Emerging trends in real estate transactions – Stephen Herring

As the great, the good and the not so good of the global real estate industry gather once again in Cannes for the industry’s annual MIPIM conference, Stephen Herring, real estate tax partner, reflects on the changes he is seeing in the market after a turbulent, post credit quake year.

Against a background of continuing stress in the capital markets, and particularly the bank lending market, we are identifying emerging trends in the structuring of European real estate market transactions.  This time last year there were few new transactions and fewer new funds (and these were often smaller scale but with prime rental streams) and the rest of the action was focused upon those entities that were in distress or were targeting distressed assets.  We are now certainly seeing a significant number of fund promoters come back to the market as confidence returns in particular sub-markets, if not for new, broadly based, "blind" funds.

As a real estate tax partner, I am obviously particularly focused upon the tax drivers:

More Aggressive Stance from Tax Authorities and Impact upon Property Structures

We are aware of a notable increase in the number of enquiries being raised by European tax authorities into structures that they perceive as abusive.  By way of example, the structures of most interest to the UK tax authorities include tax havens and they typically raise challenges where the implementation has been poor or the documentation inadequate.

What are the implications of this for real estate fund promoters in 2010?  Well, in addition to reviewing existing structures, greater care will be required in setting up new cross-border projects to ensure that they have sufficient substance in each location from the outset and that the structure chosen is sufficiently robust to withstand tax authority scrutiny and avoid nasty unplanned surprises for investors.

Continuing Trend to Lower Corporate Taxes but With More Complex Rules

Whilst economic circumstances have dramatically reduced the forecast tax take of most European governments there has been a continuing trend - which we are very confident will continue - to lower corporate taxes as individual countries compete to attract new direct foreign investment.  Whilst this trend has slowed recently we expect that there could be further corporate tax rate cuts over the next year, including the UK with the corporate tax rate perhaps falling to 25% or below.  Most governments reduce the impact of these rate falls by reducing tax allowances and reliefs.  Interest relief has been particularly affected in recent years with, for example, Germany and Italy reducing the ability for real estate companies to deduct interest upon both connected party debt and bank debt against rental income.  The UK has been no different, introducing on 1 January 2010 a so-called "worldwide debt cap" rule.  These restrictions can, of course, significantly increase the total tax burden and materially reduce net returns; for some projects the extra tax burden could be a deal breaker for acquisitions or even re-financing distressed property portfolios.

Continuing Trend Towards Investment in Climate Change Tax Enhanced Returns

Both the European Union itself and most European countries have a range of incentives for so-called “green” development projects.  Over the past year we have seen funds successfully launched to invest in these assets classes to take advantage of both these incentives and the relatively secure income streams often underwritten by generous EU grants and/or tax enhanced deductions against rental income.  Across Europe we expect to see a number of new incentives designed to attract investors as countries rush to secure their respective targets to reduce greenhouse gasses.  Poland is noticeable for having secured a large tranche of the EU funding towards these initiatives.

Tax Favoured Structures

Since the introduction of, for example, UK-REITs, German REITs and Spanish REITs there have been relatively few new IPOs but a reasonable number of conversions since 2007. The very sound and tax efficient financing structure provided by REIT legislation has been frustrated by the real estate market peak coinciding with the introduction of the tax driven legislation. Similar issues have arisen for the open-ended fund version of REITs such as the UK-PAIF.  The tax attraction of both these structures is that they are treated similarly to direct property ownership. I foresee both a much higher number of both IPOs and conversions over the next twelve months in both the UK and Continental Europe. As the tax benefits become more attractive to promoters and investors identifying capital growth from depressed recent valuations.

Conclusion

Tax has inevitably been much lower down the list for real estate promoters, investors and developers since the credit quake hit. This was quite understandable and, no doubt, quite right. However as the commercial and residential real estate markets emerge from the downturn, focusing upon the projected net return after taxation from a transaction will ensure that funding is optimised for future acquisitions.

It will be interesting to hear peoples’ views at MIPIM and see whether the appetite really has returned for both a broader range of real estate transactions and, most importantly, people to finance them.