FINANCE: The Reit time?

01 June 2008 By db staff writer

d=”standfirst”>With consumer spending likely to remain sluggish for the foreseeable future, breweries and pubcos may follow Enterprise Inns’ lead and convert into Reits. While there are immediate gains, long-term implications need careful consideration

Good news: bad news. The good news is that consumer spending is still growing, albeit at a much slower pace, according to the British Retail Consortium’s latest Sales Monitor. The bad news is that the momentum is unlikely to pick up for many months, even years, and that alcohol will suffer disproportionately.
Like-for-like sales in Britain fell by 1.5% in April compared with the same month last year, but total sales, including those from new or enlarged outlets, rose by 1%. The underlying trend, however, is downward. Despite price deflation, in the three months from February to April, the value of high street sales fell by 0.6% on a like-for-like basis. Even considering total sales, growth was just 1.9% compared with the same three months in 2007 while it slowed from 3.5% in the first quarter of this year.
There are all sorts of caveats economists trot out about these figures such as the effect of when Easter fell and what the weather was like, but the conclusion, says the BRC’s director general, Stephen Robertson, is “of further evidence that hard-pressed customers are really watching the pounds”. That bodes ill for discretionary spending, a category into which beers, wines and spirits fall, as does eating out.
And that is not an end to the gloom. Capital Economics, the respected forecasting house, says, “Consumer spending remains on course for its sharpest slowdown since the early 1990s.” It goes on to say, “We expect spending to rise by 1.5% in real terms this year and just 1% in 2009 – with the main risks to these forecasts on the downside.”
Nor will the deceleration be short-lived. Capital Economics predicts that in 2010 annual consumer spending growth “will recover to just 2% or so” and that it “will need to remain at these sluggish rates until 2012”.  Specifically it forecasts: “The downward trend in the share of spending on alcohol and tobacco in total spending is set to continue.”
Little wonder then that a leading hedge fund manager says that his primary targets for shorting (selling shares in the expectation of buying them back more cheaply at a later date) are in consumer-related sectors – and pub groups are top of his list.

Enterprising move
Brewery and pubco finance directors are scouring their tax manuals following the news that HM Revenue and Customs has given Enterprise Inns approval to convert into a Real Estate Investment Trust (Reit), subject to an internal restructuring. Boards want to know whether they should consider a similar move.
The short-term benefits of becoming a tax-efficient Reit are considerable. One calculation says that Enterprise’s corporate tax rate would fall overnight from 28% to 7% and thus boost earnings per share by about 30%. Shareholders will want cogent arguments as to why such conversions are not in their interests.
The key to Enterprise’s case to HMRC was that it could meet the Reit requirement of 75% of its income being derived from rents if the “wet” rent it charges its 7,700 tenants to supply drinks came into the equation. First to act, however, may well be Mitchells & Butlers, which has announced the intention to put its pub properties into a Reit as part of a restructuring to release value. This follows a troubled year in which a property joint venture collapsed.
There are, however, potential pitfalls in putting pubs into a Reit. First, a company would have to divide itself into an operating company (Opco) and a property company (Propco) so that the Propco could trade separately from its parent. It is far from clear whether this can be done without paying stamp duty on the property transactions. In Enterprise’s case, that could cost £120 million in a single year. Second, there are longer-term considerations about whether both could operate harmoniously. Would competing strategies cause damaging conflict? Third, commercial property is under the cosh and most commentators predict that position will worsen over the next couple of years, so conversion of pubs into a Reit carries balance sheet implications, at least in the short term.
There is also a political factor to consider. The Treasury will not want its tax take haemorrhaging too far. Already some multiple retailers are saying they will look at becoming Reits. What about hotels? Most of their income is rent for overnight rooms. So might a Chancellor wish to tighten the rules in a future Budget?

Thinking it through
The position is far from clear cut. Brokers and fund managers will make a lot of encouraging noises about pubcos becoming Reits because of the short-term boost to share prices and dividends. Lawyers and corporate advisers will be excited by potential fees at a time when business is slow. But boards will want to look at the longer-term implications and let a rival go first to learn from the experience. Even Ted Tuppen, Enterprise’s chief executive, says the company will now analyse its position over several months before making a decision about Reit status. Tellingly, he concludes, “We will only proceed with a Reit if we consider it to be in the interests of shareholders in every respect.” Don’t expect a stampede to become a Reit.  db © June 2008