Destination UK:International Property Investment andthe Role of Taxation
March 2000
Whiteknights, Reading, Berks, RG6 6AWTel: 0118 986 1101Fax: 0118 975 5344email: [email protected]://www.cem.ac.uk
Research TeamDr. T J Dixon BA PhD FRICS DipDistEdM J Beard BA MScEconK G Pottinger BSc FRICSM Brennan BA DipSurv ARICSA D Marston BSc MLE
ISBN 1 899769 285
© The College of Estate Management 2000
No responsibility for loss occasioned to any person acting or refraining fromaction as a result of the material in this publication can be accepted.
ACKNOWLEDGMENTS
Our thanks are due to:
Helical Bar, Mishcon de Reya and Grant Thornton, which (under theauspices of the Investment Property Forum (IPF)) generously funded thisresearch over a two-year period.
Members of our advisory group who included:
Michael Slade and Ian McNair-Scott of Helical Bar
Susan Freeman, Teresa Harman and Brian Slater of Mishcon de Reya
Kathryn Hiddleston and Michael Cleary of Grant Thornton
John Atkins of HSBC
Professor Andrew Baum of University of Reading (IPF representative)
All respondents to the postal questionnaire.
Those organisations, represented through interview or participation in thefocus groups, and which include:
Allied Irish Bank(GB)
Arlington Securities Plc
Barclays Property Investment
British Property Federation
Burford Holdings Plc
Conrad Ritblat & Co
Credit Suisse First Boston
Deustche Bank
DTZ Debenham Tie Leung
Ernst & Young
Green Property Plc
Hammerson Plc
Jones Lang LaSalle
Linklaters & Alliance
Norwich Union
Orion Capital Managers
Parkes & Co
Rheinhyp
Richard Ellis Financial Ltd
Rotch
Royal Bank of Scotland plc
Value Retail plc
Hillier Parker and Healey & Baker who kindly supplied us with relevant data.
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CONTENTS
Acknowledgements
Contents
Executive Summary________________________________________________________ VIII
1 Introduction ______________________________________________________________ 1
1.1 Background.......................................................................................................1
1.2 Aims and objectives..........................................................................................2
1.3 Methodology .....................................................................................................3
1.4 Format of the report..........................................................................................3
1.4.1 Background and Literature Review .........................................................3
1.4.2 Methodology and Results......................................................................3
1.4.3 Conclusions and Summary ...................................................................4
2 International property investment and development in the UK __________________ 5
2.1 Introduction.......................................................................................................5
2.2 Foreign direct investment (FDI).........................................................................5
2.2.1 Background and growth of FDI...............................................................5
2.2.2 UK National Accounts and International InvestmentPosition of the UK. ...............................................................................7
2.2.3 Determinants of International Capital Flows.............................................8
2.3 Direct and indirect property investment and development .............................11
2.3.1 The size of the markets ......................................................................11
2.3.2 Overseas property investment in the UK ...............................................16
2.4 Investors into the UK .......................................................................................17
2.4.1 German investors ...............................................................................17
2.4.2 US investors ......................................................................................19
2.4.3 Irish Investors.....................................................................................22
2.5 European cross–border investment.................................................................24
2.6 The rationale for international investment diversification ..............................27
2.7 International property diversification..............................................................27
2.8 Advantages of international property investment ...........................................31
2.9 Direct property development and joint ventures in the UK .............................33
2.10 Summary ........................................................................................................34
II
3 Real estate investment institutions in the USA and Germany __________________ 35
3.1 Introduction.....................................................................................................35
3.2 USA.................................................................................................................35
3.2.1 Real Estate Investment Trusts (REITs).................................................35
3.2.2 The evolution of the REIT structure.......................................................35
3.2.3 Evolutionary phases of REITs ..............................................................37
3.2.4 What makes REITs attractive to investors.............................................39
3.2.5 REITs and the occupier market............................................................40
3.2.6 Development of the US REIT market ....................................................40
3.2.7 REIT performance in the US market .....................................................41
3.2.8 REITS and Institutional Investors..........................................................42
3.3 REITs and institutional investors .....................................................................42
3.4 US small investors and real estate ..................................................................47
3.5 Small investors and international investing....................................................48
3.5.1 REITs in Europe.................................................................................49
3.5.2 Valuing REITs ....................................................................................49
3.6 Germany .........................................................................................................51
3.6.1 Closed and Open-end Funds ...............................................................51
