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BY Chiu-ying Wong, CFA Chartered Financial Analysts Society of the Philippines A proposal is pending in the Senate to set up Real Estate Investment Trusts (REITS) in the Philippines. The proposed legislative framework was submitted by Senator Edgardo J. Angara to the Philippine Senate in July 2007, and the bill as submitted can be downloaded from this website : http://www.senate.gov.ph/lis/bill_res.aspx?congress=14&q=SBN-63. Since then, it has gone through many revisions. This article provides a basic introduction to this new type of financial product, and explores its policy implications. How does a REIT work? In general, a REIT is a legal entity that owns income-generating properties directly or through a subsidiary, and passes on the rental income to its shareholders on a regular basis. It is usually set up by the owners of an existing income-generating property, who will initially transfer the title of the property to a separate legal entity, either a corporation or a trust (referred to as a REIT), and then list the REIT on the stock exchange by offering part of the ownership of the REIT to the public in exchange for equity infusion. The animated graphics at this website provides a simplified example of the process of setting up a REIT. Alternative forms of REITs have developed in other countries. A REIT that holds ownership of properties is often called an equity REIT. There are now mortgage REITs and hybrid REITs, the former of which holds mortgages of properties instead of ownership of properties, and the latter a mix of equity and mortgage REITs. Different countries have their own special types of REITs, mostly designed to minimize the tax burden of sponsors and investors. For example, the US has developed the UPREIT and the DownREIT. The former uses a partnership legal structure for the real estate owner and investors so that the property ownership is not transferred until a less tax-burdensome time occurs for the real estate owner. In the US, profit tax on property sale is not exempted even for REIT formation. What’s in it for REIT sponsors? The owners of the initial properties of a REIT are called its sponsors. Why do property owners want to set up a REIT, instead of, say, directly selling the property to a third party? First, the legal framework of REITs usually provides some tax benefits to the sponsors in exchange for meeting certain conditions in the types of properties held and how income is distributed. Second, instead of an outright sale, sponsors can maintain partial ownership of the income-generating property, which is often not possible in the case of a property sale. Third, a REIT set up allows the sponsor the flexibility of selling additional ownership of the REIT if the market condition is favorable, or buying back some or all of the ownership of the REIT at a lower price if the market condition is temporarily unfavorable. Fourth, REITs can help sponsors develop a new business, namely, that of asset management, where income comes from managing assets for all the shareholders of a REIT, instead of just the sponsors. What’s in it for investors? Why would investors buy a publicly listed REIT instead of a publicly listed real estate holding company? A REIT is usually mandated to own mostly properties that are already income generating, whereas a real estate holding company’s properties may still be under development and have yet to prove their income generating capability. Or these properties may be developed to be sold rather than for income. This means that the a real estate holding company’s income is less predictable than a REIT. The real estate holding company can also own other assets, without any restriction on the proportion of the other types of assets that the company holds, which, again, makes the company’s income less certain. Second, a REIT is required to distribute most of its income to shareholders while a real estate holding company is not under any obligation to distribute dividends to shareholders, even when it is making a lot of profits. These differences mean that a REIT has a more definite risk/return profile than a generic real estate holding company. Third, a REIT is usually taxed less. The REIT’s profit is not subject to corporate tax, but most of its profit has to be distributed to shareholders, who then have to pay tax on the distribution received. Why would governments want to promote REITs? Why would any government support REITs and lose revenues? First, the lower cost of financing and liquidity provided by REIT investors (as against financing through bank lending or bond issuance, which is particularly high in the Philippines) will promote investment in the commercial, industrial and residential sectors. Such investments will create jobs in construction, real estate management, and finance. Hopefully, the jobs created will feed back into the demand for real estate development, and thus sustain a virtuous circle. Without the incentives given in a REIT set-up, potential investors may simply keep their savings in deposits, or worse, use them up. Hence, REITs can be seen as means to stimulate economic growth by encouraging real estate investment, using savings from individuals, instead of say, government financial resources. Second, REITs can deepen the local capital market especially when they are listed on an exchange. Listing and trading of REIT shares, as well as the management of assets in a REIT, will generate demand for financial professionals and create high-income jobs, increase liquidity in equities markets and heighten interest in stocks. Stock transactions will generate income for the government in the form of stamp duties. In fact, in financial centers such as Hong Kong and Singapore, levies from stock transactions make up a sizable portion of governments’ total revenue. Third, REITs can be used to promote home ownership. If directed