PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 1
Andrew Petersen,
Decbert LLP'
On March 17 2004, the UK Treasury announced a consultation exercise on how property
investment funds ('PIFs')'
in the UK should be structured to encourage more efficient
investment in commercial and residential real estate.
The consultation paper reveals that
the UK Treasury is contemplating a tax-neutral vehicle which will be well-regulated and
appeal to the small investor by boosting liquidity. In order to ascertain the ultimate benefit
of PIFs to the UK economy and potential real estate investors and to try to understand what
vehicle we should end up with in the UK, this two part article will examine the characteristics
of real estate investment trusts ('REITs') currently operating in the US and throughout Europe
and compare their appeal to global real estate investors and how respective government's
successes (and failures) have formed current vehicles.
Part 1 of this article looks at REITs in the US, France and Germany. Port 2, which will
be published in the July/August issue of the Journal, will examine REITs in Belgium and
Luxembourg and make suggestions as to the kind of vehicle which should be adopted in the
UK for a PIF
If readers do have comments on the Treasury's consultation process, the Editor, Hugh Pigott
via Ann Phillip at (ann.phillip@lexisnexis.co.uk) or Andrew Petersen (andrew.petersen@dech
ert.com) would be pleased to hear them.
In any event all consultation responses by email should be sent by 16 July 2004 to:
(PIFconsultation@hm-treasury.gsi.gov.uk).
INTRODUCTION
liiiQUiD REAL ESTATE?
Even though commercial real estate in the UK has been the
top-performing asset class over the past decade, rightly or
wrongly, over the same period, direct ownership of such real
estate has gained a perception of being illiquid, inaccessible for
private investors, tax inefficient for financial institutions and,
dare it be said, expensive. As a result, recent years have seen
real estate investors across the globe seeking to make iiidirect
real estate investment risk-averse and ideally tradable. This has
led to a growing market of investors wanting to invest in real
estate in a imitised way. To accommodate this need, limited
partnerships, limited liability partnerships and offshore unit
trusts are just a few of the structures which have developed to
allow investors to 'pop in' and 'pop out' of real estate whilst
at the same time limiting liability and achieving beneficial tax
treatment. Real estate investors in every G7 country, other than
the UK, have also had the advantage of REIT-type vehicles
- essentially tax transparent collective property investment
vehicles formed for the purpose of holding assets which are
unitised like shares. This article will examine those vehicles in
order to analyse what form the PIF should take and what form
should be avoided.
WHY INTRODUCE PIFS?
The absence of PIFs in the UK has encouraged a flow of investment offshore. Through the introduction of PIFs, it is hoped to
stem this flow and redirect the £25bn or so of UK real estate
investment into a properly-regulated onshore investment vehicle, thereby protecting UK tax revenues.
A typical REIT offers a number of advantages to both
private and institutional investors:
216
it allows accessible indirect investment in real estate - participants can invest in a professionally managed portfolio
of real estate that is held in tax-transparent funds that trade
shares rather than the underlying assets. This may serve to
open up real estate investment to the small investor who
otherwise could not have had this investment opportunity;
it enables participants to broaden their investment portfolio and diversify risk;
it is tax transparent. There is only one level of taxation,
namely, at the shareholders' level. The REIT does not pay
tax on its profits thereby maximising dividends to shareholders who then pay tax on their dividends and on profits
made when they sell their shares. Typically a US REIT will
pay back at least 90 per cent of its profits to its shareholders
and in many cases even more than that, with some REITs
distributing all their profits to their shareholders. REITs can
also serve to eliminate some of the tax and other difficulties experienced by institutional investors, such as pension
funds and foreign investors, if they invest more directly in
real estate;
it provides ease of liquidation of assets into cash. One
reason for the liquid nature of REIT investments is that
the shares of many REITS are primarily traded on major
exchanges, making it easier to buy and sell REIT assets/
shares than to buy and sell real estate in private markets;
it has an advantage over stocks and bonds in terms of dividends. All REITs are required to pay dividends whereas
other companies are not and, as REITs must distribute
almost all their taxable income as dividends to shareholders, they instil confidence in the marketplace;
it offers low historical volatility. REITs tend to be stable and,
therefore, offer an attractive return for investors;
Butterworths Journal of International Banking and Financial Law - June 2004
PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 1
-
it has no minimum investment. Additionally, since REITs
must be widely held, they are ideal candidates to be public
companies.
The raft of property investment vehicles which have
been created over the last decade demonstrates the depth of
institutional enthusiasm for a PIF type structure. Hammersons
have converted to a SIIC in France, and the medical charity,
the Welcome Trust, recently announced that it was planning
to transfer its whole portfolio into a holding company in order
to attract investment for its research work. Such a holding
company could well be converted into a PIF - which could
generate more cash for Wellcome and its investors.^ Moreover,
Isis Asset Management has recently launched a £240m 'REITstyle' listed property trust for private investors, which, given
that it will pay no Corporation Tax or Capital Gains Tax ('CGT'),
will have gearing of around 40 per cent and will distribute much
of its profits to shareholders. It holds property in the office,
retail and industrial sectors and has been billed as the first fund
the nearest in structure to a REIT.^ Consequently, when FIFs
arrive in the UK, they will be competing in a fierce market and
their restrictions and regime will have to be attractive enough
for them to become the preferred ownership vehicle for real
estate investors - as they have become in the US.