3.6.2 Other sources of property finance ........................................................51
3.6.3 Types of finance.................................................................................52
3.6.4 Financing criteria................................................................................52
3.6.5 Securing property loans ......................................................................53
3.6.6 Other forms of financing ......................................................................53
3.7 Summary and Conclusions .............................................................................53
4 International financial reporting Tax and depreciation requirements___________ 55
4.1 Introduction.....................................................................................................55
4.2 IASC and the Fourth Directive.........................................................................55
4.3 Valuation of fixed assets and investment properties.......................................55
4.4 The evolution of international differences in accounting andfinance ............................................................................................................57
4.5 Legal differences............................................................................................57
4.6 Harmonisation and standardisation ................................................................58
4.7 The treatment of tax and depreciation in the UK, USA andGermany .........................................................................................................58
4.8 Treatment of depreciation ..............................................................................59
4.8.1 Depreciation Practices........................................................................59
4.8.2 Depreciation Policy ............................................................................60
4.9 The UK ............................................................................................................61
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4.9.1 Dealing companies .............................................................................62
4.9.2 Investment companies ........................................................................62
4.9.3 Plant and machinery...........................................................................62
4.9.4 Industrial buildings (IBs)......................................................................63
4.9.5 Commercial buildings in Enterprise Zones (EZ) .....................................64
4.9.6 Reform of capital allowances in the UK?...............................................64
4.10 USA.................................................................................................................64
4.11 Germany .........................................................................................................66
4.12 Summary and Conclusions .............................................................................66
5 Tax advantages for overseas investors in UK property ________________________ 68
5.1 Introduction.....................................................................................................68
5.2 The UK as a tax haven....................................................................................68
5.3 Tax policy issues.............................................................................................69
5.4 Comparative tax regimes................................................................................70
5.5 Effects of taxation on international investment flows......................................76
5.6 UK tax regime for property investors – an overview .......................................78
5.6.1 Traders and investors..........................................................................78
5.6.2 Withholding taxes ..............................................................................78
5.6.3 Interest relief for offset against rent.......................................................79
5.6.4 Double tax treaties .............................................................................79
5.7 Offshore and other vehicles in the UK.............................................................80
5.7.1 Limited partnerships ...........................................................................81
5.8 Direct overseas investment - tax advantages in the UK ..................................83
5.8.1 Indirect overseas investment - new investment vehicles?........................86
5.9 Summary and conclusions..............................................................................90
6 Summary of research questions and methodology ___________________________ 92
6.1 Research questions.........................................................................................92
6.2 Methodology ...................................................................................................92
7 Questionnaire survey _____________________________________________________ 93
7.1 Introduction.....................................................................................................93
7.2 Response rates................................................................................................93
7.3 Overseas responses........................................................................................94
7.3.1 Direct real estate investment and taxation ............................................94
7.3.2 Factors influencing direct investment....................................................95
7.3.3 Forms of real estate investment ...........................................................97
7.4 UK responses..................................................................................................97
IV
7.4.1 Direct real estate investment and taxation ............................................97
7.5 Indirect real estate investment........................................................................99
7.6 European real estate issues.......................................................................... 100
8 Interviews______________________________________________________________ 101
8.1 Introduction................................................................................................... 101
8.2 The UK as a favoured location for overseas investment ............................... 101
8.2.1 The overseas investors...................................................................... 101
