particular, it seems that there will be no allowance for a provision for capital expenditure in the 95% calculation. However the reference to "appropriate deductions" leaves the door open for there to be a sector debate here. Key to our fact finding and feedback is to focus on this element and attempt to develop the debate that took place at the time of the previous consultation document. Failure in this area will mean that the REIT will have to use triple net leases.

• There is no positive statement as to whether turnover or profit geared leases will be permitted. It seems, from the absence of comment on the point, that they will be. Accordingly, the terms of the lease of a hotel whether to a subsidiary or to a third party can be on a proper market basis. Indeed the lease will have to be on a market basis (in terms of rent value) as UK transfer pricing rules will be strictly applied to ensure that the REIT is only receiving an appropriate share of exempt rental income while any hotel management subsidiary achieves a sensible share of profits taxable in the UK on an ordinary basis.

• Both internal and external management will be allowed in relation to REITs. This leaves the possibility for expert hotel groups and professionals to set up new hotel investment REITs but also particular hotel groups to look to the creation of more "in-house" REITs investing in hotels that are already familiar to them. This form of partial realisation of assets combined with ongoing asset management fees has proved a popular model already in the industrial property sector.

• A REIT will not be permitted to invest in a single asset and indeed any single property will not be entitled to exceed a defined proportion of the total value of the assets of the REIT. Whilst it is possible simply to have a REIT conversion or that the REIT acquires a portfolio, it is quite possible that a start-up REIT will gradually build up a portfolio of hotels. In its start-up period it may only own a small number of hotels. Indeed in a portfolio purchase there may be one or two dominant hotels by value or size. Clearly some form of representation will need to be made to government on this point perhaps with a view to agreeing a period of grace, at least during the infancy of a REIT.

• The government is still considering whether a REIT should be required to be listed or not. It is assumed that the hotel sector has no reason to deviate from the view of the general property sector in that area. However, the proposal is not clear on the number of shareholders that must participate in a REIT and there might be an issue again in relation to start-up REITs as to whether they need to be listed during an initial period. Further, professional investors may wish to consider REITs, which are not in listed form.

• It is noteworthy that REITs will not be permitted to invest in derivatives. It is possible to imagine that in a start-up situation the use of property or even hotel specific derivatives may be a way to gain exposure to the hotel sector pending the acquisition of brick and mortar.

• It seems that the government wishes to impose a cap on the level of borrowing (primarily to avoid loss of tax for the Exchequer rather than to protect the retail investor!). The hotel sector will need to consider if a cap of, say, 40% or 50% is a problem. Although it is understood from our previous discussions within the sector that a 50% cap would not cause undue restriction on hotel REIT operations, the UK hotel and property sectors are well used to higher leverage already and that flexibility must be attractive. The fact is that if the vehicle is only listed rather than unlisted then the market conditions and it may be that the sector should push for that freedom.

• The final key sector issue is in relation to the conversion charge. It seems that the government will use the conversion charge to neutralise any tax loss that they expect from compromises made on other measures in relation to REITs. Cynically it may be suggested that this will be a Revenue raiser at just the time when the government coffers are in need of a boost. Setting a level of conversion charge is a difficult task and the government will be talking to representatives of the real estate sector. The major difficulty that we see in practice is that the government wishes to see REITs as a success and will have to take into account the fact that large groups e.g. of hotel owners and perhaps other real estate groups are able at the moment to sell large portfolios of assets such as hotels within a corporate wrapper and qualify for substantial shareholding relief. Accordingly, it is inconceivable that hotel groups with significant established businesses will be looking to convert the business into a REIT at the cost of any significant conversion tax whether on capital gains or on a gross asset basis. Will the government understand this? Maybe. Will they be moved by it? Maybe not.

Finally, readers should bear in mind that the major outstanding issue in relation to REITs is the treatment of distributions particularly in a foreign context. Non-UK residents will be permitted to register as REITs and thus there may be a difficulty of collection of tax from such REITs. Non-UK investors in UK REITs will be able to call for significant reductions in any withholding tax imposed. The government is therefore in something of a quandary as to whether and how to deal with this. So serious is the issue that it seems to have stopped the German REIT process in its tracks for at least one year. On the other hand, the French authorities, in introducing their SIIC in the last couple of years, seem to have accepted the advantageous status available to non-French REIT companies and non-French investors in French REITs. Again there will be a delicate balancing process between the desire to avoid the REIT being as big a failure as the housing investment trust was some years ago and the desire of Gordon Brown to protect the Exchequer.

A possible riposte to the tax protectionist argument is that at the moment the UK property and hotel sector attracts a large number of offshore investors who, through high leverage and non-resident status, pay little or no UK tax on their rental or capital return. REITs may in fact have the effect of reducing that imbalance by bringing more UK investors into the market and should also increase the SDLT take through increased liquidity. Responses in this vein may mean that the industry has to accept a lower gearing limit to ensure more distributions to investors.

All in all, there are interesting times ahead in relation to the REIT debate and the next few months will be key in relation to the final decision as to whether a REIT will indeed be introduced and its attractiveness to the hotel sector and indeed more widely.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 28/04/2005.