Appendix B:  Indirect Investment in Real Estate

Quoted Real Estate Company Shares

Real estate company shares have three main qualities, those of liquidity, diversification and gearing. The liquidity of real estate company shares is equivalent to that of other equities listed on the ISE. It is important to note, however, that both the market capitalisation of a company and the number of its shareholders can adversely affect the liquidity of a company's shares. In institutional terms, the quoted real estate sector is relatively small, with a market capitalisation of approximately £14bn.1 Of this the top six companies make up more than 60% of the total market capitalisation of the sector (Barkham [1995]. When this is compared to total institutional investment in real estate, the limited size of the sector becomes apparent. For example, at the end of 1995, direct UK pension fund investment in real estate was approximately £24bn. This may be compared with £2.5bn in indirect real estate.

In addition to the above, a quoted real estate company's performance is monitored on a regular basis by independent non-executive directors, independent securities analysts, auditors, and the business and financial media. This scrutiny provides the investor with a measure of protection, and more than one barometer of the financial health and performance of a real estate company.

The core companies within the real estate sector, such as Land Securities, MEPC and British Land, have sizeable portfolios with a wide spread in terms of both sector and location. It is also possible to gain exposure to specific sectors or locations by investing in, for example, Brixton Holdings, which concentrates on industrial real estate, or the re-launched Capital & Counties which invests solely in shopping centres. According to Venmore-Rowland [1989];

'Property investment company shares are asset-backed equities. They are subject to the vagaries of the traded market place, but their long-term performance is linked to the returns from their underlying property portfolios, and these returns may be significantly boosted (or reduced) by gearing and by management input.'

However, holding shares in real estate companies does not diversify the basic risk of equities for an investor. The requirement to diversify away from equities has been a major argument for the holding of real estate as part of a fully diversified portfolio. An important measure of the benefits of diversification is provided by an investment's correlation coefficients between other asset classes and itself. As table C.1 illustrates, over the periods, 1965-1993,1975-1993 and 1985-1993 the quoted real estate sector in the UK was highly correlated with the FT-SE All Share index. Significant in all cases at the 5% level.2 This undermines its role as a diversifier, and strengthens the argument that the quotes real estate sector be treated as just another sector of the equity market. These results are in stark contrast to those found for direct real estate, as illustrated in table 3.6 on section 3.4.3.

Asset Backed Finance

Asset-backed finance is the generic term used to describe debt financing instruments

which are backed by assets generating an income stream, servicing the interest and principal payments of the securities issued. They are similar to domestic mortgage backed securities, but differ only in the nature of the underlying assets. These have included lease receivables, credit card receivables, royalties from films and land, automobile loans and real estate leases.

The first asset-backed finance issue occurred in the US in March 1985, backed by receivables on computer leases owned by Sperry Lease Finance Corporation. The US remains the major market for such securities, with the following investors in the US asset backed finance market in 1989:

Asset-backed finance essentially applies the securitisation techniques of the domestic mortgage backed securities market to other types of corporate assets. The issues, as with those in the mortgage market, are generally structured in one of two ways, the choice being largely determined by tax and accounting considerations :

• pass through - the company wishing to obtain finance sells the assets to a grantor trust, which then issues certificates to investors essentially giving holders an equity interest in the assets of the trust. Cash flows received are passed through to the investor; or

• pay through - here the company sells the assets to a special purpose vehicle, a subsidiary, which in turn issues securities collateralised by the assets. The coupon and redemption of the securities is paid from the cash flows generated by the assets.

Dependent on the nature of the underlying assets, the maturity of such securities varies from short to medium term. This in turn determines the precise characteristics of the issued. For example, short-term securities can be issued in a form similar to commercial paper with a revolving facility.

The various securities issued on real estate assets in the US are as follows :-

• Multiple Mortgage Securities - colloquially referred to as :

  • • Ginnie Maes - mortgage backed pass through certificates issued by the Government National Mortgage Association, which in 1968 replaced the Federal National Mortgage Association (see below) as a purchaser of mortgages uneconomic for private institutions;

      • Freddie Macs - five varieties of securities, backed by conventional domestic mortgages, issued by the Federal Home Loan Mortgage Corporation;

      • Fanny Maes - issues of debt (which can include convertibles and Euro medium term notes) to private investors, to assist the provision of home mortgages,by the Federal National Mortgage Association. Although Fanny Mae is the single largest issuer of securities on the US domestic capital market after the US Treasury, the most liquid of multiple mortgage securities are:

      • Farm Credits - Farm Credit Banks Discount Notes, of between five and 180 days maturity. Their State-tax exempt status compensates for the coupon (lower than Treasury bills), and explains their popularity.

• Single Property Schemes - which sell equity interests in single properties. Investors not only receive a share of the net income generated from its rent, but also participate in any capital appreciation of the property, reflected in its market value.

