Real estate investment trusts are set to spell big changes in the world of property investment. But while developers coo over their potential tax savings, contractors are wondering what type of beast the clients, and the projects, of the future will be. Josh Brooks gets out his crystal ball …
When Gordon Brown announced the introduction of real estate investment trusts in last month's Budget, it caused barely a ripple in the House of Commons. But all over Mayfair, champagne corks were popping in property developers' offices. They had a very good reason to celebrate: after years of campaigning, for some of construction's biggest clients the introduction of REITs represents an easy way to pay virtually no tax on their holdings.
The stock market was similarly elated: the combined value of British Land, Hammerson, Land Securities, Liberty International and Slough Estates leaped £2.5bn that same day. And it wasn't only developers who were excited - the finance director of supermarket megalith Tesco took his own shareholders by surprise when he declared that as "a big property company" it might also take advantage.
What REITs will mean for construction firms on the ground is less clear, but with such excitement among their major clients, it's not something they can afford to ignore. Volumes of work are unlikely to change - it is, after all, occupiers rather than investors who determine what gets built, as Geoff Wright, a director at Hammerson, points out. But we will see a change in who's building them, and what kind of schemes they're looking for - not to mention the kind of contractors they want to work with.
Building asked developers what the future might hold …
A seismic shift in clients
Property developers fall into two broad camps - those who tend to hold on to their developments and those whose main business is to sell up and move on. The first group includes Liberty International, British Land and Grosvenor and it is they who will benefit from converting their investments into the REIT model. Residential developers or companies such as Development Securities or St Modwen don't own their assets for any length of time, so they are unlikely to make the move.
The REIT route offers developers very good returns, and there is speculation that firms will make enough money by simply investing without having to go through the risky and onerous process of developing in the first place.
Or they might choose to split off their development arm. Steve McGuckin, project director at Land Securities, says that REITs could bring about some reduction in development being undertaken by the major landowners, and breed a more focused client. "The chances are that REITs will create more pure developers." These "pure developers" would take on the hassle of development and feed properties into the REITs under pre-purchase agreements, whereby the building is sold to the trust pre-let.
For construction firms then, this could mean major shifts in their big-spending clients - some firms will pull out of commissioning, new ones will enter the fray. And the resulting people-moves in property firms mean that contractors are going to have to keep their little black books updated if they want to win work.
A rise in independent developers could also mean more work for smaller construction companies. As one developer says: "The big investors like to go with the big contractors because they have deep pockets. But that's not so much the case with the smaller developers."
Different types of project
There is conjecture, too, that REITs will come into serious conflict with the current political push for mixed-use schemes. Investors like to keep things as simple as possible because it makes it easier to track changes in the market, so they are likely to favour specialist REITs. As a result, large companies like British Land could decide to convert to not one, but several, specialist REITs focusing on industrial, retail or commercial buildings. Such a move would follow the pattern in established REIT markets like the USA, Japan and Hong Kong, where specialist trusts hold apartments, hotels, shopping malls or health facilities. Planners, however, are demanding schemes offer a mixture of retail, office and residential space. "REITs are very likely to butt up against the planning system," says David Sparrow, head of property at consultant EC Harris.
Sparrow also believes that those developers who feed buildings into the REITs will adopt a specialist approach. This is likely to mean, he goes on, pressure on contractors, as well as the facilities management firms who run the buildings, to emphasise more specialist services. This could lead to greater scrutiny of firms' track records in specific areas and again favour smaller, niche contractors over their behemoth rivals.
More pressure on costs
But perhaps where contractors will feel the greatest impact of REITs will be in clients' approaches to costs. As REITs make property investment even more attractive, they will draw a new group of very exacting and competitive investors - for example, because there is no minimum investment, banks might begin offering REIT-based products to their high-street customers. Fund managers are also expected to be particularly hard on cost overruns.
Land Securities' McGuckin argues that just as investors in other areas of the stock market scrutinise every part of the supply chain, so investors in REITs will want to know exactly what it is costing the trusts to buy in assets. That will count as much for buying existing buildings as for buying in new-build projects from developers.
In turn, developers will force contractors and cost consultants to work harder at minimising costs than ever before. "Investors will look for more transparency. It will be another reason for the construction industry to get more efficient," he says, though he adds reassuringly: "It's not a question of squeezing margins but of taking out unnecessary costs."
David Sparrow at EC Harris agrees that construction firms delivering buildings into REITs will have to become "more specialised in delivering value to the clients" and more customer-focused. "There will be an even greater need to finish projects on time and on budget," he says. "It's a trend we've seen emerging in the past 10 years. But REITs will just accelerate the changes."
What are REITs?
Under real estate investment trusts, listed companies will be able to convert their property holdings into a structure that pays no corporation tax and no tax on rental income and is easy to invest in. Instead of paying company taxes, a REIT distributes 90% of its profits as dividends straight to hareholders, who pay tax at personal levels. They will be available from 1 January 2007.