-
-
US REITS
The US REFT was created by the US Congress in 1960 for the
purpose of making real property an investment option for
the small investor. However, it was not until 1986, when as a
result of some dramatic changes in the tax laws, there was a
significant increase in REIT investment. These changes may be
instructive to those involved in the UK PIF initiative.
The original REIT rules imposed an 'all or nothing'
qualification test. A REIT that failed to comply in any respect
with the rules, for example, by 'actively engaging in a trade or
business', albeit unwittingly, lost its tax qualification entirely.
Today a REFT is taxed (at the rate of 100 per cent) on its
income from non-qualified transactions, but will not lose its
REFT status entirely with its compliant income still having the
benefits of the REFF dividend deduction.
Moreover, REITs originally were required to be passive
investors, prohibited from operating or managing assets.
Management could only be by independent third parties
(whose interests were not fully aligned with those of investors).
Today, REITs may 'operate' and provide customary services for
most types of real property, and so can be internally managed.
REITs now may own taxable REFT subsidiaries (although not
more than 20 per cent of total asset value can consist of shares
of taxable subsidiaries), that may operate service businesses
such as hotel management, day-care centres, golf courses,
hospitals and nursing homes as tenants of REFT-owned assets.
MARKET FREEDOM?
The UK Treasury's consultation paper suggests that it may be
appropriate to restrict the market freedom of a PIF, but the success of REITs is an argument for maximum flexibility, allowing
the market to refine the product. The REIT regulations do not
regulate:
- whether REITs are closed or open-ended. The UK Treasury
shows a preference for requiring all PIFs to be closed-ended
-
as a way of bringing share prices in line with net asset
value. The US markets have, without mandating closedend REITs, developed the finite life real estate investment
trust ('FREIT') in recognition of the share to net asset value
disconnect. The FREIT has a termination date by which it
must liquidate all of its assets. This reduces exposure to
interest rate risk and induces investors to factor in expected
capital distributions in valuing share prices;
the amount of gearing or leveraging. For geared REITs,
interest on debt is a deductible expense, but principal
amortisation is not; this imposes a practical limit on gearing. The National Association of Real Estate Investment
Trusts ('NAREIT') estimates the average REFT gearing is
between 4 0 - 4 5 per cent.^ In fact, the presence of leverage
at the REIT level makes a REIT a very attractive investment
for US tax-exempt investors. US tax exempt investors who
try to directly invest their funds in leveraged real estate
may incur income tax liability notwithstanding their taxexempt status; by contrast, the existence of leverage in a
REIT will generally not cause a US tax-exempt investor's
income from the REIT to be taxable (unless the REIT is a
closely-held entity owned primarily by tax exempts). This
may also be an attraction in the UK and should pass the
Treasury's tax neutral requirement;
whether the REIT distributes or reinvests its gains on sales
of assets. Net capital gains on sales of REIT assets are subject to income tax at the REIT level if retained. If distributed
to shareholders as a capital gain dividend, the gain is not
taxed at the REIT level, and is taxed to the shareholder;
individual shareholders can take advantage of the lower
long term capital gains tax rates. The ability to retain capital
allows for continued maintenance and upgrading of assets
when costs of capital rise;
the type of property a REFT may invest in. In the US, there
are both diversified and properties, and health care or selfstorage facilities.
Conversion to REIT status can generate tax liability for
capital gains realised when property is contributed to a REIT
in exchange for cash or shares in the REIT. The 'UPREIT' and
'DOWNREIT' structures have developed to minimise and/
or defer the tax impact of contributing property to a REIT;
assets Ccm be contributed to one or more limited partnerships
(controlled by the REIT), in exchange for lirtuted partnership
interests that can be traded for REIT shares. Again, the UK
could take advjmtage of this.
PuBUC VERSUS PRIVATE?
The REIT regulations do not regulate whether a REIT is publicly traded (ie listed on a recognised exchange) or privately
traded. NAREIT reports 171 publicly-traded REFTs at 2003
year-end, and estimates that approximately one-third of all
REITs are private." Institutional investors favour public REITs
for the quantity and quality of initial and ongoing disclosure
and reporting required imder the US securities laws tor public
companies; more than 50 per cent of REIT shares are owned
by institutional investors, about 15 per cent by retail public
investors, and about 17 per cent by REIT management.' At
year-end 2003, the 171 publicly-traded REITs had a total market capitalisation of about $224bn.S Of the estimated total US
Butterworths Journal of International Banking and Financial Law - June 2004
217
PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 1
real property market of $4.6tn, about $180bn (or 4 per cent) is
held by public REITs." REIT shares are liquid; about 80 public
REITs held investment grade ratings by Moody's, and 70 by
Standard & Poor's; daily trading volume in REITs is about 12
million shares.-'^'' As these figures demonstrate, the strength of
the US REIT market is the best argument for the UK Treasury
to take a mirumalist approach to regulating the PIF, allowing it
maximum adaptability which will translate into larger market
capitalisations and liquidity.