• • This type of security was first developed in the US in the 1960s and issued via Real Estate Investment Trusts ("REIT"). These fell out of favour in the 1970s, but in 1987 15-year convertible participating mortgage certificates were issued by Rockefeller Centre Properties. These were to receive cash flows from the property until review (1993), when they became convertible into ±80% ownership of the property;

• Credit enhancement - issues of securities in the market are generally rated AAA or AA. To enable issues to be sufficiently creditworthy to receive a high rating, credit enhancement techniques are used, such as:

  • • Letter of Credit from a highly rated institution which guarantees investors against loss. This loss enables the issue to take the rating of the issuer of the letter of credit, as in the US commercial paper market;

      • Monoline Insurance guarantees by AAA-rated insurance companies such as FGIC or FSA, which cover losses and so provide issues with that AAA rating. Note that British insurance companies such as Eagle Star subsequently began to write similar business by insuring loan facilities. They wrote such business for premia of around 6% flat of the amount insured for a 'normal' two-year construction loan. However, their entry to this field was on the naive basis that commercial real estate development risk was similar to that on residential housing mortgages. Substantial losses ensued, and the British companies reduced their exposure and participation in this market. To fill the resulting gap in the domestic market, the British government allowed UK building societies to set up their own 'captive' insurance companies to protect themselves against mortgage losses.

Finance Leases

The principle of a finance lease is that an interest in land is granted to a leasing company, which then grants e. g. a lease of up to 35 years to the client, who then leases on to the tenant. The rent flows in the reverse direction. The tenant pays a normal commercial rent with rent reviews to the client, who will then pay a 'financial rent' to the bank. The bank will have paid the premium i. e. an initial lump sum, to the freeholder, for the grant of the initial lease, this lump sum being used to repay the development finance or acquire the property from a third party. The client would also own the freehold and so would ultimately benefit from any increase in value of the property. After the expiry of the short lease, i. e. once the bank has been fully 'repaid', the remaining peppercorn can be bought out by the client, and the bank will transfer its interest in the remaining period of the lease to the client.

Mortgage Indemnity Guarantees

Mortgage indemnity guarantees are issued by an insurance company which insures against the risk of default on a bank loan. The insurance company takes an initial premium in return for 'guaranteeing' i. e. insuring, the bank for the risk of loss on part of its loan. For example, where a bank wishes to only lend 75% of costs but the client wishes to borrow 90% of costs, the insurance company would insure the top 15% risk for the bank in return for the payment of a premium. The important point to notice about mortgage indemnity insurance is that (if it can be obtained in today's market) it is much cheaper than, say, mezzanine finance offered by a merchant bank. However, it remains to be seen for how long this gap in the market will be maintained. Insurance companies are increasingly aware of the true risks they are undertaking.

Revolving Underwriting Facilities

In simple terms, the borrower arranges a facility with two tiers of banks - underwriters who guarantee the provision of the finance, and tender panellists who bid for the finance if it suits them to do so.

Programmes can be arranged on annual, evergreen (medium term renewed annually),

or fixed medium term bases.

The tender panel banks bid can be as low as a few basis-points over LIBOR. The borrower also pays an underwriting fee and together these two form his cost of borrowing. If the tender panel decline to lend the underwriters will be committed to lend at, say, 15-25 basis-points over LIBOR.

The credit risk of the borrower must be undoubted, as the bidding is by telephone and

is very quickly conducted - there is no time to analyse a complicated credit risk, a company in difficulties or a small unknown company. For these reasons most companies need to have shareholders funds of £50-100 million and be able to issue programmes of £25 million upwards - in practice programmes of £50-100 million plus are the normal size.

These facilities are general unsecured corporate facilities, but the companies may have to honour covenants on minimum net worth, gearing ratios and profitability tests e. g. interest cover. To make such facilities secured the issuing company must have most of their assets unencumbered not charged as security to banks. The underwriter and tender panellists will not lend if any other lender is secured. Therefore such facilities are usually inappropriate to finance real estate development except for the very largest companies with strong credit ratings.

Interest Rate Swaps

Averse movements in interest rates can be reduced by the use of caps and floors. The most common form was the `cap', which sets a top limit on the rate of interest that may have to be paid. The interest on the loan is paid at the negotiated rate (LIBOR +x basis-points) with the cap reimbursing any interest paid above a set level. This is effectively an option, with the cost being paid at the outset, but which is separate from the loan. The cost of the cap varies with the degree of protection required e. g. one set at current LIBOR will be more expensive than that set at current LIBOR + 300

basis-points. Also with the term. Long caps cost more than short caps. As an option separate from the loan, it can be sold at any time through the bank it was purchased from.

Floors are the reverse of caps, in that should it be thought that LIBOR will not fall from, say, its present level, a floor can be sold. The buyer pays a premium on that option which can offset that on the cap, and contractually binds its seller to reimburse the difference between the negotiated rate and whatever LIBOR falls to.

The use of a cap and floor together is known as a collar, which sets upper and lower limits on the interest payable on a loan. This is now one of the most popular commercial interest rate swaps.

These have been maintained even after the advent of LIFFE, which provides series of interest rate options and contracts which can be used to hedge. However, they are of fixed duration and thus not strictly attuned to commercial requirements.

Unitisation

Unitisation is the process of dividing the beneficial interest in a property into tradeable units, enabling a single property to be held in multiple ownership.

