Even as some green shoots of recovery emerge, many tenants are still struggling to pay their landlords as the pandemic dents their cashflows and profits. This has left many Real Estate Investment Trusts (REITs) with a cash crunch – obliged to pay out 90% of their tax-exempt income profits from their property rental business to shareholders, but without the cash to do it. This is particularly true for REITs with high weightings in embattled sectors such as retail.
In this space, HMRC has been relatively understanding in the short-term about the impact of COVID-19. However, REITs that are unable to meet the 90% distribution criteria will have to pay tax on their property profits and gains. This may not have been factored into any budgets or cashflow forecasts at the start of the year and will also put pressure on investment returns.
It is perhaps more concerning that if, over a period of time, the REIT has breached the regime conditions more than once - or where HMRC considers the breach of a condition to be serious - HMRC may issue a notice withdrawing the REIT from the regime. The property business would lose its cherished REIT status with all its associated tax advantages. While the gap between rent charged in the accounts (and therefore counted as income) and the actual rent received (providing much needed cash) exists, the problem will remain and is likely to worsen.
In the longer-term, there are solutions. Land Securities recently announced that it would sell off around one-third of its property portfolio to focus on higher growth sectors and away from under-pressure areas such as retail.* In the office market, we see companies re-imagining their offering to tenants – putting in more meeting spaces and fewer desks. In addition, many landlords have come to agreements with their tenants to repay income at a later date, which can put further pressure on cash flow. However, while these are prudent moves over the longer-term, they do not help in the short-term.
This comes at a time when there is the potential for greater HMRC scrutiny on governance, particularly in areas such as corporate criminal offence, the senior accounting officer rules and tax strategy. REITs are already facing greater scrutiny from some of their key investors, who are placing increasing value on environmental, social and governance criteria when investing. REITs need to ensure they are fully equipped for a future that may look very different.
Steps to take
Maximise tax reliefs – are REITs optimising their capital allowance claims or have they considered them largely redundant as they aren’t tax paying? REITs may want to revisit the amount of allowances claimed in a particular year to ensure they are claiming the full amount to which they are entitled. This is especially important this year, as it could lower the total profits required for distribution to shareholders. This can help REITs to meet property income distribution (PID) conditions, while retaining cash in the business to improve working capital. There is also the added benefit that by identifying full levels of capital allowances on current assets held and on future acquisitions, a REIT will be able to pass on more allowances to a future owner and this can be reflected in the sale price.
REITs can also work with their contractors to maximise research and development (“R&D”) claims. Again, this is often overlooked, but it is becoming increasingly common for REITs to work closely with their main contractors to ensure R&D claims can be made and the benefits can again be reflected in the pricing of the contract.
Harnessing technology - We have seen a number of REITs looking at various tax technology projects recently, of which the most interesting are focused on robotic process automation (RPA). With modest investment up front, we have seen businesses reap significant returns, both in terms of the accuracy and speed with which they can complete tasks, and in terms of employing staff more efficiently. With repetitive manual tasks taken care of, it allows existing staff to be redeployed into more valuable areas.
This doesn’t have to be just related to tax compliance, it can extend to any repetitive task: filing of statutory accounts, Company Secretarial returns, email processing, filing and distribution, data transfer and downloads between systems and reconciliations are just a few examples, many of which are currently prepared manually.
A change of structure? - It may be an appropriate opportunity to look at whether the existing structure is fit for purpose or whether there is the potential to simplify, create efficiencies and save costs. We have seen a number of REITs acquiring existing structures rather than buying more direct real estate. This may enable them to transfer assets or sell unwanted areas.
Consider disposals – asset disposals are an obvious route to generate cash, but REITs need to give consideration to the tax structure of any proposed disposal of real estate assets. Equally, the market is still in flux as the impact of the pandemic remains unclear. As such, disposals may not be the hoped-for panacea and there is a risk of selling ‘crown jewel’ assets for which there is liquidity.
REITs need to have a plan to deal with this cash crunch: there are steps they can take to shore up their cash flow in the short-term until longer-term measures kick in. At Smith & Williamson, we have worked with a number of real estate businesses going through these difficulties and can help.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.