-
-
FRENCH REITS
iNTRODUaiON
France recognises various types of real estate companies.
However, two types of real estate companies correspond generally to the notion of REITS: Societes Civiles de Placement
Immobilier - (Civil Real Estate Investment Companies)
('SCPIs'), and the Societes Immobilizes d'Investissement
Cotees - ('SIICs'). SCPIs invest directly in real estate and their
shares may be purchased by the public, although they are not
listed on a stock exchange, as the shares are not negotiable
securities. SIICs, which were recently created by the French
Finance Law for 2003,^^ are hsted companies which invest on
a long term basis in real estate assets to be leased either to businesses or as dwellings or in shareholdings in companies having
the same purpose.
SCPIs
SCPIs are subject to strict regulations as regards the type of
investments they may make, the information they give out
to the public, their management, and more particularly the
system of share transfers. However, various recent reforms-^'^
have reduced certain restrictions on SCPIs and have granted a
specific tax regime to SIICs, making those investment vehicles
more attractive. As a result, a SCPI:
- must have as its exclusive purpose the acquisition and
management of a rental real estate portfolio, whether
for dwelling or commercial purposes. Subject to strict
conditions, an SCPI may undertake maintenance, repair,
improvement, rebuilding and expansion works. For example, the cost of extension may not exceed 30 per cent of the
market value of the property and 10 per cent of the SCPI's
portfolio. Moreover, the cost of any rebuilding work on
real estate owned by the SCPI cannot exceed 10 per cent
of the total value of the SCPI's real estate portfolio. A SCPI
may sell its real estate assets only if four conditions are
met:
- the sales do not constitute the company's usual
activity;
- the sales transactions do not have a speculative
purpose;
- the sales are not made less than six years after the
property has been purchased; and
- the cumulated value of the real estate being sold does
not exceed 15 per cent of the market value of the SCPI's
portfolio (assessed at the end of the last tax year);
- is managed by a 'societe de gestion' (management company) accredited by the AMF,^"* and supervised by a supervisory board consisting of at least seven shareholders. The
SCPI must also appoint a real estate expert who makes a
yearly report on the valuation of the company's real estate
218
-
-
portfolio. Each real asset must be separately valued at least
once every five years;
must have a minimum capital of €760,000 and at least 15
per cent of the capital must be subscribed by the public
within one year of opening of subscription;
must have shares in nominative form and must have a par
value of at least €150. However, the shares can be transferred either over the counter or on the secondary market
by the management company. Pursuant to the 2002 reform,
a complex system has been put in place in order to protect
investors in SCPIs, which basically consists in the management company matching sale and purchase offers as
closely as possible;
is not subject to corporate tax and is tax transparent.
Revenues received by shareholders are subject to the personal (or corporate) income tax in the real estate income
category. In case of sales of shares, capital gains are treated
as real estate capital gains. In addition, registration taxes
(droits d'enregistrement) in the amount of 4.80 per cent on
the price on shares in SCPIs are due upon transfer;
permits non resident investors to be subject to a 25 per cent
withholding tax on dividends distributed by the SIICs, subject to treaty relief or reduction (which generally reduces
the withholding rate to 15 per cent for minority investors
and to 5 per cent for parent companies).
Moreover, mirroring a post Barker report aim, recent French
legislation^^ offers tax advantages to encourage owners of
real property, including SCPIs, to invest in housing projects,
whether in older or new constructions, and in particular to
lease their property in favour of low income individuals. The
main advantages relate to the granting of a tax depreciation of
the investment made in a SCPI and tax deduction of any rental
revenues received from the SCPI.
SIICs
Essentially, SIICs are French corporations with a minimum
share capital of €15m listed on a French exchange and whose
principal corporate purpose is the purchase or construction of
real property to be leased out, or the direct or indirect investment in companies having the same corporate object.
SIICs are subject to corporate income tax, but may opt for
a tax transparent regime in exchange of their undertaking to
distribute dividends. Pursuant to this preferential tax regime
two types of profits are tax exempted at the corporate level:
profits from rental of properties and capital gains from the sale
of such properties as well of from the sales of companies which
they own. However, in order to benefit from the special regime,
profits from rentals must be distributed in the amount of at
least 85 per cent before the end of the financial year following
the year in which such profits were made. At least 50 per cent of
any capital gains which were tax exempted must be distributed
within two financial years of the sale in order for the exemption
to continue to apply. SIICs may operate their business outside
France, however, the preferential tax regime only applies to
French assets in SIICs' portfolios.