8.2.2 Attractions of the UK real estate market ............................................. 102
8.3 The role of Taxation in the investment decision, and theperceived view of the UK tax regime............................................................ 102
8.3.1 The relative importance of taxation ..................................................... 102
8.3.2 The importance of stamp duty for transaction costs............................. 103
8.4 Overseas ownership structures and investment vehiclesoperating in the UK....................................................................................... 104
8.4.1 Tax-efficient vehicles and structures ................................................... 104
8.4.2 Indirect investment ........................................................................... 105
8.4.3 The competitive environment of the UK listed propertycompany ......................................................................................... 105
8.5 Development of a UK tax transparent, tradable propertyinvestment vehicle........................................................................................ 106
8.5.1 The future of UK securitisation........................................................... 106
8.5.2 The potential consequences for the UK market ofintroducing securitised vehicles. ........................................................ 106
8.6 Conclusion .................................................................................................... 107
9 Focus Groups ___________________________________________________________ 109
9.1 The UK as a destination for overseas investment.......................................... 109
9.2 The future of the quoted property company.................................................. 112
9.3 Conclusion .................................................................................................... 112
10 Conclusions ____________________________________________________________ 114
10.1Global investment trends and the growth of competition ............................. 114
10.2The UK as a destination for overseas investment.......................................... 115
10.3The determinants of overseas investment..................................................... 115
10.4The tax treatment of UK and overseas investors. .......................................... 116
10.5Tax efficient vehicles.................................................................................... 116
10.6Overseas competition, and the status and performance of theUK listed property company.......................................................................... 117
10.6.1 Competition as a global phenomena................................................... 117
10.6.2 Competition within the UK ................................................................. 117
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10.7The domestic threat: market distortions, and inequalitiesbetween asset classes................................................................................... 118
10.8Conclusion .................................................................................................... 119
11 References _____________________________________________________________ 120
Appendices _______________________________________________________________ 125
Appendix 1: Basic qualifications for a REIT .................................................. 125
Appendix 2: Belgian SICAFIs........................................................................ 126
Appendix 3: Questionnaires.......................................................................... 127
Appendix 4: Tables of Results....................................................................... 134
Appendix 5: Additional Comments from Questionnaire ................................ 144
TABLES
Table 2.1 Major Industrial Countries (G7): Gross Flows of FDI and Portfolio Investment ($billion)..........................................................................................................................6
Table 2.2 FDI Flows 1990-1996 (Source, OECD, 1996) ........................................................7
Table 2.3 Global Markets of Commercial Real Estate ........................................................12
Table 2.4 Regional Distribution of Higher-Grade Commercial Real Estate.............................12
Table 2.5 Top Ten European Property Companies (source: GPR, 1998)...............................14
Table 2.6 Open and closed-end funds...............................................................................18
Table 2.7 US Funds: European Transactions (1997-98) (source: Parkes, 1998)....................22
Table 2.8 Yields in Dublin and London Q4 1998.................................................................23
Table 2.9 The three largest purchasers of French commercial property................................26
Table 2.10 Variation in Purchaser’s Transactions Costs (adapted from DTZ, 1998b)..............29
Table 2.11 European Property Performance Benchmarks (source: Blundell, 1998)................30
Table 3.1 The four sectors of the property finance market (source Staveley, 1997)................36
Table 3.2 US Property Market Penetration by Public REITs and Corporations ......................39
Table 3.3 Institutional investors with nearly 100% investment in REITs in 1995.....................43
Table 4.1 Classification based on corporate financing (after Nobes and Parker, 1998) ...........59
Table 4.2 Summarises depreciation systems from buildings in OECD countries (OECD, 1991).59
Table 5.1 Overview of UK Property Tax for Overseas Investors ............................................69
Table 5.2 Likely Effects of Taxation on Net Imports of Portfolio Capital in Short or MediumTerm (source: Ruding Commitee, 1992)...............................................................76
Table 5.3 Property Investment Vehicles: A comparison......................................................82
Table 5.4 Average Tax Charges (after SBC Warburg Dillon and Read, 1998) ........................86
Table 5.5 Belgium SICAFIs (as at 29 June 1999)...............................................................88
Table 5.6 Average Daily Volume – SICAFIs.......................................................................89
Table 5.7 European Pension Funds: Real Estate Weightings, 1998 ....................................89
Table 7.1 Country of origin of respondents ........................................................................94
