With the launch of the UK Real Estate Investment Fund (REIT) on 1 January, 2007, the property industry and its advisers are in the midst of an exciting period. Some companies are already well advanced in their preparation for conversion into a REIT. Others are considering whether to convert and, if so, what preparatory changes they should make to their business. All are carrying out research and adopting strategies so that the hopedfor benefits that the market anticipates from the introduction of REITs are exploited and any pitfalls avoided. But why all the excitement?

A REIT is essentially a vehicle that invests in property and enjoys a measure of protection from corporate tax in return for an obligation to distribute a significant amount of the vehicle's cashflows to shareholders. Broadly, a REIT aims to provide returns to investors that more closely mirror returns that investors would expect if they owned property directly.

The excitement that such a vehicle generates stems from the potential benefits these characteristics should have for a variety of stakeholders. Liquidity (it is the shares in the REIT, rather than the asset, which is traded), tax efficiency (the REIT does not pay corporation tax on its rental income or capital gains, but instead passes these tax liabilities on to the investor), increased confidence in the market's valuation of property companies (there is more trading data upon which valuations can be based) and a larger and more diverse investor base have all been cited as potential fruits of the introduction of REITs.

The predicted knock-on effect of these is that property companies may start to trade at a premium to Net Asset Value where traditionally they have traded at a discount; or at least they may trade at less of a discount. The predictions are given a measure of credibility by what has happened in other jurisdictions where, generally, property companies have gone from trading at a discount prior to the introduction of REITs to trading at – or close to – a premium post introduction.

The examples set by other jurisdictions also serve as a reminder that we are playing catch-up. REITs have been an important part of the real estate markets in the US since 1960 and in Australia since 1971. They have existed in the Netherlands and Belgium since 1969 and 1995 respectively and, more recently, were launched in the Far East in early 2000 and in France in 2003. Alongside the UK, Germany is also hoping to introduce a REIT with a 2007 launch date.

The Finance Act 2006 is the primary legislation for the implementation of UK REITs and was given Royal Assent on 19 July this year. This will be supported by the REIT Regulations which will provide further detail including stipulating the sanctions for failing to comply with the conditions for REIT status HM Revenue & Customs (HMRC) has the power ultimately to throw a company out of the regime). Revised drafts of the Regulations were circulated on 11 July and are currently being reviewed with comments to be submitted by the end of August. Guidance on the legislation will also be issued to give a steer as to what exactly HMRC expects.

Those companies that are keen to convert to a REIT on or soon after 1 January, 2007, are currently undergoing a period of self-analysis to check their compatibility with the requirements of the regime. Companies will be either fine-tuning or implementing wholesale changes which they will have been preparing for some time. The main areas that these companies will focus on include:

. stress-testing borrowing models to ensure that they can satisfy the 125% interest-cover ratio;

. looking at the shape of the business to ascertain what proportion of it qualifies as a tax-exempt property rental business. Do they want to pay a 2% conversion charge on all of their qualifying assets, or might it be better to dispose of some before converting? And what about the future? A recent discussion in the Financial Times focused on whether some of the 'conglomerate' property companies might be better off demerging to be sector-specific. From an investor's perspective, this could give greater control over the make-up and diversity of their portfolio; and

. looking at corporate constitutions to prevent penalties being payable by the REIT if it pays dividends to shareholders of a 10% or more. Companies are looking at ways to identify 10% shareholders and mechanisms for preventing payments being made to them. In the event that payments are made, the REIT will want some way of reclaiming the penalty from the offending shareholder. There are also discussions between the property industry and the UK Listing Authority and HMRC. It is hoped that HMRC will approve the approach to be adopted by companies in their articles of association so as to avoid (or at least limit) the risk of a penalty being incurred by the REIT under the 10% shareholding rule. For some companies, this issue is less about prevention and more about making changes to current shareholdings by, for example, requesting a shareholder to sell its shareholding over 10% or by entering into a dividend strip.

Not everyone will want, or be able, to convert. These include the traders and developers who may not have sufficient investment property and owner-occupiers. However, even these groups are likely to have an important part to play in the post-REIT world. The launch of REITs could provide opportunities as companies looking to convert rationalise their portfolios. Those that cannot convert immediately will also have the benefit of seeing whether the regime, in its current form, delivers what it promises and, with this, will be able to make an informed decision on whether to convert later.

In between those that are likely to, and those that cannot convert, will be a range of companies with specific concerns, including:

. those with a 10% shareholding (see above);

. offshore property investment companies. These companies are likely to have a low or even non-existent UK tax bill. Converting will, therefore, not offer any immediate significant tax benefit and will carry the added sting of a 2% conversion charge. However, it will be interesting to see how this changes over time. Notwithstanding the tax neutrality, offshore companies will have to balance the costs of having offshore structures (and, perhaps, a change in investor demand as an alternative onshore supply emerges) with, for example, the flexibility of not having mandatory distribution requirements or limits on the size of shareholdings. There is also speculation that generally, retail investors would rather invest in an onshore REIT as opposed to an offshore fund as they are perceived as offering a greater sense of protection both in terms of increased regulation and statutory tax efficiency; and

. private property companies will also be in an interesting position. Do they obtain a listing and convert or simply wait to be bought by a REIT? Either option removes historic chargeable gains and avoids corporation tax that would have been payable on a normal disposal of their properties.

It is not just the property sector that will be affected by the introduction of REITs. All counterparties to REITs will have to become accustomed to the way they operate, both legally in terms of the restrictions legislation places on them, and commercially in the business models they adopt. Thankfully, the operating rules are relatively flexible. The Government has been looking for increased professionalism from landlords, particularly in the residential sector.

Other groups likely to be affected are insurance companies, pension funds and other investors who will be reassessing the 'direct/indirect' question for their real estate capital allocations. Those with a bias towards direct investments may see REITs as a way of spreading the risk in their real estate portfolio without having to raise the bigger capital sums that direct investment demands. Further, given the greater diversity that real estate as an investment will offer because of the creation of a new investment option, funds might even commit a greater proportion of capital to real estate as an asset class.

Until the introduction of REITs, it is only possible to speculate as to how the UK property market and beyond will be affected. Whatever happens, it promises to be an intriguing journey.

Simon Clark is a partner and head of European real estate and Tom Road is an associate at Linklaters.