There was an interesting article in the Financial Times yesterday (12/2/2016) by Vanessa Houlder on the possibility that deduction of interest costs against profits will be disallowed by the Chancellor in his next budget. Is this is what has recently spooked the commercial property market? The British Land share price is down 25% since last November, Land Securities is down a similar percentage, and even well diversified property investment trusts such as TR Property are down 16%. Surely property companies should have been more resistant than most companies to the general decline in share prices being seen as somewhat defensive (even boring) income stocks? They have long term relatively stable income and are likely to be less affected by declines in commodity prices than many businesses.
According to the FT article, it is possible the Chancellor will not allow interest costs in excess of 30% of EBITDA to be allowed against corporation tax. Potentially this could affect any companies that are highly geared or have large assets which are financed via debt. For example utility companies are often in that position although it is suggested there may be exemptions for those companies developing infrastructure for the public good.
Is this simply an attack on private equity companies and the way they evade tax? Such companies often acquire businesses and then load them up with debt. The interest on that debt often wipes out the profits. If the lender is located overseas in a low tax environment then the profits and potential tax thereon also disappear overseas. This might be seen as another attack on “hedge funds” and “asset strippers” so could be just another populist attack on their activities, but there is also surely some merit in regulating the avoidance of UK tax in this way.
As regards property companies, they also tend to rely on large amounts of debt finance. Indeed as interest rates have fallen, all companies have tended to expand via debt finance rather than issuing equity. This writer has been somewhat wary of property companies in the past, particularly smaller ones. The business model of their management seemed to be: set up the business, borrow as much as you can from any foolhardy bankers; if the assets grow in value on what is in essence a geared play then all is well and you look a hero; if the assets fall and you come unstuck then you default and it becomes the banks problem and you move on to the next proposition. In other words it a gamble using the lenders money.
Would listed property companies be vulnerable to such a restriction on corporation tax deductions? I took a look at British Land and Segro (formerly Slough Estates). British Land is actually not particularly highly geared (loan to value about 35%), and the percentage of EBITDA represented by interest costs is less than 10%. At Segro it is somewhat higher at 21%, but even so a limit of 30% would not cause any problem.
So why have the share prices of large property REITS fallen so far and so rapidly of late? This seems to be a feeling that the money that has flowed into property in recent years from overseas may be going the other way. But it seems more to be a slowdown in new investment in commercial property than a withdrawal. Also British Land and Land Securities have a heavy focus on London and the South-East where property of all kinds is now looking highly valued. For similar reasons the share price of house builder Berkeley Group has fallen back. It also seems possible that there is some contagion from the fact that lots of FTSE-100 stocks have been falling, so anything in that index might be suffering. In addition London office rentals might have declined as companies have become nervous about the future although the firm evidence for this seems scarce.
But it does seem unlikely that any change in deductibility of interest will badly affect property companies, or be the cause of recent share price declines in such companies.
It may just be a sign that the market falls are irrational, values are being marked down across the board regardless of the real situation.
The traditional reason that interest payments are deductible is that they are taxable in the hands of the recipient. Unless they start coming with a tax credit it represents double taxation. That would also benefit conglomerates who could lend money internally from a trading activity to fund a property portfolio.