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Table 7.2 Location of real estate investments owned or managed by respondent organisations94
Table 7.3 Breakdown by sector of UK direct real estate investment from overseas ................95
Table 7.4 Use of direct and indirect investment vehicles by overseas investors. ....................97
Table 7.5 The most important factors for allocating funds in UK real estate investmentsuggested by UK respondents............................................................................98
FIGURES
Figure 2.1 UK Direct investment flows ................................................................................9
Figure 2.2 UK Portfolio investment flows .............................................................................9
Figure 2.3 UK net international position ............................................................................10
Figure 2.4 UK and Foreign Property Holdings....................................................................10
Figure 2.5 GPR Indices 1983-98 ......................................................................................13
Figure 2.6 Global public real estate markets (source Jones Lang Wootton, 1999).................15
Figure 2.7 International real estate securities (source Jones Lang Wootton, 1999)................15
Figure 2.8 Overseas Investment in the UK (source: DTZ, 1998a) .........................................16
Figure 2.9 Returns from Irish Property Investment compared with other EU countries 1989-9823
Figure 2.10 European cross-border office investment in 1998..............................................25
Figure 2.11 European cross-border retail investment 1994-1998..........................................25
Figure 2.12 Total returns 1989-98, 1997 and 1998 (source: IPD) .........................................30
Figure 3.1 Growth of Annual Market Capitalisation in REITs (source: www.nareit.com)..........37
Figure 3.2 Stages of REIT growth (after Mueller, 1998).......................................................38
Figure 3.3 Equity REITs: Total Monthly and Annual Return 1988-98 (based on NAREIT Index)42
Figure 3.4 The main REIT investors ..................................................................................45
Figure 3.5 REIT institutional investors - Simon DeBartolo Group .........................................46
Figure 5.1 Effective marginal tax rates ..............................................................................72
Figure 5.2 Net present value of depreciation allowances .....................................................72
Figure 5.3 The ‘tax wedge’ ..............................................................................................73
Figure 5.4 Corporate tax rates .........................................................................................73
Figure 5.5 Taxation on capital / financial transactions as a percentage of total taxation, 1996(source OECD)..................................................................................................74
Figure 5.6 Taxation on capital / financial transactions as a percentage of GDP, 1996 (SourceOECD) .............................................................................................................74
Figure 5.7 Property taxation as a percentage of total taxation, 1996 (source OECD).............75
Figure 5.8 Property taxation as percentage of GDP, 1996 (source OECD) ...........................75
Figure 5.9 USA Limited Partnership (after Soares, 1996)....................................................81
Figure 5.10 Comparison of After Tax Returns ....................................................................85
Figure 7.1 Attractiveness of investment determinants in the UK for overseas investors. .........95
Figure 7.2 Attractiveness of UK taxation components to overseas investors.........................96
Figure 7.3 Attractiveness of investment determinants for American, Dutch and German clientsof UK investment managers/advisers. ..................................................................98
VII
Figure 7.4 Attractiveness of taxation components for American, Dutch and German investors inUK real estate as viewed by UK investment managers/advisers. ............................99
Figure 7.5 Perceived deficiencies in UK indirect real estate investment market.....................99
VIII
EXECUTIVE SUMMARY
Why this research?
This research was undertaken to seek answers to two questions of mountinginterest to all those who invest in commercial property:
n Do foreign investors in UK property enjoy tax or other advantagesover UK property companies which enable them to outbid their UKcompetitors?
n If such advantages do exist, how can UK property companies redressthe balance and compete in future?
What are the findings?
Four main conclusions are drawn from the evidence:
n UK property companies suffer from a lack of liquidity which arisesfrom double taxation of their income and the discount to net assetvalue at which their shares trade on the stock exchange.
n Serious inequalities exist between the main asset classes,particularly in terms of their tax treatment and overall transactioncosts. Tax differentials distort investment markets and run counter topolicies aimed at improving efficiency and economic welfare. In thisrespect, property lies at a disadvantage compared with other assets.
n The UK tax regime offers a clear competitive advantage to overseasinvestors in the UK, who enjoy both a lower overall burden of taxationhere and some tax discrimination in their favour. Their interest in theUK market, however, makes a significant contribution to its liquidity.
n The trend towards indirect investment in property through REIT-typecompanies, limited partnerships and other securitised vehiclesenjoying tax transparency could well lead to the future demise of theUK property company.
Why do we need property companies?
Property companies offer an investment channel which no other type oforganisation has so far matched.
Investors benefit from management expertise in asset selection, resulting inportfolios of high quality properties. Gearing, which raises returns in a waythat the regulations governing REITs and similar vehicles do not permit,provides additional benefits, as does the liquidity of stock marketinvestments.
Property companies have also performed a crucial role in propertydevelopment and investment in the overall economy.
To remain in business, however, property companies have to earn returnsabove those of their competitors in order to redress the imbalance betweentheir tax burden and that of their overseas competitors.