Shares of SIICs are also eligible for tax-efficient saving
schemes such as plans d'epargne en actions or PEA (share
savings plans) which makes them attractive to individual
investors as well. In order to induce large French property
Butterworths Journal of International Banking and Financial Law - June 2004
PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 1
companies with older building portfolios (and hence large
latent capital gains tax exposure) to opt in to the SIIC regime,
recent legislation provided for a one time exit tax of 16 per cent
on all capital on gains on real estate portfolios.
GERMAN OEFS
Germany has well-established tax-transparent property vehicles in the form of the open-ended real estate funds ('OEFs')
and in 2003, the OEF market was worth €14.43bn. From the
investor's perspective, OEFs are similar to REITs - paper assets
that are backed by properties, tax exempt on the corporate
level, and have the possibility to accumulate or disperse assets
in small lot sizes. Like US REITS, OEFs also accept contributions from individual private investors and then pool resources
to buy real estate that would otherwise be out of the financial
reach of those investors. Unit shares can be returned to the
fund at any time at the going bid price.
Capital investment companies that offer OEFs are
regulated by a comprehensive and tight legal framework,
regulating such legal aspects as licensing requirements,
the organisational structure, the function and purpose of
custodians, permitted investments, investment restrictions,
valuation, accounting, auditing and publication requirements.
The state supervision of the rules codified in the Investment
Act is exercised by the federal financial supervisory authority
- BaFin. In 2002, the 4th Financial Market Promotion Act
facilitated the ability of OEFs to invest internationally outside
the European Union and the European Economic Area. Before
the Act, it was only possible to invest 20 per cent of the fund's
capital outside the Eurozone. Now 100 per cent of the fund's
capital may be invested internationally, as long as their
unhedged currency exposure does not exceed 30 per cent of
the fund's capital.
However, with the introduction of the Investment
Modernisation Act 2004, the German real estate industry hoped
for the introduction of 'true REITs' and the establishment of a
laissez faire free market approach which in turn could boost
the suffering German real estate economy. Unfortunately,
the Investment Modernisation Act fell short of allowing
properties and property companies to serve as possible
investment vehicles of investment stock corporations and the
establishment of 'true REITs', is currently ruled out under
German legislation.
Notwithstanding this, future amendments to the act should
give investors the choice, in the real estate field, of investing
in an investment stock corporation or a fund separate from
the assets of the company and interest groups are already
lobbying to transform Germany into a large REIT market. The
introduction of 'true REITs' could avoid the tight regulation
concerning OEFs, resulting in an opening up of the real estate
market to investors who are ready to take a higher amount
of risk than the traditional investors in OEFs (and who are
expecting a considerably higher return from their real estate
investment). Such a move could present the German OEFs
with a tough challenge, by putting pressure on their capital
inflows if investors choose to switch their money into listed
REIT vehicles.
*
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
turing in the banking department of the London office of
Dechert LLP. He is grateful to his international colleagues:
Michael Hirschfeld, Nadine Yoimg, Richard J Temko, JeanPierre Magremane, Marc Seimetz, Pascal Bouvy, Joseph
Smallhoover and Oliver Piatt for their respective contributions and his colleagues in London: Mark Stapleton and
Ciaran Carvahlo for their comments.
The name may change to reflect the financial structure
and the government (in an indication that they may not be
happy with PIFs as a name) has welcomed alternative suggestions. After all, it could not have been called a Property
Investment Trust (after the Housing Investment Trusts of
the 1990s), since one could imagine the take up in a product
called a PIT to be relatively low.
See http://www.hm-treasury.gov.uk/budget/budget_04/
associated_documents/bud_bud04_adproperty.cfm
See Housing Today, 20 February 2004 pi 5.
See Property Week, 16 April 2004 p23. The fund will be a
Guernsey-exempt investment company with its shares listed on both the London and Channel Islands stock exchanges. It will offer investors a target yield of 6.75 per cent, as
well as the potential for income and capital growth.
See http://www.nareit.org/researchandstatistics/
See http://virww.nareit.org/researchandstatistics/
Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real
Estate Investment Trusts Handbook (Thomson 2004), at
p5.
Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real
Estate Investment Trusts Handbook (Thomson 2004), at
p5.
Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real
Estate Investment Trusts Handbook (Thomson 2004), at
p5.
Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real
Estate Investment Trusts Handbook (Thomson 2004), at
p5.
Societe Civile Immobiliere, SCPIs, SIIs, societes de location immobiliere transparente or societes immobilieres de
copropriete transparentes.
Law no. 2002 -1575 of 30 December 2002.
Reglement COB No 2001-06, Decree of 26 April 2002.
The management company may be either a societe anonyme
(corporation) (whose capital must be at least €225,000) or
a societe en nom collectif (commercial partnership) with the
condition that at least one of its partners is a societe anonyme
having a minimal capital of €225,000.
Law No. 2003-590 of 2 July 2003.
