The Technical Side of Raising Capital through a Real Estate Investment Trust (REIT)

On September 14, 1960, President Dwight D. Eisenhower signed legislation that created a new approach to income-producing real estate investment – a manner in which the best attributes of real estate and stock-based investment are combined. REITs brought the benefits of commercial real estate investment to regular citizens of the state – benefits that had previously been available only through large financial intermediaries and to wealthy individuals. The original legislative intent was that REITs would be an inclusive approach that would allow all Americans to enjoy the benefits of investing in high-quality commercial real estate. The REIT approach to real estate investment has been refined and enhanced over the ensuing years, but this goal of inclusivity remains at the core of the REIT model. Research by the National Association of Real Estate Investment Trusts (Nareit)[1] shows that REITs have fulfilled this promise. Today, approximately 145 million Americans live in the roughly 43% of American households that own REIT stocks, directly or indirectly through mutual funds, ETFs or target date funds. The popularity of REITs in financial markets is not without reason. Historically, REITs have delivered competitive total returns based on high, steady dividend income and long-term capital appreciation. Their comparatively low correlation with other assets makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns.

For the Republic of Kenya, REITs present a unique funding opportunity. The rapid growth of the population in Kenya has caused an unprecedented boost in housing demand. The estimated demand for housing in 2010 was 206,000 units (124,000 in rural areas and 82,000 in urban centres). Despite this increase in demand, there exist limited funding options to meet this need in the Kenyan economy as the primary mortgage market remains the principal source of funds for housing in the country. REITs thus offer a valuable alternative for developers to raise capital for various real estate projects. The latter is further accelerated by the Kenyan government’s current affordable housing agenda, which has set a target for the construction of 500,000 new residential homes for its citizens.

What are Real Estate Investment Trusts (REITS)?

Through the enactment of the Capital Markets (Real Estate Investment Trusts) (Collective Investment Schemes) Regulations, 2013, REITs have been introduced into the Kenyan economy. Regulation 2 defines “real estate investment trust” means a trust established in Kenya for investment in real estate but does not include an exempted real estate investment trust. Further, “real estate investment trust scheme” or “REIT scheme” means an arrangement made or established for the purpose of collective investment by persons in real estate for the purpose of earning profits or income from real estate as beneficiaries of a trust which is divided into units in which:

1. persons contribute money or money’s worth as consideration to acquire rights or interests to gain the benefits from pooling of funds and the investment in real estate;
2. the persons investing do not have the day-to-day control over the management of the assets of the real estate investment trust; and
3. the assets are managed by an entity;

and includes such other arrangements as may be prescribed by the Capital Markets Authority to be a real estate investment trust scheme but does not include an exempted real estate investment trust. Regulation 7 requires that all REIT assets be held in the name and under the control of a trustee for the benefit of unit holders .The REIT Regulations restricts the trustee of a REIT to, inter alia, invest in eligible real estate assets through investment in an Investee LLP incorporated in Kenya which directly owns the eligible real estate and which is wholly beneficially owned and controlled by the trustee in its capacity as the Trustee of the REIT. The Trustee only acts in a fiduciary capacity as trustee of the REIT to protect the interests of the unit holders and does not take part in the day to day management of the REIT. Regulation 54(1) requires a REIT to be managed and administered by a licensed REIT manager whose mandate is prescribed in accordance to the regulations.

Types of REITS

1. Income Real Estate Investment Trusts (I-REITs): This is a real estate trust that primarily derives its revenues from rental properties. The investors gain through rental income and capital appreciation from the investments undertaken.

The objectives of an I-REIT are generally limited to acquiring long-term investment of income generating real estate, marketing and sale of real estate, retention and management of real estate assets with the objective of earning income, undertaking incidental and connected activities related to the assets of the trust and undertaking development and construction activities.

1. Development Real Estate Investment Trust (D-REITs): This is a type of real estate trust where resources are pooled together with the goal to develop real estate projects. Once a development has been completed, a D-REIT may be converted to an I-REIT and here the investors may choose to either re-invest their funds, sell, lease their shares or they can choose to sell the developments that have been undertaken.

The objectives of a D-REIT are limited to acquisition of eligible real estate, investment in eligible investment, undertaking of real estate development and construction projects which include but are not limited to, housing and commercial projects. They also market and sell real estate, retain and manage the real estate assets and undertake incidental or connected activities.