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What are the attractions of the UK property market for foreigninvestors?
The mid to late 1990s have seen mounting interest from overseas in UKproperty, which in this period was the most popular European destination forproperty investors. Germans were attracted by UK lease structures andmarket characteristics. US investors have come for risk-adjusted returnswhich were higher than those obtainable in the US market. Other investorscame for the stability of the market, familiarity of the culture and the strengthof the economy.
Generally the prime attractive force has been the quality of the market, and inparticular the depth and sophistication of the London property market.
Once an investment decision has been made, overseas investors benefitfrom a liberal tax regime. Levels of corporate and personal taxation in the UKare perceived as among the lowest in Europe, and specific features of thetax system favour the overseas investor.
Further benefits have arisen from double tax treaties leading to ‘treatyshopping’, inter-state differences in thin capitalisation rules, and the ability tofinance investment in the UK from abroad. There are therefore effective taxshelters for UK rent income.
How are investment markets distorted?
A wide disparity now exists between the duty levied on UK propertytransactions and that borne by transactions in other assets. This hascertainly contributed to the popularity of the equity market generally, andbears some responsibility for the inflation of share prices.
Higher transaction costs reduce liquidity as transactions become morewidely spaced. Liquidity is further reduced where overseas investors aredeterred by the premium they have to pay. Incoming US investment isparticularly hit by the rise in UK stamp duty, a more sensitive issue forAmericans since there is no federal tax on property transactions.
The rise in transaction costs has contributed to the difficulties of UK propertycompanies in raising new capital, as the liquidity of their shares has declined.
The relative tax burden on property transactions is higher in the UK thanelsewhere in the EU. For transactions in financial assets it is currently one ofthe lowest.
Is the UK a tax haven for foreign property investors?
The report concludes that the UK offers some special tax advantages toforeign investors. This occurs partly because the rates of corporate taxationgenerally are lower than those elsewhere and partly because foreigninvestors enjoy significant concessions.
Some UK tax arrangements give preferential treatment to non-residentinvestors. Immunity from capital gains tax and the freedom to set interest onnon-UK borrowing against the withholding tax on rental income are leadingexamples. The profits from land deals enjoyed by non-resident trading
X
companies are also protected from UK corporation tax by double tax treatiesor through the issue of discount bonds
Overseas investors in UK property can exploit offshore vehicles. Limitedpartnerships of US investors enjoy tax advantages by investing throughcontrolled companies in the UK. The UK itself is a tax-efficient, offshorelocation for investment in other countries, particularly those of the EU.
The attractions of a tax-efficient UK market for non-resident investors bringgreater liquidity, serving the interests of UK resident investors, but give non-residents a competitive edge in bidding for properties.
Why securitisation?
Improved property market liquidity in the UK awaits the emergence of a largetax-transparent vehicle issuing securities tradable in secondary markets to awide investor base. Limited partnerships do not perform this role fully in thattheir investor base has been restricted and their ‘shares’ are non-tradable.Future reform may address these problems.
Treasury reluctance to support legislation sanctioning such vehicles in theUK has been a further reason for the institutions’ disenchantment withproperty. Without a resurgence of the institutions’ interest, the UK propertymarket will continue to be starved of liquidity.
Although large tax-transparent REIT-type vehicles might reactivate theinterest of UK institutions in the property market, the models researchedhave some limitations. Gearing, investment portfolios, share ownership, andprofit distribution are governed by tight restrictions. The stock marketperformance of REITs and SICAFIs also appears to be more volatile and torequire higher returns than that of the market as a whole.
How will EU tax harmonisation affect property markets?
Despite the decline in the value of the euro, the use of the single currencyhas lowered transaction costs and promised to expand cross-border tradeand investment flows. In turn this gives rise to a move for tax harmonisation.
Any future EU tax harmonisation policy which raises UK taxes to a higherEuropean norm might reduce the levels of inward investment, with furthereffects for liquidity.
There is reason to believe that rate revisions could well be upward. Theunreconstructed social welfare economies of continental members requirehigher tax rates than those of the UK to maintain their levels of socialsupport, certainly in times of economic stagnation. The attempt in 1999 toraise the UK withholding tax on interest payments from zero to 20% offersanother indication of this trend.