Andrew Petersen is Counsel specialising in cross border
acquisition and real estate financing and corporate restrucButterworths Journal of International Banking and Financial Law - June 2004
219
PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 2
Andrew Petersen, Dechert
LLP'
On March 17 2004, the UK Treasury announced a consultation exercise on how property
investment funds ('PIFs')l
in the UK should be structured to encourage more efficient
investment in commercial and residential real estate.2 The consultation paper reveals that
the UK Treasury is contemplating a tax-neutral vehicle which will be well-regulated and
appeal to the small investor by boosting liquidity. In order to ascertain the ultimate benefit
of PIFs to the UK economy and potential real estate investors and to try to understand what
vehicle we should end up with in the UK, this two part article will examine the characteristics
of real estate investment trusts ('REITs') currently operating in the US and throughout Europe
and compare their appeal to global real estate investors and how respective government's
successes (and failures) hove formed current vehicles.
Port 1 of this article, which was published in the June issue of the Journal, looked at REITs
in the US, France and Germany. Port 2 examines REITs in Belgium and Luxembourg and
makes suggestions as to the kind of vehicle which should be adopted in the UK for a PIF.
If readers do have comments on the Treasury's consultation process, the Editor, Hugh Pigott
via Ann Phillip at (ann.phillip@lexisnexis.co.uk) or Andrew Petersen (andrew.petersen@dech
ert.com) would be pleased to hear them.
In any event all consultation responses by email should be sent by 16 July 2004 to:
(PIFconsultation@hm-treasury.gsi.gov.uk).
BELGIUM
In 1995, Belgium enacted legislation permitting the creation of
'societes d'investissement a capital fixe en biens immobiliers'
('SICAFIs') or closed-end real estate investment companies.
Prior to that time, the only publicly-offered collective investment medium for real estate investments in Belgium was the
real estate certificate ('certificat immobilier'). The real estate
certificate, which continues to be available on the Belgian market, is a type of asset trust certificate which entitles the holder
to a ratable share of the net income and gain from an underlying real estate asset (typically, a single building leased to one or
more tenants).
The major differences between the certificat immobilier
and the SICAFl are the latter's greater diversification of risk, its
association with the active management of the underlying real
estate portfolio and its greater liquidity.
REGUIATORY REGIME
The legal framework for SICAFIs was established by the Royal
Decree of 10 April 1995 issued under the Law of 4 December
1990, which is the basic Belgian law governing collective investment funds and investment companies. Like other investment
funds and companies, a SICAFl must be approved for public offering by the Belgian Banking, Finance and Insurance
Commission ('BFIC'). A SICAFl must be established in corporate form and, with limited exceptions, may invest only in 'real
estate assets'. Such assets may include not only buildings, but
also options, leasehold interests and other rights in buildings,
voting shares of real estate companies related to the SICAFl,
and real estate certificates.
The SICAFI's investments must be diversified in such
manner as to assure a spreading of investment risk according
to the investment policy set forth in the SICAFI's articles of
association. Subject to possible derogations granted by the
BFIC, a SICAFl may not invest more than 20 per cent of its
assets in any single real estate project. For corporate accounting
262
purposes the SICAFI's assets are appraised periodically by
an independent chartered surveyor, based on prevailing
market prices; the assets are recorded in the SICAFI's financial
statements at their appraised value and are not depreciated. A
SICAFl is permitted to leverage its assets by borrowing but its
total debt is not permitted to exceed 50 per cent of its asset value
(determined at the time each new borrowing is contracted). A
SICAFl is also required to distribute at least 80 per cent of its
annual net income on a current basis.
TAXATION
Although SICAFIs are, in principle, subject to Belgian corporate income tax, like other investment companies their taxable
income is limited by Decree to the amount of any non-arm'slength benefits transferred to them by related parties and to
the amount of certain miscellaneous items which are not tax
deductible. Hence, in practice, SICAFIs are essentially exempt
from Belgian corporate income tax. Withholding taxes withheld on dividends paid to a SICAFl may be credited against
any tax payable by the SICAFl and any excess will be refimdable. On the other hand, property tax payable by the SICAFl
in its capacity as owner of buildings in its portfolio, although
constituting in principle a tax-deductible expense, will in
practice not generate any tax deduction given the absence of
mainstream corporate income tax liability. Dividends paid by
a SICAFl to its shareholders are subject to a withholding tax
of 15 per cent, except that no withholding tax is payable if at
least 60 per cent of the SICAFI's portfolio consists of Belgian
residential real estate. Dividends paid to foreign investors can
also qualify for a reduced rate of withholding tax under certain
double tax treaties.
Like other registered investment companies, a SICAFl is
subject to an annual franchise tax, currently equal to 0.06 per
cent of its asset value (such tax is scheduled to increase to 0.07
per cent in 2005 and to 0.08 per cent in 2007).
A SICAFl must also pay an annual fee to the BFIC equal to
Butterworths Journal of International Banking and Financial Law - July/August 2004
PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 2
the sum of: (i) 0.0075 per cent of the net assets of the SICAFI as
of the end of the preceding calendar year; and (ii) 0.075 per cent
of the gross amount of shares of the SICAFI issued in Belgium
during the preceding year.
