Comparison of REITs and Tax Credits

Comparison of REITs and Tax Credits

Executive Summary

REITs provide capital, not affordability

Introducing REITs into the UK financial markets will create opportunities for average Britons to participate as equity shareholders in the cash flow and value growth of income-producing real estate.

It will do virtually nothing to create new affordable housing or to create long-term affordability.

What REITs do ... and what they don't do

The REIT role: cheaper equity capital

In the simplest terms, REITs are an ownership vehicle with two great attributes: (a) passthrough of tax consequences, and (b) liquidity via free tradability. These features make REITs the vehicle of choice whereby common investors can buy into real estate ventures as they would in equity shares. Expanding marketplace access reduces the cost of equity capital and fuels investment in targeted sectors of income-producing real estate (offices, shopping centers, hotels, rental apartments ... but not for-sale homes).

REITs in the US

In the US, REITs have a thirty-year history divided into an early year (the 1970's) and a modern era (1995-beyond). Earlier REITs were used for speculative and developmental investments and proved so unsuccessful that the industry all but went into hibernation until 1995, when it re-emerged as principally a vehicle to hold long-term stable, performing assets in income-producing real estate.

Today, according to the National Association of REITs (www.nareit.com), total market capitalization of publicly-traded REITs is about $220 billion (http://www.nareit.com/aboutreits/index.cfm) of which $35 billion (or 16%) is residential, and all of that is private, conventional rental stock . The largest is Equity Residential, www.equityresidential.com , with 212,000 apartments and a market cap of $8.1 billion.

Not a home builder

REITs are an ownership device, not a developmental device. They are suitable for long-term income-producing properties such as apartments, not for-sale homes.

Not suitable for affordable housing

REITs seek to maximize cash flow. They do this by containing operating expenses (good) and raising rents as much as they can. Raising rents is, of course, incompatible with long-term affordability.

None of the publicly traded REITs has any significant presence in affordable housing; indeed the REIT with the largest concentration, AIMCO, has been trying for several years to sell its affordable portfolio (http://www.aimco.com/about/dispositionslist.asp) acquired through acquisitions of several major affordable developers including the former National Housing Partnership.

Mortgage REITs

Some REITs specialize in originating mortgages rather than equity positions. Were such REITs to emerge, they might be expected to lower the cost of home mortgages ... slightly.

Creating affordability by closing the cost-value gap: Housing & Regeneration Tax Credit

Affordability and the cost-value gap

Since housing prices are the distilled reflection of the marketplace's willingness to pay for housing 1, housing that is affordable for low-income households faces an intrinsic cost-value gap:

The cost to create it, is greater than
The value (in economic terms) derived from affordable rents/ home price.

Only government can close this gap on an ongoing basis. The private sector will not because it does not want to; the private sector is legitimately interested in maximizing profit, which means minimizing

The equity paradox

Like other governments, the UK has from time to time sought to deliver affordability by using the cheapest capital available - either very low cost loans or outright grants. Nevertheless, grant is unrecoverable and 100% debt is too risky.

Sound property finance requires equity (a) to provide a shock absorber for unexpected market conditions, (b) to give debt confidence (and hence lower its cost), (c) to bring private investment capital in as a watchdog over sponsor performance, and (d) to create market discipline around resource allocation decisions (which property do we develop?).

Yet equity is, by definition and irrefutable economic gravity, more expensive than debt. It demands higher returns and it creates long-term upward pressure on rents and home prices. Hence the equity paradox: we need equity to make deals viable, but the more we use, the less affordable they are.

The proper role of fiscal incentives: soft equity using tax incentives

The equity paradox is solved only by using soft equity that serves the same fiscal purposes as equity but without demanding a cash-on-cash return. In this context, soft equity means:

Provided by private capital.
Takes downside risk and transfer risk to the private sector.
Receives its return without undermining long-term affordability.

Soft equity using tax incentives is thus not simply a performance-based grant, it is a fundamental step change in delivery. It uses a different delivery system (Treasury, not Housing), has reliable clawback (while grant has none), and offers all the market disciplines.

HART as the tool of choice

The Housing And Regeneration Tax Credit (HART; www.hartcredit.org.uk ) has been custom-designed for the UK using best-practice principles proven in the US over the last 25 years. It has secured:

An endorsement from the National Housing Federation, in its manifesto.
A favourable econometric review by ABROS, a respected UK consultancy.
Strong support among housing associations.

HART is the tool of choice for creating genuine affordability in Britain.

1 These higher prices for developed property translate into higher prices for undeveloped land. Except for odd blips of timing, or when government owns the land and puts it into play below market value, it is economically impossible for government to prevent market demand from raising prices for completed homes and for developable land.