NAREIT - International Insights

Property companies worldwide have been flush with capital the last few years, helped by low interest rates, strong fundamentals and a growing investor base. Now it looks like global real estate is going to get a hand from a new helper: the Dutch government.

Concerned over the stability and longevity of the Netherlands’ pension system, the Dutch government plans to introduce a set of rules in January 2007 that would increase disclosure, reporting and funding requirements. As a result, pension funds will have to adjust their weightings to meet the new rules—and real estate stands to benefit from increased allocations.

The $1.05 trillion Dutch pension funds sector currently holds somewhere between 6.5 percent and 9 percent of its assets in real estate, depending on the source. The bulk of that capital goes abroad. Even a 2 percentage-point increase would mean nearly $20.6 billion more investment capital for the world’s real estate companies.

The new rules, called the Financial Review Framework (Financieel Toetsingskader, or FTK) center on the requirement that pension funds value assets and liabilities using the effective interest rate given by the swap curve (0.05 percent above the government bond rate) as the discount factor, rather than the 4 percent fixed discount rate they currently use. The FTK also includes three tests of pension funds’ ability to meet their obligations, each with a different time horizon: a minimum test, a solvency test and a continuity test.

The FTK could boost real estate investment in three ways. First, pension funds compelled to tighten asset/liability matching over time will be drawn to the positive correlation between real estate income and wage rates, a key determinant of pension funds’ future liabilities. Second, as internal risk models under the FTK will assess the risk of the entire investment portfolio in relation to liabilities, pension funds are likely to diversify in order to meet the test.

“More funds will move out of equity and fixed-income and into real estate, private equity, commodities, hedge funds, etc.,” says Peter-Hans Budde, head of institutional relations at Kempen Capital Management in Amsterdam.

Third, real estate assets will have the lowest solvency ratio at 15 percent, compared to 25 percent for equities and 30 percent for commodities. “One could say that the cost of capital decreases by investing in real estate,” Budde says. Technically, the FTK, like the bulk of Dutch pension funds, categorizes REITs as “property” rather than “equity.”

The FTK framework comes at a time when a growing number of investment strategists across the globe are calling for an overall increase in pension funds’ real-estate weightings. A study by Ibbotson Associates showed that portfolios with an allocation to U.S. REITs posted higher total returns with lower risk than a portfolio without a REIT allocation. In an October 2005 white paper, Nick Tyrrell, director of research and strategy for JP Morgan Real Estate’s European Team, called for European pension funds to up their real estate weightings from the current average of around 6 percent to between 10 percent and 15 percent, citing, among other reasons, property’s low correlation with other asset classes and its strong suitability to liability matching.

The market, at least in Europe, seems to agree: A survey by UBS shows expectations that nearly half of European pension funds will increase their real estate allocations to between 10 percent and 15 percent in the near term.

While Dutch pension funds are among the biggest foreign investors in U.S. REITs, some are currently more enthused about other markets. “The U.S. is too expensive right now,” says Boudewijn van Loen, a real-estate portfolio manager at F&C Asset Management, which manages $60.7 billion of Dutch institutional capital and recommends a “hold” on U.S. REITs.

He says he prefers the public European market, “which is emerging in that there is not much property on the list.” If and when Germany and the U.K. allow REITs, he says, those markets will be very attractive, “not so much for the tax transparency, but for the fact that [REITs] will create a new investor base.”

Nonetheless, according to Barden Gale, managing director of real estate at ABP Investments U.S., Inc., the U.S. branch of Dutch-based pension giant ABP, Dutch pension funds are not likely to pull capital out of U.S. REITs. He says that there is a growing appreciation for factors other than price. “There is a movement in pension funds toward long-dated assets—and that’s what you have in real estate.”

Meanwhile, the local Dutch REIT industry is looking for a little attention of its own. The REIT-like “Fiscale Beleggingsinstelling” (FBI), introduced in 1969, has become outdated. French and Belgian structures are more flexible than the FBI, and all indications are that the proposed German and U.K. structures will be as well. And the disadvantage of the FBI vis-à-vis the SICAV (Société d’Investissement à Capital Variable) regime of Luxembourg is so great that many REITs have abandoned the Netherlands to set up shop in Luxembourg.

“The biggest problems are the complicated shareholders’ conditions, the financing limits and [the] very narrow interpretation of the permitted activities,” says Ronald Wijs, tax partner at Loyens & Loeff Amsterdam. As for the permitted activities, the main sticking point is the restrictions that the FBI places on development.

The Institutionele Vastgoed Beleggers Nederland (IVBN), the Dutch Fund Association (DUFAS) and the European Public Real Estate Association (EPRA) are lobbying the Dutch Finance Ministry to create a new structure effectively equivalent to the SICAV, with no shareholder restrictions, no requirement for distribution of dividends, but no treaty protection. The proposed changes would give Dutch REITs much more financial flexibility and would make them more attractive to international investors.

“Basically, we are now waiting for a modernization of the old regime to make Dutch REITs more competitive in Europe,” Wijs says.

In a Dec. 20, 2005 press release, the Dutch government announced it had agreed to a legislative proposal pushed by the banking sector for a new fully exempt investment fund regime that will be introduced in parallel to the current FBI. As explained by Wijs in a note to clients, participating funds will:

• be fully exempt from corporate income tax;
• be exempt from Dutch withholding tax on profit distributions;
• not be subject to any conditions as to the composition of shareholders;
• not be subject to a mandatory profit distribution;
• not be subject to any annual stamp duty or “taxe d’abonnement.”

• there will be no entitlement to protection under the Dutch tax treaties;
• the Investment Fund is not entitled to a refund of Dutch withholding tax (on dividends distributed to the Investment Fund new style).

According to Wijs, Dutch REITs will not fall within the scope of the new regime. “This is because, if foreign investors could invest in Dutch real estate via the new investment fund, they could repatriate Dutch real estate income abroad free of any Dutch tax.”

The upshot? Pension funds have been dealt with, and banks have for the most part been given what they wanted—maybe Dutch REITs will be next.

U.K. REIT Update

In December, the U.K. government published the first version of a draft bill for REITs, showing the government’s thinking on the framework and setting a baseline for negotiations on the shape of the bill that will go before Parliament this summer.

The draft makes clear that after years of hand-wringing, the U.K. Treasury and tax authority are open to seeing REITs in place in January 2007. But the government’s concerns about risk and the tax take come through in the draft in the form of proposed restrictions that leave some in the industry wondering about the effectiveness of the proposed REIT structure.

The government intends to deter REITs from development projects through an “interest cover test,” capping at 2.5 the ratio of profits-plus-financing costs divided by financing costs. Liz Peace, CEO of the British Property Federation and a member of a REIT working group in close contact with the government, estimates that this test translates to a 40 percent gearing level. She adds that would be “a problem for most of the companies” that would consider conversion.

Additionally, the government plans to limit individual shareholdings in REITs to a maximum of 10 percent in order to prevent tax revenue from going overseas. Foreign holders of stakes greater than 10 percent receive broad tax credits in the U.K.’s foreign tax credit system.

The conversion charge the real estate companies will have to pay in order to become REITs is an important question mark. If the charge, which is likely to be based on either total assets or capital gains tax owed, is set too high, some companies might not convert, industry sources say.

Industry leaders had until Jan. 27 to respond to the draft. According to Peace, they will look for breaks on the restrictions, not to mention ways around them. Failing that, the industry will have to ask itself how much the REIT structure is worth. “Are we just seeking to convert into REITs, or are we going to have to change?” Peace asks.

Theodore Murphy is a New York-based freelance journalist and the U.S. correspondent for Real Estate Europe.