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Proposed Law on Real Estate Investment Companies
Date Posted: March 16, 2009by: Tadeo F. Hilado, Senior Partner/Head, Corporate and Special Projects Department
There is a proposed law in Congress which seeks to provide the regulatory framework for real estate investment companies or “REICs”. According to Sen. Edgardo J. Angara, the Chairman of the Senate Committee on Banks, Financial Institutions and Currencies, the legislature will take steps to hasten the approval of the proposed law.
The proposed law (the “Bill”), seeks to promote the establishment of REICs, which are commonly known as real estate investment trusts or “REITs” in other countries which adopt the trust form for such entities. Currently, there is no law in the Philippines which governs the trust form of publicly listed collective investment schemes. Once such a law is passed, REITs may be established as well.
REICs are publicly listed stock corporations established for the sole purpose of owning income-producing real estate assets, i.e., assets which generate steady income streams. Examples are shopping malls, residential and office buildings or complexes for rent, hotels, and even toll roads and other infrastructures. These income streams are required to be distributed regularly as dividends to the REIC’s stockholders. The Bill mandates a REIC to distribute annually at least 90% of its net income as dividends to its stockholders.
In short, REICs are basically rent or toll collectors which are mandated to distribute its collections as dividends to its stockholders. In order to ensure the steady stream of collections, the REIC’s real estate assets must be investment grade, income-producing and professionally managed properties. To make REICs more attractive as investment vehicles, REICs are given tax concessions (as will be explained below).
Since a REIC is required to be listed in the stock exchange and have a certain level of public ownership, small investors are able to invest and participate in the ownership and earnings of large real estate assets such as shopping malls, which ordinarily they are not able to do. Moreover, because REIC shares are publicly listed and traded, REIC stockholders have the benefit of liquidity and a ready market for their shares, which direct owners of real estate do not have.
The shares of stock of a REIC may also appreciate in price, enabling the REIC stockholder to have a higher total rate of return consisting of price appreciation plus the dividend yield, which other investment products cannot offer. Thus, REIC shares can be attractive investments, as they have been in countries like the United States, Australia, Japan and Singapore, among others.
A REIC is different from a real estate developer which develops real estate for the purpose of selling the developed properties (e.g., residential condominium units) to buyers in the real estate market. A REIC generally cannot engage in development activities, and can only invest in completed income-producing properties which the REIC must continue to own in order to generate the income streams which are then required to be regularly distributed to the REIC’s stockholders as dividends.
A REIC is also different from existing publicly listed real estate operating companies or “REOCs”, which also own income-producing real estate assets such as shopping malls and office buildings. The basic difference between a REIC and a REOC is that a REIC is tax transparent while a REOC is not. This means that the income of a REIC is not taxed at the level of the REIC, and is taxed only at the level of the REIC’s stockholders when they receive the same as dividends.
The Bill provides that the dividends distributed by the REIC are deducted from its gross income to arrive at its taxable income, which ordinary corporations including REOCs cannot do. Since the REIC is required to distribute at least 90% of its net income as dividends, the REIC will have a very small or no taxable income, and hence will be tax transparent.
In contrast, the income of a REOC (without deduction of any dividends it may distribute) is subject to corporate income tax, and the dividends it pays to its stockholders will again be subject to the applicable tax on dividends. The mandatory dividend policy and tax transparency of a REIC allows it to pay higher dividends to its stockholders, and makes its shares of stock more attractive as investments.
The Bill adopts the regulatory principles which have been successful in relatively young REIT markets such as Singapore, as distinguished from mature REIT markets like the United States and Australia. Among the salient provisions of the Bill are the following:
- External versus Internal Management – The Bill provides for external management of the REIC, which is the rule in most Asian countries, and not internal management which is adopted in the mature REIT markets. Thus, a REIC must have a REIC Fund Manager and a REIC Property Manager which are independent and separate from the REIC. Such external management is deemed to result in more professional management and protection to investors.
- Gearing or Leverage Limits – The Bill provides that the total debt of a REIC should not be more than 35% of its total assets. The leverage can be increased up to 70% if the REIC is given an investment grade credit rating by an accredited rating agency. These gearing limits are similar to those imposed in other Asian REITs. Although there are no leverage limits in some mature REIT markets, high or unlimited leverage is risky and results in interest payments which erode rental income and reduce dividends to investors.
- Investment in Foreign Assets – The Bill provides that 75% of a REIC’s total assets must be invested in income-producing real property located in the Philippines. Thus, up to 25% of the total assets may be invested abroad. In more mature markets, REIT funds are invested abroad because local investment grade properties have run out, which is not the case in new REIT markets.
- Development Activities – As mentioned above, a REIC must not undertake property development activities unless it intends to hold on to the developed property upon completion. The total contract value of property development activities and investments in uncompleted property developments should not exceed 10% of total assets. There are similar restrictions in other Asian countries because development activities are seen as risky and putting in jeopardy the REIC’s expected consistent dividends.
