The Promise that failed but will perhaps succeed in the future
Real Estate Investment Trusts (REIT), which have been successfully implemented abroad for many years, incorporate, among other things, economic benefits to the capital market, the real estate market and to private and institutional investors. In this article, we will explain what REITs are, what advantages they offer, their implementation in Israel, recommendations for improvement of the existing model, and how this financial tool may be employed in order to significantly stabilize the Israeli real estate market.
It was during the late 90s and early years of the new millennium that the Israeli real estate market experienced a deep and prolonged crisis. The underlying reasons which led to this crisis were many and varied: the political-security situation, an ongoing shortage of workers in the construction industry, a drop in demand, a credit market that is limited in size and nature, and is characterized by high interest rates.
One of the attempts to solve this crisis was the import of a certain model that had been successfully implemented abroad for many years, and which involved the establishment of a Real Estate Investment Trust, otherwise known as a REIT. The benefits offered to the construction market by the establishment of Trusts that specialize in real estate industry are varied: increased diversification of sources and additional credit to the real estate market, easier and more efficient realization of real estate assets, and an increase in stability of the real estate market and associated industries, not to mention the positive impact the move was expected to achieve in other markets such as the diversification of portfolio assets held by institutional investors, the opening of new investment opportunities that are both stable and varied with a relatively low transaction costs to households, the upgrade of the capital market, and even the expedition of tax payments to the National Treasury (due to the obligation of Trusts to distribute their earnings on an ongoing basis).
The “Conversion” of Real Estate Investment Trusts
And so, December 2003 saw the publication of a report that was prepared by a committee appointed by the Israeli Securities Authority (ISA) and National Income Tax Office for the purpose of reviewing and establishing recommendations for proper regulation of all REIT activities. Based on the recommendations of the aforementioned review, Income Tax ordinance Amendment 147, which regulates (among others) the manner by which REITs are to be the established and managed, came into force. This amendment also includes specifics of income tax issues that are involved.
The problem is that it has been more than five years since this amendment was instituted, while the number of REITs that were established in accordance with the detailed outline of the Income Tax Ordinance is minimal. On the other hand, in light of the dramatic recovery the real estate market has undergone in recent years, it appears the discussion dealing with the reasons for the lack of success in formulation of effective regulation which would regulate the establishment and management of REITs was pushed aside.
Furthermore, we are convinced that even in current times during which the government has been implementing various policies for dealing with the price increase in the residential real estate market, the establishment of REITs could make significant contribution in this aspect as well (as detailed below).
Current Principles and Suggestions for Improvement
We will now outline the main points of the existing arrangement alongside our own recommendations for possible changes in the current format. Recommendations which may serve to encourage the establishment of additional REITs:
- The establishment of new companies – The need to establish a new company (whose shares are registered for trading within 12 months of its establishment) was determined in order to minimize the exposure of various investors to the company’s past liabilities. However, the input of existing assets into the new company gives rise to a new tax problem which constitutes a significant barrier in establishment of REITs by various real estate groups as it applies to the transfer of existing assets which are owned by the investors into possession of the new company. Our recommendation is to change the existing policy by removing the requirement to establish a new company while providing a mechanism that would enable controlling shareholders to offer all other investors protection against any past liabilities. Alternatively, the complete elimination of the tax imposed on the transfer of capital into REITs, under condition the company complies with all other Ordinance requirements for a period of several years. In this context, it is important to remember there is a limit imposed on all Trusts that requires them to distribute all earnings (as detailed below), a fact which in any case generates a sure income to the National Treasury by way of taxes.
- Restrictions on Concentration of Ownership – The ordinance sets a limit according to which at least 50% of the trust (its capital and means of voting) would be distributed between five different investors, and this in order to prevent excessive concentration of controlling interest by shareholders within the fund . It goes without saying that this restriction deters the majority of active real estate groups from establishing REITs. Our recommendation, considering the circumstances and characteristics of the Israeli capital market, is to mitigate this requirement by reducing the number of controlling shareholders allowed to three or even two, or grant REITs an adaption period of several years for proper adjustment while maintaining the public’s interest in preventing excessive concentration of control.
- Realization of the Potential Incorporated in Trust Assets – The Tax Ordinance has set forth requirements according to which all Trusts must realize no less than 70% of the potential planning of all assets, because without the income generated by such assets, the Trust would be required to pay a tax rate of 70% (!). The objective behind this requirement is to minimize the exposure of investors to failed assets and to their improvement process. By contrast, the relative advantages offered by REITs, in terms of both accessibility to capital and in the level by which real estate assets are managed, present an obstacle. In light of this requirement, trusts would avoid the purchase of assets that fail to realize their full potential as a result of mismanagement, inadequate professionalism and lack of capital. Our recommendation is to reduce the demand for realization of planned potential to 50%, in such a manner that on the one hand would minimize the exposure of investors to complex assets, while on the other, would enable REITs to purchase undeveloped assets and improve them.
- The Trust would be entitled to manage all yielding real estate assets in its possession, excluding management of Hotels and Old Age Nursing Homes, which it must assign to external parties. In our view, this restriction makes no sense considering the fact that it is the government that has been promoting the establishment of REITs based on the recognition that REITs are both professional and experienced in the establishment and management of real estate ventures. The restriction imposed on REITs from fulfilling their comparative advantage in management of hotels and nursing homes, which are profitable ventures that traditionally require professional management abilities within this yielding branch of real estate, also undermines the primary objective behind the establishment of REITs and should as such be abolished.
In addition to the aforementioned requirements and restrictions, there are additional requirements by which REITs must abide, and all for the purpose of protecting the interests of public investors and minimizing their risk, for example: Incorporation of the Trust must be conducted in the form of a company, company securities must be registered in the Tel Aviv Stock Exchange, profits must be distributed in form of dividends on an annual basis, minimum investment rates in profitable real estate and Israeli based assets must be set, the maximum leverage a Trust is entitled to employ must be restricted, and so forth.
Summary
The Israeli real estate and capital markets have come a long way in recent years. REITs can make a significant contribution by increasing diversity of capital funding sources for the real estate markets, improving liquidity thereof, providing owners of complex assets with the opportunity to sell their assets to sophisticated investors, and by doing so, enable private investors to participate in the real estate market in a professional manner while minimizing risks and costs. However, the potential for such a significant contribution may, in our opinion, be realized by implementation of the recommendations we have detailed above.
Furthermore, at present, the state is trying to cope with the rise in residential real estate prices which has made it difficult for young couples to purchase an apartment as a result of a rising demand for residential apartments from private investors who are interested in purchasing them for investment purposes. By increasing the diversity of real estate investments available to investors, by way of encouraging the establishment of new REITs, it would be possible to lure many investors into joining a REIT, and by doing so, somewhat reduce the demand for residential apartments as an investment.