CONVERSION
Due to the SICAFI's essentially exempt status insofar as Belgian
income tax is concerned, special measures were also taken to
prevent existing private real estate companies from converting
tax-free to SICAFIs in order to avoid paying capital gains tax
on appreciated real estate assets. Tlius, the conversion of an
existing real estate company into a SICAFI is assimilated for
income tax purposes to a corporate liquidation and gives rise
to an 'exit tax' of 19.5 per cent, applicable to any latent capital
gains on the company's real estate assets (ie, measured as the
difference between the market value of such assets and their
tax basis in the hands of the real estate company). A further 10
per cent withholding tax is then imposed on the company's net
asset value following payment of the foregoing tax.
EVOLUTION OF SICAFIS
Following the adoption of the SICAFI regime, a number of
large Belgian real estate developers either created SICAFIs or
transferred assets to existing SICAFIs by way of sale or merger.3 Approximately a dozen SICAFIs are currently listed on the
Belgian stock exchange, with aggregate assets of nearly 65bn.
Their portfolios fall into four general categories: office buildings, retail properties, semi-industrial properties (warehouses)
and residential properties. The largest SICAFIs are active in the
office building sector and have portfolios ranging from €260m
to ei.Sbn. In most cases, the SICAFI's sponsor or related companies hold a sizeable portion of the outstanding shares and
tl\e 'free float' rcmges from 30 per cent to 80 per cent of the total
share capital. The level of indebtedness varies from 14 per cent
to 49 per cent of total assets, the weighted average indebtedness
of all SICAFIs being approximately 41 per cent. Over the past
several years, the average net dividend of aU SICAFIs has been
in the range of 6 per cent and total annual return on investment
has been in the range of 15 per cent to 20 per cent. SICAFIs have
thus substantially outperformed the Belgian stock market. A
number of SICAFIs are currently trading at substantial premiums above their net asset value, although others trade at a
slight discount off their net asset value. In less than ten years of
existence, SICAFIs have established themselves as the investment vehicle of choice for private investors wishing to invest
in a diversified portfolio of real estate assets. Although the
general robust performance of the Belgian real estate market
has contributed to this success, the liquidity, tax efficiency and
general prudential supervision of SICAFIs by the BFIC are also
key factors which have encouraged the relatively high level of
investment in SICAFIs.
LUXEMBOURG
Luxembourg has long been recognised as an attractive jurisdiction for the setting up of real estate investment vehicles. Over
recent years, primarily as a result of stock market growths,
Luxembourg's real estate investment funds have benefited
from an increasiiig popularity, and this is expected to continue.
At the end of 2003, 13 regulated real investment funds were
registered in Luxembourg, comprising seven retail funds and
six institutional funds, with an aggregate net asset value of
e2.86bn representing 0.30 per cent of the total net asset value of
all Luxembourg regulated investment funds.
The funds may be classified into two main categories of
real estate investment funds: public and private. Both types
of funds have separate target investors and consequently the
regulations in respect of each are different.
PUBLIC FUNDS
These consist of regulated real estate investment funds (ie
funds which are undertakings for collective investment
('UCIs')) and which need to be approved and supervised by
the Luxembourg regulators.^ Within this category are: (1) unit
trust type funds, ie the 'Fonds Commun de Placement' ('FCPs')
(which can be open- or closed-ended); and (2) company type
funds, ie the SICAF which is a closed-ended fund and the
SICAV which is an open-ended fimd.
The principal object of UCIs is the investment in real estate.
For this purpose, the term 'real estate' comprises:
- property consisting of land and buildings registered in the
name of the UCI;
- shareholdings in real estate companies (including claims
on such companies) the exclusive object and purpose of
which is the acquisition, promotion and sale as well as the
letting and agricultural lease of property, provided that
these shareholdings must be at least as liquid as the property rights held directly by the UCI;
- property related long-term rights such as surface ownership, leasehold and options on real estate investments.
UCIs face a number of restrictions:
- in order to achieve a minimum spread of the investment
risks, UCIs may not invest more than 20 per cent of their net
assets in a single property, such restriction being effective
at the date of acquisition of the relevant property. Property
whose economic viability is linked to another property is
not considered a separate item of property for this purpose.
This 20 per cent rule does not apply during a start-up
period which may not extend beyond four years after the
closing date of the initial subscription period;
- should the investors have the right to redeem their shares,
the UCI may provide for certain restrictions on this right.
These restrictions must be clearly and precisely described
in the offering prospectus;
- the aggregate of all borrowings of the UCI may not exceed
in average 50 per cent of the valuation of all its properties;
and
- at the end of the financial year, management inust instruct
the property valuer(s) to examine the valuation of all properties owned by the UCI or by its affiliated real estate companies. These UCIs pay an amuial subscription tax ('taxe
d'abonnement') of 0.05 per cent of their net asset value,
which is reduced to 0.01 per cent for institutional funds/
subfunds /classes.
PRIVATE FUNDS
These consist of Luxembourg real estate companies, which are
not governed by the legislation on UCIs, but by the general
company law. Unlike UCIs, their target investors are types of
joint venture, whereby the participants enter into private con-
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PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 2
tracts. Consequently they do not face the same restriction or
regulation as a UCI.
