First in a four-part series on European Investment Issues.

The creation of a UK REIT regime was not always a sure thing, according to John Gellatly, head of indirect investments and strategy for Merrill Lynch Investment Managers in London. Gellatly (whose group was recently acquired by Blackrock in a deal expected to close in Q3) is a keystone in the REIT-creation process there, one of a six-person industry team that has been advising the government on the need for, and structure of, UK REITs for the past three years, and he co-wrote the 90-page report that established the guidelines for REIT status. But as late as mid-March, when we met at Mipim, Gellatly could muster no more than cautious optimism--not that REITs would pass, but rather that they'd pass in a reasonable structure. Stumbling blocks included questions about gearing limits; shareholder taxes; and, most serious, conversion charges. "If this structure is not attractive to the industry," he said at the time, "for whatever reason, or specifically if the conversion charge is too onerous, people will simply not convert." While conversion charges are non-existent in the states, there is European precedent and this was a major stumbling block, one Gellatly charged would represent "a major potential loss for the UK." A week later, when the government unveiled it's 2006 finance bill, Gellatly and the industry as a whole breathed a sigh of relief . . . and began to make plans for doing business in a post-REIT world. A follow-up interview with Gellatly last week addressed the areas of concern, the work left to do and what the future looks like for the UK investment market.

GlobeSt.com: How did you get involved in the REIT process?

Gellatly: Back in 2001, the government was saying there was no way there would be REITs in the UK, and the industry dropped the subject. Then in Budget 2003, the government brought it up again in very vague terms. I was one of six experts from various disciplines who advised the government on the need for and potential shape of UK REITs. We came from three major industry bodies, RICS, the British Property Federation and the Investment Property Forum. I sit on the board of the forum and chair their research. At the time, I was also a real estate equities analyst with Credit Suisse First Boston.

GlobeSt.com: When we met in Cannes you mentioned three hurdles to the passage of a structure that would be reasonable. The biggest can of worms was conversion charges. Satisfied?

Gellatly: It's pretty good. We always knew there would be a conversion charge, and we wouldn't mind paying a big charge if the rest of the structure was going to be terribly flexible. The reality was that we knew where they were coming from on the rest of the structure, and we worried that they would get too greedy on the charge. The fact that they've gone for a 2% gross asset value charge is good, especially when you consider the alternative, which was a 50% levy on the contingent capital gains tax. Where it gets slightly more problematic is what this means for the unlisted sector or the offshore vehicles that might want to move onshore. They might not have any imbedded tax, and it's 2% coming off their gross assets. So I'm not sure how many of those will look to convert immediately. Obviously, the government will make more money if those guys come onshore. The legislation states, by the way, that you can pay 2% up front or over four years time, but then you end up paying 2.15% for the privilege of deferral.

GlobeSt.com: Another area of concern, although not as big a dust-up area, was gearing limits. How did that play out?

Gellatly: They originally said we would have a gearing limit that was a ratio: profit less gross interest over gross interest, and that that ratio must be more than 2.5 times. We essentially said that they had to define what "profit" is and make provisions for capital allowances--depreciation. Otherwise we're not going to have enough money to meet the ratio. We also argued for net interest and not gross interest. Finally, we said that even if you do change the profit charge to allow for capital allowances, since the gap in financing is so much tighter in the UK than anywhere else in the world, a more sensible number is 1.25. So far, they've come back and accepted the definition-of-profit argument, which is good, and they've accepted that we should be at 1.25. But it's still gross interest and not net. The reason for that, I think is that they don't want us carrying cash balances.

GlobeSt.com: It's a compromise you can live with, no?

Gellatly: It's a minor compromise, indeed, in the scheme of things.

GlobeSt.com: What about the 10% shareholders rule?

Gellatly: That's a rock we just can't get around, and the government is very alive to the issue. Basically, they're saying they'll impose market solutions so you can own more than 10% of the company. You just can't take the dividends out at more than 10%. Other solutions would include putting the dividends into a trust structure. Over the next few months, we'll be working with them on the technical guidance notes.

By the way, this issue stems from when the French REITs were created. They paid out dividends with no tax. The dastardly private Spanish companies came over the Pyrenees and bought the French companies with lots of leverage, took the tax-free dividends from France to Spain and paid off the debt with tax-free income, leaving the French taxman wondering where his tax was. So it was a big issue.

GlobeSt.com: Despite those areas of concern, is the verbiage of the legislation close to what moves into law in January?

Gellatly: The legislation is pretty damn close, but there might be a battle or two there for the industry before UK REITs are law. The legislation now gets taken through the committee stages in Parliament. The draft finance act is scrutinized by all sides of the political spectrum, and they'll go through it line by line. After that it goes to Royal Assent, which is generally granted at the back end of summer.

GlobeSt.com: But there is nothing that will derail it altogether.

Gellatly: Nothing that I can see. Everyone understands what we're trying to achieve now. Inevitably, there'll be things that have to be resolved, but these are minimal.

GlobeSt.com: What's the impact on the UK investment market and for that matter, on pan-European investments?

Gellatly: There will be a massive acceleration of capital coming into the listed sector. When French REITs passed, they went from euro 10 billion to 26 billion. We reckon the German market will hit euro 130 billion within five years when they approve. It's about five now. In the UK, stocks jumped 8% on the day of the announcement, so the market was very receptive. In a year's time, most of the UK listed sector will have converted or be en route to conversion. Of course, some won't convert because their business model doesn't suit it, and it's not one size fits all. We also expect a number of new entrants to the market, such as corporates spinning off their real estate. For example, Tesco, the supermarket group, is already talking about it. And I'm sure there'll be a lot of noise if not action by offshores considering coming back. In all, we're jolly well pleased on a number of levels.

Instant Insights /

Merrill Lynch's John Gellatly <i>--First in a Series</i>

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