1. Islamic REITs: Regulation 122 states that where it is proposed that REIT securities be issued in respect of a real estate investment trust scheme which is to be offered or in any way represented as an Islamic REIT or Islamic securities, then in addition to complying with the provisions of the Act and these Regulations, the trustee shall:
  - prior to any offer or issue being made, appoint a Shariah adviser to assess the compliance status of the REIT scheme and in the event of the resignation, retirement or termination of such adviser, the trustee shall ensure that a substitute Shariah adviser is appointed as soon as is practicable;
  - in appointing a Shariah adviser, comply with the requirements on any law in Kenya and the views of any Kenyan regulatory authority and may take accounts of the views of any party whose views are influential or accepted as determining or ruling on Shariah principles applicable in Kenya, and
  - together with the REIT Manager, ensure that the Shariah adviser establishes and updates from time to time Shariah guidelines for the assistance of the trustee and the REIT manager and conducts Shariah compliant assessments:
    - of the terms of the scheme documents and of the REIT securities;
    - on any real estate asset prior to acquisition or disposition;
    - of the tenants and changes in tenancy arrangements to ensure that only permissible activities and businesses are conducted by the tenants or if some non-permissible activities are conducted, then the level of such activities falls below the acceptable maximum and by how much;
    - on the method and terms of any borrowing or financing to be entered into in respect of the trust;
    - of any insurance contracts and the parties with whom such contracts or arrangements are entered into; and
    - of the proposed method and terms of investment in any eligible assets.

The Shariah adviser shall, in addition to any other periodical report required to be prepared by the Authority and matters to be included in semi-annual and annual reports, prepare and submit to the trustee a report confirming compliance with Shariah principles.

In the case of an Islamic REIT, the trustee shall request a report from the Shariah adviser confirming that any acquisition or disposal shall not affect the compliance of the Islamic REIT with Shariah principles.

The Trustee and REIT Manager shall consult the Shariah adviser whenever required and put in place a reporting mechanism and procedures to ensure that the continuing disclosure obligations under regulation 42 are complied with as regards with the compliance of an Islamic REIT and Islamic REIT securities with Shariah principles.

It is important to note that the Regulations state that a Shariah adviser shall be deemed to be an expert who by virtue of his occupation, religious standing, expertise or reputation combined with his understanding of the Kenya financial sector, capital markets and Shariah requirements as regards finance is accepted by the Authority from time to time as being competent to provide an authoritative statement on the compliance of a real estate investment trust scheme with Shariah law.

Ways of raising capital through REITS

According to the Regulations, there are two major ways to raise capital through REITs:

Equity financing through the issuance of units
Debt financing

Equity Financing

One of the core proponents of implementing REITs in an economy, especially for property developers is the capacity for REIT structures to raise capital through the issuance of units. In a REIT structure, a unit is a stock-based investment security which acts as an undivided share, right, interest or entitlement in the assets held by the REIT as a whole. Purchasers of units in a REIT scheme are named unitholders, and through the beneficial interest tied to each unit, are entitled to any financial distributions made in the REIT as the scheme’s beneficiaries. In this manner, units are similar to dividend-paying stocks which offer regular payments to their holders.

Notably, units do not confer an interest in any particular asset held by a REIT. This improves the sustainability of the REIT scheme, as it substantially insulates the scheme against legal risk. Through the sale of units in a REIT scheme, developers can access financing from public markets in order to construct new properties, improve and develop current REIT assets and optimize the management and operation of REIT assets held by the REIT scheme. Despite the fact that Islamic REITs present an opportunity for developers to access Islamic finance through Shariah-compliant means, an Islamic REIT is yet to be brought to market.

Debt Financing

Debt financing in REITs is yet another advantage which ought to be considered by developers. According to a paper published by the Federal Reserve Bank of Chicago[2], bank loans to REITs are typically moderately sized two to three year credit lines that are distributed through the syndication market. The normal financing pattern for REITs is to finance real estate acquisitions with unsecured credit and then refinance the debt with common or preferred stock offerings or senior notes and subordinated debentures because they lack the ability to retain much cash (80% of realized income must be distributed to shareholders[3]).