These companies either purchase real estate directly or, for
tax reasons, indirectly through subsidiaries. These companies
are fully taxable entities, although dividends received from
subsidiaries and capital gains on the participations held in
such subsidiaries may under certain conditions be exempt in
Luxembourg under the 'participation exemption'.
PIF - WHAT VEHICLE SHOULD THE UK ADOPT?
From the analysis of REITS across Europe and in the US, it is
submitted that consultation should bring a PIF which has a
combination of the following:
- a safe, tax-efficient environment for people to invest in
commercial and residential real estate in a way which is
less risky than buying a single residential real estate on
a buy-to-let basis. This will reduce volatility in the commercial and residential real estate sector and will meet the
government's aim of reducing the sector's exposure to debt
and interest rate cycles;
- no restriction on external or internal management.
Although the US experience has shown that those REFTS
which are internally managed are the best performers and
internal management clearly helps align the interest of
management and investors, PIFs should not be prohibited
from being externally managed;
- shares which are liquid and freely tradable. The majority
of REIT shares can be purchased on major stock exchanges,
and orders can be placed through stockbrokers. Financial
planners and investment advisers can help to match an
investor's objectives with individual REIT investment;
- no personal liability for investors;
- a structure which allows taxable income to be passed
through rather than being independently taxed;
- accessibility. Both US and non-US sources invest in US
REITs which are owned by thousands of individuals, as
well as large institutional investors, including pension
funds, endowment funds, insurance companies, bank trust
departments and mutual funds. However, the French experience has shown that, in respect of SIICs, the biggest gains
have gone to property companies, the state and foreign real
estate investors and not to domestic investors or the French
public. This may be a warning to the UK;
- an attractive rate of return. Dividends should not be so
high that they prevent development or refurbishments of
properties or subsidies for low rents;
- a free market approach to restricting the PIF's development activities. No restrictions on development would
certainly help PIFs play a role in urban regeneration and
assist the government's much wider post-Barter approach
to affordable/social housing. It is notable that the property
industry, post consultation, has highlighted this area as one
of the major concerns for the success of PIFs;
- a free market approach to gearing and leveraging. In this
article, we have seen that some jurisdictions, for example
Belgium, restrict gearing where the SICAFI is based on a
regulated investment vehicle, whilst other major economies, such as the US and France do not restrict gearing
or leveraging, although in practice the market typically
appears to gear up to 50 per cent of asset value. In the US
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for geared REITs, interest on debt is a deductible expense,
but principal amortisation is not; this imposes a practical
limit on gearing. On the question of how much borrowing
should be allowed, the Treasury appears to favour a low
level of borrowing in order to increase scrutiny and market
stability. However, a note of caution should be sounded,
as with debt currently at a cost which is extremely low, it
could prove an expensive way of raising finance to force a
PIF to turn to the capital markets for funding for each proposed activity. Indeed if the Treasury were to limit a PIF's
borrowing powers and combine this with a requirement for
high income and capital distributions then a PIF's constant
visits to the equity markets could prove unattractive to
those listed property companies who would be considering converting to become a PIF. Further, debt finance need
not be costly. With a credit facility the debt servicing costs
are disclosed up front and, through hedging instruments,
can remain the same throughout the term of the facility.
Also, when considering vehicles which are complementary
to PIFs, such as CP185 funds, in respect of retail investors,
new tax rules allow authorised property unit trusts to gear
up to 100 per cent of gross asset value and up to 50 per
cent of the fund can be in development. As it is important
that PIFs can compete if they are to be successful, from the
analysis of REITS across Europe and in the US, it is submitted that the UK should not attempt to restrict the gearing
on PIFs, but instead allow a market approach to gearing
levels. The US model provides the form of investor scrutiny
required by HM Treasury as the REITS there have to issue
capital and then the analysts decide if it is a good or bad
deal;
a portfolio as diverse as possible providing a wide but
straightforward choice for investors wishing to invest in an
onshore regulated property investment vehicle. This may
in turn lead to a lowering of the cost of capital, and provide
a reliable source of capital to buy real estate, so enabling
the developer to recover its invested capital and take out
its entrepreneurial profit, which in turn may spur development^ and lead to a more stable and efficient real estate
market. Although this does raise a concern as to whether
the small investor, ie the public, is ready for such a vehicle.