at residential housing development, REITs can provide liquidity for developers. It can improve the Philippines’ poor savings culture. Savings in the form of equity in housing will provide a cushion when the residents retire. Governments may benefit in the long-term from REITs because they can spark activity in the real estate sector. However, it is by no means a certainty that the overall benefits to the government can offset the immediate tax revenue loss arising from the tax concessions to REIT. In addition, while many tax concessions available to REITs are applicable to existing real estates, the long term benefits of REITs, such as the promotion of real estate development and capital market growth can only be estimated. Several of the tax concessions contained in the current proposal to the Senate are particularly contentious. These are : •    Exemption from capital gains tax. Normally, when a corporation sells a property, it will have to pay 6.0 percent of the selling price or fair market value of the property, whichever is higher. It is not clear whether such transfer of property, and then later the sale of shares, would incur capital gains tax, VAT, or the transfer tax levied by local government units. An exemption will have a significant potential revenue loss to the government. If the property has a fair market value of P1 billion, for example, the capital gains tax alone would be P60 million. •    Exemption from corporate income tax if 90% of rental income is distributed to shareholders. An ordinary corporation, whether listed in the stock exchange or not, is required to pay corporate income tax (currently at 35.0 percent) before considering any distribution of dividends to shareholders. Then, if and when the shareholder receives a dividend, the dividend may be subject to a dividend income tax. In the current REIT proposal, REITs will be exempted from paying corporate income tax, provided that 90% of rental income (net income before depreciation and amortization) is distributed to shareholders, and shareholders will also be exempted from dividend income tax. Suppose a real estate property generates P100 million in rental income after deducting operating expenses. For a non-REIT corporation, it will have to pay P35 million in corporate income tax to the government. If the remaining income is distributed to shareholders, and the shareholder’s dividend income tax rate is 10.9 percent, then another P6.5 million will go to tax revenue, giving the government a total tax receipt of P41.5 million. In the proposed REIT framework, if the REIT distributes 90.0 percent of its rental income to shareholders, then the REIT would be exempted from corporate income tax. Under the proposal, REIT shareholders would be exempted from dividend income tax, resulting in a total revenue loss of P41.5 million. Stamp duties to be collected from the trading of listed stocks of the REIT will mitigate these revenue losses directly. The more frequently the shares are traded, the more the stamp duties that would be collected. Income tax may also be collected from the original owner when the REIT delivers proceeds from the sale of some of the original owners’ shares. Further down the road, the economy will benefit from faster and cheaper property development, as well as jobs created in the construction industry. The direct beneficiaries of the tax concessions to REIT would initially appear to be the REIT investors. However, the original property owner also stands to gain substantially, since he will continue to own a portion of the property in the form of REIT shares, which are exempt from many taxes. The portion of ownership that he will sell to the public will include a liquidity premium, since REIT owners can sell shares much more easily than ordinary real estate owners. Hence, the direct tax concession benefits would most likely be received jointly by the investors and the original owner, while the indirect benefits would be spread to the whole community over time, initially as fees from stock market transactions, and eventually on larger investment in real estate sector. Will REITs attract investor interest? That depends on existing investment opportunities and investors’ perception of real estate investments. Foreign investors will be comparing the Philippine real estate with Southeast Asian countries and look at the strength of the peso. The higher the level of attractiveness, the less concession will be needed, and vice versa. It was reported in May this year that the Department of Finance has given support to the REIT bill, subject to some amendments to the tax concession proposals. Since then, no news has been heard on the bill. About Chartered Financial Analyst Society of the Philippines (CFAP) The Chartered Financial Analyst Society of the Philippines (CFAP) is a member society of CFA Institute, the global membership association that administers the Chartered Financial Analyst (CFA) curriculum and exam programs worldwide; publishes research; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 96,000 members, who include the world’s 83,000 CFA charterholders, in 133 countries and territories, as well as 135 affiliated professional societies in 56 countries and territories.  CFAP was founded in the Philippines in 1997 with the support of the Capital Markets Development Council, Inc. (CMDCI).  CFAP's mission is to be the thought leader in the Philippines’ investment and finance industry.  For more information, please visit www.cfaphilippines.org. *Disclaimer: Readers are solely responsible for their own investment decisions and should thus conduct their own research and due diligence and obtain professional advice. INQUIRER.net will not be liable for any loss or damage caused by a reader's reliance on information obtained from our web site. INQUIRER.net receives no compensation of any kind from companies or industries or funds that are mentioned here.