From property loan stocks to globally respected REITs: How South Africa rewrote the rulebook

The REIT Report on Classic Business with Michael Avery

There was a time when listed property in South Africa came wrapped in something called a property loan stock. It sounded less like an investment and more like something your bank manager warned you about after hours. Fast forward to today and the picture looks very different. Real estate investment trusts are cleaner, simpler and far more transparent than their predecessors. But the real story is not about tax perks or clever structuring. It is about turning bricks and mortar into something investors can actually trust in their portfolios.

On the latest episode of The REIT Report, proudly brought to you by the South African REIT Association, host Michael Avery and Alistair Anderson of Property Flash sat down with Louis van Manen, Head of Real Estate and Construction at BDO, to unpack how South Africa moved from financial engineering to a globally respected REIT regime and why that evolution matters far more than the tax tail ever did.

The property loan stock era

Van Manen was candid about the reputation property loan stocks carried. He recalled his first exposure to one as a third-year trainee in 2004 when he asked the financial director why the fund paid so much interest out to its shareholders. He did not get a proper answer at the time but he now understands exactly what was going on.

The property loan stock model was an attempt to replicate a direct property investment for shareholders but through a more structured listed vehicle. The problem was that it relied on interesting loan structures inside groups as a way to flow profits up to the top. The listed entity would have linked units in issue rather than ordinary equity shares. The debentures that formed part of those linked units carried terms that effectively bore interest at the profit levels of the company. In practical terms it was a mechanism to strip profits out to shareholders as interest payments.

That approach raised ongoing question marks with SARS. There was always a niggling feeling in the back of everyone’s minds as to whether the revenue authority was comfortable with these structures and whether the interest-based distributions were fully tax deductible. It was, in van Manen’s words, a messy way of getting profits to shareholders given the regulatory tools available at the time.

Why the REIT dispensation changed everything

The REIT legislation introduced in 2013 transformed that picture. According to van Manen the current framework gives both companies and shareholders far more certainty as to the tax treatment of REITs and the flow-through mechanisms that underpin distributions. It also offers comfort that REITs are highly regulated vehicles.

To qualify as a REIT an entity must first be listed on a recognised exchange which brings its own listing requirements that need to be adhered to and monitored on an ongoing basis. On top of that the exchanges apply specific REIT requirements that must be complied with continuously. For investors seeking regulatory certainty this layered oversight is a significant comfort.

Van Manen argued the alignment with global REIT standards was a vital step and one that arguably should have come earlier. Every country competes for international investment and without a more regulated environment South Africa was losing out to foreign capital. The REIT legislation put the country on an equal footing with international competitors from a regulatory perspective and made the sector markedly more attractive to overseas investors.

The tax case for being a REIT

The biggest selling point of REIT status, van Manen said, is the capital gains tax exemption that REITs enjoy on the disposal of qualifying immovable property. It is a powerful tool for long-term investors.

REITs routinely recycle capital and properties as they seek to enhance their portfolios and returns. When a normal company sells a property it triggers a capital gains tax liability that must be settled with SARS at that point. REITs are exempt from that capital gain on qualifying properties which means they can reinvest the full proceeds on disposals. Over the long term the absence of that repeated cash tax outflow can have a snowball effect on investor returns.

Why retail investors should pay attention

For ordinary South Africans looking to build wealth through the JSE, REITs offer a compelling entry point into property. South Africans have traditionally enjoyed investing in property because it makes them feel like they belong. Not everyone can invest directly in property though and a single-property investment exposes the owner to area risk and single tenant risk among others.

Investing in a REIT gives exposure to a well-diversified portfolio of properties that is professionally managed. JSE regulations prevent excessive gearing which adds another layer of protection. Investors also benefit from pre-tax cash flows that typically arrive as regular six-monthly distributions which creates a useful level of cash flow certainty.

Van Manen pointed to tax-free savings accounts as a particularly powerful vehicle for REIT investment. While the overall lifetime limit is not huge, starting early allows investors to receive tax-free returns on an ongoing basis and to enjoy tax-free capital growth over the long term.

Pension funds and retirees

For pension fund trustees and independent financial advisers building retirement portfolios the REIT structure offers real advantages. Qualifying pension, provident and retirement funds enjoy tax exemption. Provided a REIT ticks all the compliance boxes distributions flow tax-free into these funds which means pre-tax money can be invested on behalf of ultimate beneficiaries and growth can accumulate without tax leakage over time.

The predictability of six-monthly distributions is particularly valuable for funds that need to pay out annuitised investments to beneficiaries. For individual retirees that same cash flow certainty is critical. As van Manen put it, the last thing a retiree wants is to be uncertain about when and whether a company is going to pay a dividend.

The income tax nuance

One common misconception worth clearing up is the tax treatment of REIT distributions in the hands of individual investors. They are not dividends in the conventional sense. The REIT receives a deduction for the distribution it makes to shareholders which creates the tax neutrality that flows through the structure. But the distribution received by the individual shareholder does not typically qualify for the dividend exemption that applies to other companies. It is taxed as income.

For an individual on the top marginal rate that can mean tax of up to 45% on the distribution. Retirees are generally in lower tax brackets and benefit from primary, secondary and tertiary rebates which brings the effective rate down. And when distributions are received within a tax-free savings account or a tax-exempt pension or provident fund the tax is further delayed or avoided altogether.

A success story with room to grow

Looking back across more than a decade of the REIT dispensation van Manen sees a genuine success story. There was an early misconception among some that REIT might stand for really exempt from income tax. It is not that simple. The legislation is short but complex and it is intertwined with the Companies Act, IFRS requirements and JSE regulations in ways that are quite unique. After an initial learning curve REITs came to the party and applied the tax laws properly and the sector became a nicely regulated instrument.

The economy has not always played along. From around 2017 there was a downturn that made life difficult for REITs and then the Covid-19 pandemic created another tumultuous period. But REITs came through that crisis well. They were proactive, reinvented themselves in important ways and found alternative routes to attract and retain tenants.

One area where van Manen would like to see progress is private REIT legislation. Many countries have a private REIT concept for unlisted vehicles. South African legislation has been amended to accommodate this but Treasury’s draft proposals released earlier in the year limit the scope to wholly owned subsidiaries of investment funds rather than, say, family-owned property businesses. That narrows the range of opportunities for private investors and private equity.

The payout ratio trade-off

REITs must distribute at least 75% of distributable earnings and in practice most pay out close to 100%. That high payout ratio limits the internal capital available for expansion or reinvestment and leaves REITs more reliant on debt and equity raises to fund growth.

Van Manen acknowledged there have been informal calls for the JSE to revisit that 75% threshold but noted that it sits broadly in line with international norms. Pre-Covid most REITs were distributing close to all of their distributable profits annually. Covid changed that picture and average payout ratios have come down somewhat with a gradual uptick since. For some REITs the high payout requirement makes it difficult to retain enough cash for capital repairs, maintenance and reinvestment and that may be one reason some private property groups have held back from entering the REIT environment.

Real income, real assets, real insight

From messy property loan stock structures with uncertain tax treatment to a well-regulated, internationally aligned REIT regime the journey has been transformational for South African listed property. The tax benefits are real, but the deeper story is about trust, transparency and the kind of predictable, professionally managed income stream that makes REITs a cornerstone of modern investment portfolios.

Listen to the full conversation here: https://iono.fm/e/1668900