The small investor should ideally be educated as to what a
PIF investment entails, and thus its risks;
a fair conversion charge. The Treasury appears to be adamant on a tax-neutral position. Any entry or exit level
conversion charge must serve its purpose and should
not prohibit the conversion of property-owning vehicles
which may wish to convert to PIF status. A charge set
too high could easily discourage conversion and not raise
any money for the Inland Revenue. One-off stamp duty
charges based on a percentage of net asset value have been
proposed, as have exit charges based on CGT liabilities (following SIICs in France and SIC APIs in Belgium). However,
the trouble with CGT exit charges is that most UK companies have low CGT liabilities and so this would not favour
the tax-neutral position;
the ability to encourage investment by non-UK residents: at
present, non-UK resident investing direct in UK property
can receive their income gross and are exempt from capital
gains tax on the disposal of UK property." It is submitted
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PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 2
that non-UK residents investing in a PIF should also be
treated in the same way as if the non-UK residents were
investing direct in UK property and thus able to receive
their income gross. The Treasury is not yet convinced of
this, and has asked for suggestions as to hovi' the concepts
inherent in the non-resident landlords' scheme could be
satisfactorily adapted to investment made in PIFs by nonUK residents. The proposal to treat potential distributions
of realised capital gains of non-UK residents taxable in the
same Vk^ay as income distributions may act as a disincentive
for non-UK residents to invest in a PIF. Introducing a system of sourcing rules to establish the factual composition of
distributions to distinguish between distributions arising
from capital gains and distributions arising from income
should not be dismissed by the Treasury as 'too complex'.
residential market (which, given the scope of the consultation paper, is looking increasingly unlikely), or face too great
a restriction on the development projects they can undertake,
or are forced to have an element of residential stock in their
portfolio, then it is more than likely that they wUl go the way
of the BES and HTTs.
The goveniment though seem determined not to make
these same mistakes. A key feature of a PIF is to prevent this
exercise being wasted and once again to attempt to align the
after-tax returns from holding real estate indirectly with those
obtained from holding property directly. Given this incentive,
the consultation paper and process is both vital and timely, if
we are to follow the examples of the countries set out in this
article and introduce a UK REIT (there I said it, much better
than PIF) which will succeed and ultimately benefit the UK
economy.
PUBLIC VERSUS PRIVATE?
The consultation paper envisages that a PIF would be listed
on the Stock Exchange to ensure the widest possible access for
small investors to operate in a well-regulated environment.
The Treasury highlights the greater regulatory regime that
applies to listed companies. However, the take up of investment in approved investment trust companies is not great and
it is submitted that this would be a mistake. It is clear that there
are both advantages and disadvantages to being listed. Clearly
there are advantages for investors if their units can be traded
on a recognised exchange; similarly there is also room for private REITs, as we have seen from the successful private REIT
market in the US. Thus a PIF should be capable of being listed
but should not have to be.
*
1
EMPEROR'S N E W CLOTHES?
The consultation paper has raised a number of important questions which require answering. The form that a PIF should
take (including its name, although on a personal level what
was wrong with REITs or Realty Investment Funds ('RIFs')?)
is now in the hands of those that respond to the consultation,
the Treasury and the Inland Revenue. It should be remembered, however, that we have been down this road before. For
example, during the last housing boom, the government of the
day extended the reliefs available in the Business Expansion
Scheme ('BES'), which were originally intended to help small
businesses, to include private landlords. TelUngly, the scheme
was described in 1993 by the then shadow Chancellor, Gordon
Brown, as 'a tax avoidance opportunity for top-rate taxpayers and the banking establishment'. It was shut down soon
after. The next attempt to boost private renting, the Housing
Investment Trust ('HIT'), went to the other extreme. HITs were
launched in 1995, but had so many limitations and restrictions,
that running a HIT was virtually impossible and, accordingly,
the market ignored the scheme. If PIFs are confined to the
2
3
4
5
6
Andrew Petersen is Counsel specialising in cross border
acquisition and real estate financing and corporate restructuring in the banking department of the London office of
Dechert LLP. He is grateful to his international colleagues:
Michael Hirschfeld, Nadine Young, Richard J Temko, JeanPierre Magremane, Marc Seimetz, Pascal Bouvy, Joseph
Smallhoover and Oliver Piatt for their respective contributions and his colleagues in London: Mark Stapleton and
Ciaran Carvahlo for their comments.
The name may change to reflect the financial structure
and the government (in an indication that they may not be
happy with PIFs as a name) has welcomed alternative suggestions. After all, it could not have been called a Property
Investment Trust (after the Housing Investment Trusts of
the 1990s), since one could imagine the take up in a product
called a PIT to be relatively low.
See http://www.hm-tieasury.gov.uk/budget/budget_04/
associated_documents/bud_bud04_adproperty.cfm
Given the substantial real estate transfer tax applicable in
Belgium, contribution of existing real estate to a SICAFI
by way of merger or capital contribution in kind is a
particularly attiactive route since it generally enables the
parties to avoid such tax on the transfer of the property to
the SICAFI.
Law of 19 July 1991 (institutional funds) or by part II of the
Law of 20 December 2002 (retail funds).
Analysts at Citigroup Smith Barney beUeve that the UK real
estate sector's market capitalisation could double to £40bn
if the regime changes. This is on the assumption that PIFs
wOl be able to invest in both the residential and the commercial real estate markets.
Unless the disposal falls within scope of s 10 or 10a of the
Taxation of Chargeable Gains Act 1992.
This Journal should be cited as follows:
( 2 0 0 4 ) 0 7 JIBFL [page no]
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