Abr 012013

The revised legislation (effective 1st January 2013) for the creation of Spanish REITs (SOCIMIs) has been widely welcomed in investment circles both in Spain and the international community. Hardly surprising, considering that the original legislation introduced in late 2009 resulted in a grand total of «zero» SOCIMIs formed in three years.

So what was the problem? Well first of all, one of the principal attractions of a REIT in most countries is that the income is not subject to corporation tax, and rather the participants themselves are taxed on the dividends received. This concept was apparently inconceivable to the original legislators. Granted the corporation tax was set at the reduced level of 18%, but this was patently not good enough to convince anybody to take the leap.

There were of course other issues which have also been revised in an effort to render more attractive the creation of SOCIMIs. These include the option of going public on the Alternative Investment Market (MAB); the reduction of the minimum capital requirement to 5M€ from 15M€; the reduction of the minimum number of properties from 3 to 1; the right to 100% finance from the existing 70%. All these measures were brought in to create a more flexible system, thus allowing for smaller REITs and a lower cost structure.

But this article does not purport to detail the legislation itself, but rather to question whether SOCIMIs are an adequate response to Spain’s current real estate nightmare?

Let us therefore analyze those groups and property owners who may be considering creating a SOCIMI.

In the first instance, Spain’s most pressing issue lies in the close to 300.000M€ held either on the balance sheets or on the loan books of (read bad debts) of the banking system. How can SOCIMIs help solve this problem?

Not greatly, if you consider that a large percentage is land for development (or «not for development» the hard truth will largely prove in the coming years), and projects under construction, there is not much in the way of income production on the horizon. REITs are of course principally designed for income producing portfolios.

OK, but what about the increasing emphasis on the residential rental market? There must be REIT potential there?

«Yes» is the answer. If that is, you’re happy with a pretty low return. Residential rentals are still comparatively low in Spain and in the boom years (when capital values had admittedly gone crazy) would yield a return of between just 2% and 3% p.a. Today, in spite of significant falls in capital values, and an increasing demand, (largely through necessity), for rental accommodation, that return may be around 4.0% – 4.5%, hardly attractive enough to entice investors in their droves back into the quagmire of Spanish real estate.

So what of the large Spanish Property Companies (Metrovacesa / Colonial …) who do have quite substantial commercial leased portfolios, offering potentially higher yields. This appears to be an avenue worth exploring. Except that most, if not all of these once upon a time “kings” of European real estate, are carrying such heavy accumulated losses that they won’t need to pay corporation tax for years to come. So why bother to bake a complicated cake if you can’t taste the main ingredient?

Moving on…. There is a lot of talk that the first REITs may come from local Family Offices interested in gaining greater tax efficiency on their existing portfolios. Undoubtedly the new legislation would suggest that this could be the case. After all, you can now create a SOCIMI with just one asset and a value of around 5M€. As I understand it, however, one of the principal ideas of REITs is to give the little man a chance to invest in property without having to hand over life savings, and not as a way for the wealthy to pay lower taxes. I cannot see that small family office based REITs will either be attractive to the little man, and more to the point, I cannot see Family Offices releasing much in the way of free float to invite 3rd party investors into their very private environment.

Another option and potentially much more probable is the conversion of large portfolios of retail properties which have been sold in sale and lease backs over the past 5 years or are being prepared for such end. In many cases these are sold by banks to international consortiums of funds. The banks gain much needed liquidity. The buyers, in turn have generally engaged in a strategy of “buy wholesale, sell retail”.

This was fine in the early part of the recession, when private investors still believed that buying your local bank branch was the safest investment on the planet. Yet after a promising start, sales of individual units have inevitably slowed down as the banking sector is drawn further and further into question.

Thousands of high street units will close over the coming years under pressure from a combination of consolidation of brands, the internet and European Union mandates. This will push many landlords either into agreeing amicably to cancel leases or into complex litigation.

The problem is that a SOCIMI based on this type of asset will likely face similar problems of credibility and concentration of risk.

That said, this does seem to be the likely way forward for the creation of the early Spanish REITs. It is of course not only banks, but potentially supermarkets, high street chains and hotel groups.

Beyond that, I believe that we will start to see the creation of organic SOCIMIs developing specialist or mixed use portfolios over several years.

So back to the original question of whether SOCIMIs will be a solution to Spain’s property crisis. The answer, I believe is “No”. As with most conversations on the Spanish property market these days, the conclusion is that it’s not the demand that’s a problem but the product and the pricing.

SOCIMIs are however a very welcome initiative for the long term sustainability of real estate investment in Spain, long after the storm has passed.

1st April 2013