Alternative strategies have emerged in recent years for financial institutions with captive real estate investment funds. With interest rates worldwide at an all-time low (the European Central Bank recently cut its main interest rate in half to 0.25 percent), dormant capital is out of the question.
Alternative strategies have emerged in recent years for financial institutions with captive real estate investment funds. With interest rates worldwide at an all-time low (the European Central Bank recently cut its main interest rate in half to 0.25 percent), dormant capital is out of the question.
Firms are seeking to increase the returns they receive on financial assets, whilst creating liquidity in a sluggish market.
One of the ways in which companies are able to do this is by using capital held in a real estate investment trust (REIT) to engage in securities lending transactions.
In lending securities the REIT is able to make a small amount of profit on each transaction, whilst being protected from the risk inherent in the speculation. The risk involved in securities lending is minimal for the lender, and exists mostly in the potential for counterparty default. This risk, if the asset manager is prudent in its lending decisions, is considerably smaller than the risk of stock volatility.
A REIT in the US must distribute a minimum of 90 percent of its taxable income to its shareholders on a yearly basis. A qualifying REIT is permitted to deduct dividends paid to its shareholders from its taxable income. As a result, most REITs distribute their entire taxable income to their shareholders, and therefore pay no corporation tax.
Taxes are, however, paid by shareholders on the dividends they receive. As a result of this, most US states do not require REITs to pay any income tax. A REIT cannot pass any tax losses through to its investors, making it an attractive vehicle for obtaining capital liquidity. For this reason there is no incentive for REITs to hoard capital, and alternative strategies make sense from a business point of view.
Another attractive aspect of securities lending to REITs is Section 1058 of the Internal Revenue Code. This legislation prevents securities loans from being classed as taxable events—which means that the securities firms can deal as they wish with securities that are lent to them.
Many REITs were been hit particularly hard by the financial crisis, owing to their exposure to bad mortgage debt and their narrowly focused business model. Low consumer confidence has driven down demand for commercial and retail space, whilst overall property prices have remained high as businesses seek to invest their capital in tangible assets such as real estate.
Conversely, many equity REITs have, in the five years since the subprime mortgage crisis, recaptured most or all of the value that was lost. This is particularly true of REITs that were heavily invested in areas of the market where property prices have outperformed the world average. REITs with assets concentrated in cities such as New York and Los Angeles have been able to outperform the stock markets they operate in owing to the inflated price of property brought about by the lack of confidence in other, less concrete investments.
Wolters Kluwer, a financial services company, recently launched a module for its REIT software platform that adds automated securities lending functionality. This added capability demonstrates that there is a demand amongst REITs to explore alternative avenues of capital handling.
Continental
There are fears in Europe that the proposed Financial Transaction Tax (FTT) could prove prohibitively expensive to the securities lending industry.
This may be contributing to the slow uptake in securities lending by European REITs at a time when economic factors make it an attractive option in the US.
But the European REIT market is similar to that in the US, in one important respect. If a buyer can provide a capital gains tax deferral when selling a property asset, and provide the seller with a percentage return on the asset, that the buyer can gain a negotiating advantage over its competitors.
With careful planning, US REITs can invest in the European market in ways that can preserve the tax benefits of the REIT structure.
There are fears that the FTT could reduce this advantage to the point that it becomes an unviable market for inward investment.
The FTT is designed to dissuade financiers from excessive short trading. It will do this by taxing trades and derivatives. As the profits obtained in short transactions are small and executed regularly, the tax could prove to be too effective by discouraging such a volume of trades that the taxes raised are negated by the reduced free flow of capital.
Some politicians view the tax as a way of forcing banks to pay for the costs of the financial crisis. Arguably, it may only succeed in redistributing the burden whilst reducing overall economic activity, and therefore GDP.
Financial institutions often find that securities lending transactions are necessary to obtain the returns that their REIT was formed to facilitate. Whether or not a REIT can be used in this way depends on the definition of the income earned by the REIT through securities lending, for tax and legal purposes.
For this reason, a financial institution hoping to use a REIT for securities lending should ensure that its income passes the REIT tests in its country of domicile.