A 1985 RICS report sought to tackle the shortage of long term capital for real estate development. It considered unitisation in the US and Australia, and suggested three alternative vehicles for the UK:

• Property Income Certificates (PINCs);

• Single Asset Property Companies (SAPCOs); and

• Single Property Ownership Trusts (SPOTs).

PINCs

Those are designed to have similar characteristics to a direct investment in a single property, with the added advantage of greater liquidity, being tradeable, and without the obligation of management. This allows investors to take a small stake in a large property and so diversify their portfolios.

PINCs were intended to allow real estate owners and developers to raise capital on a property without incurring a capital gains tax liability on the whole asset or necessarily surrendering management control.

A PINC comprises two elements :

• the right to receive a share of the quarterly income from the real estate investment; and

• an ordinary share in a specially created company which manages the property. PINCs were to have been traded with other listed securities by market makers on the ISE, who would decide the minimum tradeable amount and the trading spread in bid and offer prices.

Vendors would decide the proportion of the interest, while investors would have the freedom to sell the PINCs on the secondary market without any restrictions, such as pre-emption rights.

PINCs also allow gearing in several ways, either by borrowing or incorporating a tradeable debt instrument, but capital allowances do not flow through to investors.

SAPCOs

The only example to date is Billingsgate City Securities plc. That company was floated on the Luxembourg Stock Exchange in 1986 (Single Property Schemes not being permitted in the UK at the time), dividing investment into three layers combining both debt and equity, viz:

• Deep (32.5%) Discount First Mortgage Bonds, offering a fixed return with the property as security;

• Cumulative Preferred Ordinary shares, with priority equity rights over rent and capital but ranking after the bonds; and

• Ordinary shares, which ranked after the bonds and preferred shares for income. These carried the company's Corporation Tax liability, all management expenses and any CGT liability on disposal of the property, but benefited from 69.56% of the gross increases in rental and capital value.

The ordinary shares, therefore, constituted a highly geared investment, but were never seen in the market as they were all retained by the Berisford Group, the owner of the underlying asset.

SPOTs

Intended to provide investors with an equitable interest in a property which is held for them by trustees. However, these schemes were unable to obtain amendments to CGT legislation enabling tax transparency. This ended their further development and use.

Property Unit Trusts

An investment medium allowing tax-exempt pension funds and charitable trusts to invest in a diversified real estate portfolio. They are particularly suitable for small funds without sufficient resources to purchase direct real estate investments. However, their benefits are swamped by disadvantages:-

• lack of depth in the secondary market;

• illiquidity, withdrawals being dependent on subscriptions from other investors, or a sale of the underlying asset. Redemption, therefore, can often involve a lengthy procedure;

• unit prices are not responsive to new market information;

• substantial differences between bid and offer prices require that a long-term investment is made before a gain is made;

• this discourages switching;

• high management charges; and

• units are a passive investment with no opportunity for investors to become involved in management.

However, unit performance mirrors that of the underlying direct investment portfolio.

Off-Balance Sheet Financing

The techniques used to keep assets and liabilities off the balance sheet include:

• holding them in companies which avoid the technical definition of a subsidiary (which would have required them to be included in the group accounts), when in practice these companies form part of the group;

• holding them in joined-venture companies where neither of the owners had control and which therefore did not need to be included in the accounts of either of the parent companies;

• selling' properties to supposedly independent companies which would raise finance on their own account. However, in practice the vendor would have an option that gave it the right to buy the property back on terms giving it the benefit of any growth in value;

• selling properties to a financial institution and leasing them back, but again retaining the right to repurchase at a future date;

• setting up partnership schemes to own properties, where the partnerships again avoided the definition of a subsidiary; and

• selling properties to another company where the terms of the original venture shared any profits made on a subsequent resale.

Non-/Limited Recourse Lending

The scale of development in the 1980s required financing beyond the capability of many real estate companies without further capital enlargement of their balance sheets, as gearing would have become too high.

By having the associate company (≤ 50% equity) borrow for or finance a development, parent companies benefited from, inter alia not having to account for that element of associated debt in its own gearing ratios, whilst retaining the equity share of profits from it.

That accounting benefit was compounded by the recourse terms usually attached to such loans, which provided minimal redress in the event of a developer defaulting.

Limited recourse contractually bound the developer to completing the development on time and within budget, but some were couched in terms of 'best endeavours' bases only. However, many had financial penalties attached to default or withdrawal.

There was no recourse by the bank to the parent companies which owned the ≤ 50% stakes in the associate. Parent companies, could ignore the plight of the defaulting associate and its bankers with no immediate harm to themselves. However, their own financing packages which subsequently required refinancing might encounter difficulties, as bankers could then exercise their collective strength to enforce the outstanding 'moral' obligations.

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1As at 30th January, 1995.

2It should be noted that the FT-SE All-Share index includes the majority of companies in the quoted real estate sector. Therefore, a degree of correlation would be expected, however, they make up a very small proportion of the total index.

3The Daily Telegraph, p. 7 April 1St, 1993.