Things may have changed, but they aren't all bad for the real estate investment industry under lockdown. Jessica Patel highlights the investment structures that are most attractive to investors.
Although many transactions have been abandoned, shelved indefinitely or are under renegotiation, due to the current situation, real estate investment still remains an attractive asset class for investors.
Recent conversations with real estate investment clients have re-inforced the belief that, not only is there still liquidity within debt and equity markets (although senior leaders are taking a more-conservative approach), investor appetite hasn’t diminished. In fact, investors are finding opportunities at attractive valuations, even while the effects of the COVID-19 lockdown are posing searching questions for the sector.
Changing behaviour from office occupiers
The most obvious question is whether the global response to COVID-19 will cause significant changes to working environments. Now that entire offices have proved the remote working model can be effective while maintaining productivity levels, many office occupiers will be looking to re-assess their long-term property needs. With social distancing likely to continue, will workforces be encouraged to stay working from home, and in future will some offices only be required for important meetings?
With COVID-19 changing the way we work, live and buy, occupier requirements may look and feel very different in the post-lockdown world. For example, we've seen landlords using available space more innovatively, by adopting mixed-use strategies to manage risks and maintain returns. This has proven a successful way for landlords to manage their own risks and cater to emerging business models, such as data centres and life-sciences businesses.
Healthcare real estate in the spotlight
The pandemic has prompted a debate as to whether care homes, specialist care homes and other retirement-living facilities are capable of meeting demand. But also whether they will prove adequate for our future needs.
From a real estate investment perspective, healthcare is considered a low-risk asset class, offering stable, long-term returns, which is why we expect the sector will continue to attract significant institutional investment, both from the UK and overseas.
Different structures available to real estate investment
After looking at the prospects for the different real estate investment sectors, it’s worth taking some time to consider how that capital can be deployed. At present, we're seeing investment through a broad range of structures.
The decisions are typically driven by a combination of commercial and tax considerations, but there are some common structures worth exploring. Whichever structure is chosen, it is important to take into account the tax profile and mix of investors between tax-exempt and non-exempt. Having a clear understanding of this at the outset will help to optimise the underlying structure and mitigate tax leakages that could negatively impact returns.
Off-shore investment structures
Investors looking to acquire UK commercial real estate have typically routed investments through off-shore companies, mainly as a way to benefit from off-shore tax advantages. While this type of structure is still common, the UK government has introduced a series of tax changes to level out the playing field between UK and overseas property structures.
Broadly, all property disposals and certain share disposals holding property directly or indirectly are within the charge to UK tax from April 2019, subject to certain exemptions. Non-resident landlords are also within the scope of UK corporation tax from April 2020.
That said, off-shore structures still have some benefits compared to UK structures. For example, there’s no stamp duty to pay on the acquisition of shares in an overseas company, or units of a Jersey Property Unit Trust (JPUT) holding commercial property. Also, there’s potentially no with-holding tax on intra-group interest, although this could change in the future.
There are other non-tax benefits for off-shore investors to consider. For example, Jersey has a strong legal and regulatory framework familiar to overseas investors. Jersey company law offers greater flexibility with respect to structuring returns and making distributions to investors, whereas the UK has stricter reserve requirements. For these reasons, we’re still seeing capital inflows into Jersey structures, including Jersey incorporated companies that are managed and controlled in the UK.
Alternative real estate investment structures
The pooling of capital by certain structures, such as JPUTs and partnerships can meet the definition for a collective investment vehicle, which allows access to the transparency and exemption election to shift the tax point on gains realised in the structure to investors. This is particularly attractive where the end-investor is exempt from UK tax. It’s worth seeking advice before implementing these structures, as there are other conditions and requirements of which investors should be aware.
Real estate investment trusts (REITs) are becoming increasingly popular because they provide long-term stable income flows to investors, which is attractive to pension funds in particular. REITs are well-recognised in the US, Asia and Australia, so overseas investors are broadly familiar with the structure.
REITs also provide a trusted and HMRC-approved on-shore platform for UK real estate investment. The main benefit is that the REIT itself is broadly exempt from UK corporation tax on rental profits and gains of property business, plus it enjoys an automatic uplift in the base cost of a property when it acquires the shares in a corporate. This gives REITs an immediate competitive advantage when bidding for deals.
REITs within REITs
It’s also worth noting that with careful planning, a UK REIT can sit under an existing off-shore REIT. This provides a tax-efficient structure where reduced treaty rates can be accessed. Otherwise, a 20% with-holding tax rate applies on distributions by REITs. This with-holding tax rate can be eliminated altogether for certain investors, such as pension funds and sovereign wealth funds.
We are also seeing a lot of specialist REITs emerging in sectors such as logistics, social housing and healthcare. These REITs provide investors with a focused management team, a clear investment strategy and expert knowledge.
Efforts to make the UK more competitive are being stepped up
Finally, it’s worth mentioning that the government is currently undertaking a review of the UK funds regime from a tax and regulatory perspective, specifically looking at the UK as a location to pool investment and for funds to hold assets. The aim is to make the UK more attractive and competitive, particularly after Brexit.
Although the UK has one of the lowest corporate tax rates and a broad dividend exemption, UK-based investment structures still face a number of potential barriers. Therefore, a holistic review of taxation within the real estate investment funds industry is welcome, particularly one that addresses key issues, such as VAT charged on management fees, interest deductibility, substantial shareholding exemption for qualifying institutional investors and a potential relaxation of the REIT regime, which could open the door for more on-shore UK REITs.
It's encouraging to know that the government is listening to the real-estate industry and putting measures in place that encourage the pooling of more capital into UK property.
To discuss real estate investment further, contact Jessica Patel.