REITs and development activity. Industry still waiting for a draft law.
08-02-2017
The draft law on real estate rental companies, published in October last year, has failed an attempt of public consultations. More than 60 pages of various comments, convinced the Ministry of Finance that the law should be written from the beginning.
One of the most interesting topics of discussion while giving opinions on the project was the issue of REITs ability to deal with the development activities. While the previous draft of the law did not include any special contraindications in this respect, currently the representatives of the Ministry of Finance state that the ministry is not interested in a situation that REITs are involved in the construction on their own.
It is difficult to find a particular logic in the position of ministry officials. Apparently they fear that developers would abuse the REITs for tax purposes and at the same time they may earn too much.
Meanwhile, in vast majority of countries where REITs exist, they can carry out development activities. For this type of companies this is, in addition to organic growth and the acquisition of finished objects, normal method for business development leading to increase in revenues from rental REITs, however, have its own specifics and the development activity conducted by them must comply with certain principles.
To illustrate these principles, let us imagine that we are a typical, small stock exchange investor who holds a certain amount of money that we can ultimately invest in real estate. Before we choose "our" REIT, we analyse the market on which it operates, and supply conditionings of a specific location, where it holds its property. We found it! We choose the REIT, which holds in its portfolio shopping malls in Warsaw, Krakow and Gdańsk. The history of "our" REIT shows a stable appreciation in share prices, let's assume 4% per annum. "Our" REIT pays a dividend to investors at a regular basis at a decent level, let's assume, 4% per annum. Consequently we assume, that the investment in "our" REIT will yield "some" 8% return per annum. We buy shares and are looking forward with a satisfaction to the dividend. However, one day some industry media begin to write about "our" REIT. The Management Board informs that "our" REIT acquired two more plots in Rzeszów (saturation: 1321.5 m2 GLA per 1,000 residents) and in Lublin (saturation: 932 m2 GLA per 1,000 residents), and announces the issue of shares with the intention of constructing there new, big shopping malls.
As a shareholder, we begin to wonder ...
What will happen if "our" REIT just cannot handle such an investment? Something goes wrong with the general contractor? REIT will exceed the budget approved for this project? It will not find in these difficult cities the tenants for retail space? Or maybe "our" REIT will decide to reinvest the profit rather than paying out to shareholders? To what extent the construction of new projects is to be financed from the issue of shares, and from a bank loan? And generally, what is the current liabilities to assets ratio of our REIT? Will the new credits make the roll-over of existing debt more difficult for the company? When our REIT is going to put the new galleries to use? In 2 years? In that case, does the issue of new shares now not lead to the dilution of the shareholding structure and consequently jeopardize the amount of dividend per share in this fiscal year?
These questions asked both by us and a group of other similar investors, lead to a rapid sell-off of shares of "our" REIT and - as a consequence - to bury its development plans in Rzeszów and Lublin (due to a drop in stock prices and resulting threat of loss of "issuance capacity").
As it is clear from the above example, the REITs planning to start also development activity, have to focus from the very beginning on different types of investors. Their offer will be addressed to entities willing to accept higher risk in exchange for a higher return on investment. It is somehow obvious that the construction of an object by the REIT on its own is associated with a number of risks, but it also provides an opportunity to create a much higher value than, for example, purchase of already functioning real estate. This value "costs" in this case, much less capital, thanks to which the shareholders can expect correspondingly higher return on investment.
Of course, in the case of REITs implementing real estate development strategy it is extremely important to communicate with the market. The investment strategy chosen by the REIT must be clearly communicated already in the prospectus. How to conduct this communication in practice, is shown by an example of American REITs involved in real estate development. For example, Armada Hoffler Properties, Inc. on its website describes in detail the extensive experience of its Management Board in carrying out development activities. It indicates how many shares of the specific REIT and how long the Management Board holds in its own pocket. It describes in details the projects completed and high rates of return, earned for investors through its shares. Information policy of Armada Hoffler Properties seems to communicate: "easy, we are familiar with the construction of real estate so your money is in good hands. You'll see the total yield of your shares ...”
Much attention is given by REITs dealing with real estate development to explaining the organizational and capital structures of a specific project. Because we can see in the above example, that the issue of shares of the REIT to finance the construction of real estate may lead to temporary dilution of the shareholding structure and the apparent drop in the net value of assets per share and dividend per share. Therefore, the US REITs generally implement the real estate projects using the UP-REIT structure, in which the investors and partners of the specific project acquire stock or shares of a REIT's subsidiary, implementing the project, while they receive the shares of REIT only after putting the investment into use.
The Ministry of Finance is going to publish a new draft law on real estate rental companies, already in February. Let's see, to what extent it will allow Polish REITs for profitable business in development activity, and their investors - for rate of return much higher than the standard.