As stated, due to the inability of REITs to retain cash, lenders expect to be repaid from the proceeds of equity or subordinated debt issues. Therefore, a fundamental aspect of REIT lending by banks is focused on a REIT’s ability to access the capital markets. In determining a REIT’s access to capital markets, certain factors are considered by lenders. These factors include:

Experience: Lenders prefer REITs with strong operating histories and experience, and penalize companies with poorer expertise and experience.
Legislation: Tax considerations play a key role in accessing both local and international finance. Notably, via the Tax Laws (Amendment) Act. 2020, promulgated on 25^th April 2020, Kenyan REITs enjoy tax exemptions when transferring properties to a REIT. Further, REIT investee corporations enjoy corporate tax exemption, currently at 25% per annum.
Complex structure: If the market has difficulty determining who is ultimately responsible for a project and the true financial picture, lenders can be reluctant to provide financing. Complicated management structures can obscure the true leverage of the organisation.
Ratings issued from rating agencies: In order to access financing, especially in a primary financial market such as Kenya, REITs ought to be rated by a reputable rating agency. Despite the fact that ratings are not a substitute for meticulous and professional analysis, a strong rating can stimulate access to longer term debt issued by international financial institutions.
Asset values: Rating agencies consider the value of the underlying real estate assets when assigning ratings. A negative outlook for the assets for a particular real estate sector may impact the listing price of REITs investing in these assets and increase the cost of leverage as well.

According to the Regulations in Kenya, through the trustee, REITs can enter into borrowing arrangements subject to the provisions of the scheme documents. The arrangement can be by the initiative of the trustee so as to preserve the value of the assets of the trust and this must be done in the best interests of the REIT security holders. The trustee may also do so on the request of the REIT manager so as to give effect to the objectives of the scheme, to acquire real estate assets, to undertake capital expenditure or to refinance existing borrowing. It is important to note that the trustee is authorized to provide security over the assets of the trust to secure the funds borrowed.

In an I-REIT, the total borrowing entered into by the trustee or by any REIT investee company or investee trust cannot exceed, in aggregate, at the time the liability is incurred, thirty five percent of the total asset value of the trust. However, the limit of the total borrowing does not prevent the rolling over or refinancing of any debt and the amount rolled over or refinanced should not be more than the amount originally borrowed. The above notwithstanding, the trustee may, on its own initiative or on the recommendation of the REIT manager and with the approval of REIT security holders by way of an ordinary resolution, borrow up to a maximum of forty percent of the total asset value of the trust for a temporary purpose for a term not exceeding six months. The latter limit varies in D-REIT schemes whereby the trustee, with the approval of REIT security holders by way of an ordinary resolution borrow or enter into a financing arrangement of up to a maximum of seventy-five percent of the total asset value, for a temporary purpose for a term not exceeding six months.

Conclusion

As Kenya continues to unravel the potential which REITs represent, one can only be excited at the myriad possibilities which may source from the adoption of the REIT model by developers in Kenya’s real estate market. Further, the promulgation of the Finance Bill 2021, which introduced various tax incentives has created the unique opportunity for local and international real estate developers and financiers to utilise REITs as an efficient vehicle to turbocharge the growth of both the real estate and financial markets in Kenya.

Post-coronavirus, we believe that the REIT model and its various benefits, particularly its capacity to unlock both local and international capital for the development of various types of real estate will be a staple of Kenya’s financial markets. It is essential to consider that one of the core challenges facing the adoption of REITs is the lack of understanding of the REIT model and its benefits by both retail and sophisticated investors in Kenya. The efforts of the REITS Association of Kenya in sensitizing the general public regarding the existence and benefits of REITs will enable Kenya’s financial and real estate markets a great deal by educating Kenya’s investing public.

[1] Nareit is an American trade association that deals with real estate investment trusts (REITs) and serves as the industry’s voice to policymakers, investors and the general public.

[2] Points to Consider when Financing REITs, Catharine M. Lemieux and Paul A. Decker; Emerging Issues Series, Supervision and Regulation Department, Federal Reserve Bank of Chicago, June 1999 (S&R 99-7)

[3] Regulation 72 of the Capital Markets (Real Estate Investment Trusts) (Collective Investment Schemes) Regulations, 2013