- Minimum Public Ownership – The Bill requires a REIC to maintain at least 1,000 shareholders each owning at least 100 shares and who in the aggregate own at least 30% of the outstanding capital stock of the REIC. Moreover, a REIC must not be a closely-held corporation as defined in the Tax Code. This requirement is meant to ensure public ownership of REICs, and to prevent REICs from being used by closely-held entities just to avail of the tax concessions given to REICs.
- Minimum Paid-Up Capital – The Bill requires a REIC to have a minimum paid-up capital of P100 Million at the time of its registration. Some sectors, however, suggest that the minimum capital requirement be increased to P1 Billion, in order to ensure that only financially capable players will enter the market. REIC Fund Managers, on the other hand, are required to have a minimum paid-up capital of P10 Million.
- Limits on Foreign Ownership of REICs – Consistent with existing Constitutional and statutory limitations, foreigners can own up to 40% of the outstanding capital stock of a REIC which owns land in the Philippines. However, a REIC which owns income-producing real estate assets other than land can be 100% owned by foreigners. The acceptable control test and layering structures for land owning entities may also be applicable to REICs.
It should be noted that under the Bill, the above requirements (other than those which are mandated by the Constitution and/or other statutes), can be modified by the Securities and Exchange Commission after “taking into account public interest, the need to protect investors and develop the country’s real estate investment industry to make it globally competitive”. Thus, for flexibility, the requirements initially stated in the proposed law may be modified by rules and regulations which the Securities and Exchange Commission may issue, rather than by the more difficult and time consuming legislative procedure of amending the law.
Atty. Tadeo F. Hilado was the Vice-Chairman of the Senate Technical Working Group which drafted the Senate bill on REICs.
- External versus Internal Management – The Bill provides for external management of the REIC, which is the rule in most Asian countries, and not internal management which is adopted in the mature REIT markets. Thus, a REIC must have a REIC Fund Manager and a REIC Property Manager which are independent and separate from the REIC. Such external management is deemed to result in more professional management and protection to investors.
- Gearing or Leverage Limits – The Bill provides that the total debt of a REIC should not be more than 35% of its total assets. The leverage can be increased up to 70% if the REIC is given an investment grade credit rating by an accredited rating agency. These gearing limits are similar to those imposed in other Asian REITs. Although there are no leverage limits in some mature REIT markets, high or unlimited leverage is risky and results in interest payments which erode rental income and reduce dividends to investors.
- Investment in Foreign Assets – The Bill provides that 75% of a REIC’s total assets must be invested in income-producing real property located in the Philippines. Thus, up to 25% of the total assets may be invested abroad. In more mature markets, REIT funds are invested abroad because local investment grade properties have run out, which is not the case in new REIT markets.
- Development Activities – As mentioned above, a REIC must not undertake property development activities unless it intends to hold on to the developed property upon completion. The total contract value of property development activities and investments in uncompleted property developments should not exceed 10% of total assets. There are similar restrictions in other Asian countries because development activities are seen as risky and putting in jeopardy the REIC’s expected consistent dividends.
- Minimum Public Ownership – The Bill requires a REIC to maintain at least 1,000 shareholders each owning at least 100 shares and who in the aggregate own at least 30% of the outstanding capital stock of the REIC. Moreover, a REIC must not be a closely-held corporation as defined in the Tax Code. This requirement is meant to ensure public ownership of REICs, and to prevent REICs from being used by closely-held entities just to avail of the tax concessions given to REICs.
- Minimum Paid-Up Capital – The Bill requires a REIC to have a minimum paid-up capital of P100 Million at the time of its registration. Some sectors, however, suggest that the minimum capital requirement be increased to P1 Billion, in order to ensure that only financially capable players will enter the market. REIC Fund Managers, on the other hand, are required to have a minimum paid-up capital of P10 Million.
- Limits on Foreign Ownership of REICs – Consistent with existing Constitutional and statutory limitations, foreigners can own up to 40% of the outstanding capital stock of a REIC which owns land in the Philippines. However, a REIC which owns income-producing real estate assets other than land can be 100% owned by foreigners. The acceptable control test and layering structures for land owning entities may also be applicable to REICs.
It should be noted that under the Bill, the above requirements (other than those which are mandated by the Constitution and/or other statutes), can be modified by the Securities and Exchange Commission after “taking into account public interest, the need to protect investors and develop the country’s real estate investment industry to make it globally competitive”. Thus, for flexibility, the requirements initially stated in the proposed law may be modified by rules and regulations which the Securities and Exchange Commission may issue, rather than by the more difficult and time consuming legislative procedure of amending the law.
Atty. Tadeo F. Hilado was the Vice-Chairman of the Senate Technical Working Group which drafted the Senate bill on REICs.
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