Tesco Says No to REITS

Real Estate Investment Trusts (REITs) are a tax-efficient onshore vehicle attracting neither capital gain nor corporation tax, provided 90% of profits are paid to shareholders.

The first REIT was launched in the US in 1960, but by 1992 the US market was worth only $2bn. However, once limits were revoked on expanding portfolios, investment took off and now stands at some $360bn.

The Dutch pioneered REIT in 1969 and in the last decade Belgium and France have joined in. In the UK, REIT legislation went live in January 2007 and Germany and Italy should follow suit later this year. There are also thriving REIT markets in Asia, particularly Australia, Japan, Malaysia, Singapore and Hong Kong. In the last, the spin-off of the government's property holdings in a November 2005 REIT produced the world's largest ever IPO, worth $2.6bn.

The appeal to institutional and small investors is clear. So too is the utility for property companies in the UK, many of whom are expected to convert to REIT status. Final changes to the regulations have boosted the expected success of the vehicle – for instance, dispensing with the requirement that only listed companies could establish a REIT. The level of profit to be dispensed to shareholders has also come down from 95%.

The UK treasury may benefit by up to £2bn from the 2% conversion charge to a REIT, but most companies will see much larger contingent capital gains tax liabilities wiped out.

The appeal for trading companies, such as banks and retailers, with a large stock of property would also seem to be clear. In the UK, they could release cash while retaining an equity interest in their property.

UK legislation mirrors other REIT systems where no single investor can hold more than 10%, but this limitation can be overcome by having subsidiaries taking up further shares.

RISKY REITS

For the outside investor, however, REITs based on the property associated with a single company may seem risky. As one analyst remarked: "All the eggs are in one basket. Property investment funds, even those devoted to particular sectors, have always benefited from a diversification of risk. There is also the fact that the tenant of a REIT won't want to pay over the odds."

There is a further concern for REIT vehicles arriving in 2007 as much of the property market may have topped out. Beyond a possible economic slowdown in the US, property investment returns are falling as interest rates rise. In anticipation of a bigger market downturn, will the greater liquidity, tax transparency and the domestic (rather than offshore) regulation of property mutual funds attract money away from traditional property investment?

Some companies are already committed to launching their own REIT. Short-term office premises provider Workspace estimates that while it would cost £20m to convert, it would be freed of £140m of contingent capital gains tax liabilities. Big Yellow, which manages self-service lock-up premises, has calculated that 88% of its business would become tax exempt as a result of the move.

There was speculation that Tesco would also adopt REIT status. However, as group treasurer Nick Mourant makes clear, the retailer is maintaining its current arrangements: "Because REITs allow the shelter of pregnant capital gains on property, plus the tax efficiency on profits generated from property holdings, they are immediately relevant to quoted property companies, and I expect that the majority will be converted."

Tesco, which holds some £15bn of property on its balance sheet, with a market value of nearer £23bn, has made an interesting analysis. Mourant says: "We have decided not to convert ourselves into a REIT because the operations of our property and retail business are interlinked. It is our ability to run our retail operations that drives the value in our property. There is a theoretical value in splitting ourselves into a REIT, but it is not something we are currently considering."

Mourant believes that ultimately the value of a property is produced by the cash flow generated off it. Describing Tesco modestly as 'a reasonably efficient retailer', he says that, as such, the company would expect to generate more value than a less efficient rival.

Tesco's portfolio is split 80:20 between freehold and leasehold. Mourant says: "In May 2005, we announced that over the following five years we would undertake a £5bn programme of sale and leaseback. We would use £1.5bn of the proceeds to either buy back existing shares or offset the effects of scrip dividends or share options on fully diluted earnings per share. If you look at the capital spend that Tesco puts down each year, it is around £3bn. So directionally, a £5bn sale and leaseback programme with £3bn of new property coming on board is keeping our freehold / leasehold mix at the 80:20 level."

From Tesco's point of view, its sale and leaseback arrangements also offer it the same continued ownership advantages that could come from a REIT. Mourant explains that, as its sales and leasebacks are primarily carried out in joint ventures with property companies and financial institutions: "We have an equity interest in the future growth of those properties such that both the landlord and the Tesco tenant are operating the store to best advantage."

Mourant says it is important to remember that Tesco is, first and foremost, a retailer. "If we were a property company, we would be one of the biggest in the UK. However, our property is the means by which we can retail food and other services."

Tesco's continuing expansion into Slovakia, Poland, the Czech Republic, Hungary and Turkey means that 60% of its retail space is now outside the UK. However, given higher domestic property values, 66% of its assets' book value (£10bn) is in the UK.

PUTTING THE CUSTOMER FIRST

Tesco does not put its shareholders first. "Tesco does what is best for customers rather than what is best for investors," explains Mourant. "We are out to earn the lifetime loyalty of customers. Our success comes from following what our customers want. What is right for customers will ultimately be right for our shareholders. In a choice between what is right for the customer and what is right for the markets, we always favour the customer. That sounds very positive and grand, but that is the way the business thinks about it."

Perhaps this is another reason why Tesco does not think REITs are right for it; the new investors would be one step removed from the core retailing activity that drives the business.