What is the future for property companies?
Currently, property companies in the UK are disadvantaged by thedifferentiating tax regimes applied to corporate and unincorporatedinvestment organisations. In the absence of strong institutional interest,property development and investment depend more heavily on their
XI
entrepreneurship. Their tax status, however, exacerbates their difficulties inraising new capital
The research suggested that barriers between European markets wouldcontinue to fall and pan-European tax-efficient securitised investmentvehicles would emerge. These might still be subject to the kind of restrictionsthat control REITs and SICAFIs.
In this environment a strong view in the research was that listed propertycompanies, fewer in number, could operate alongside such vehicles,focusing more on development, redevelopment and refurbishing, andexploiting the new profit opportunities these vehicles offered.
Future property investors would probably have to be more client-oriented,since accounting and business changes were pointing to a more flexibleproperty market.
How was the research carried out?
This independent research was carried out by the College of EstateManagement, Reading, during 1999–2000 and comprised the followingstages:
n Postal questionnaire survey of overseas property investors from USA,Germany and the Netherlands, and UK-based property advisers;
n Face-to-face interviews with real estate specialists from a variety ofdisciplines; and,
n Two focus groups with specialists in the field to address key researchquestions.
The research was funded by Helical Bar, Grant Thornton and Mishcon deReya under the auspices of the Investment Property Forum.
1
1 INTRODUCTION
1.1 BackgroundForeign investors enjoy unfair tax advantages over indigenous companieswhen investing in UK property – is this true and, if so, can anything be doneabout it? These are the questions that sparked off research by the College ofEstate Management, starting in 1997 and resulting in this comprehensiveexamination of comparative tax regimes and real estate investment flowsacross the UK, Europe and the US.
The economic and financial environment of UK property investment anddevelopment has been changing rapidly in recent years, creating moreuncertainty than usual in the industry. Much of the change has been clientdriven, the consequence of the institutions’ declining interest in property.
This trend has been counter-balanced by growing interest in the UK marketshown by overseas investors. For property companies, changes in financialreporting standards, recently introduced and in the pipeline, have causedconcern for their effects on profit statements and balance sheets. UK bankshave shown extreme caution in their approach to lending, following their £40billion exposure to property in the early 1990s.
Pension funds in particular have adopted a more cautious approach for anumber of reasons. For them the biggest problem has been the illiquidity ofproperty as an investment, highlighted in the collapse of the market in the early1990s. The success of government in taming inflation, if only for the present,has also affected property’s perceived value as a hedge against inflation. It isstill far from clear to what extent the ability of direct property investment tomatch long term liabilities will suffer. The 1995 Pensions Act requiredmanagers to value their pension liabilities by reference to gilts and equitiesonly, omitting property from the calculation. This implied that property is not agood match for pension liabilities, even though the funds themselvesacknowledge it is.
The progress of financial deregulation both in the USA and in leading EUcountries also has stimulated overseas real estate investment by banks andmutual funds alike.
The European single market, the Exchange Rate Mechanism (ERM) and itssuccessor, European Monetary Union (EMU), have reduced, or have beenpredicted to reduce, the costs and risks of European cross-border investmentflows. For example, some argue it is likely that the euro will increase cross-border investment by reducing currency risk, which in turn will generateinternational expansion from companies based inside and outside ‘Euroland’(Branson,1999).
It is also likely that the drive to integrate stock exchanges and futures marketsin Europe will simplify and reduce the cost of borrowing. Falling transactioncosts are also likely during a drive towards a more transparent real estatemarket. Indeed, a European Society of Chartered Surveyors (ESCS)conference in 1998 suggested the euro would lead to easier cross-bordercomparison of investment conditions, leading to a convergence of propertyyields and cycles and resulting in greater pressure on governments to
2
harmonise taxes. The benefits of international portfolio diversification should,therefore, be more readily available.
However, country-specific restrictions and barriers still operate, as identified ina report on foreign direct investment by the Economist Intelligence Unit (EIU,1998). Global harmonisation of property markets and standardisation of rulesand regulations (including differences in valuation guidelines) governing realestate are essential steps, therefore, to boost investor confidence andpromote transparency in the regimes which govern cross-border real estateinvestment.
Outside Europe, in the USA, banks and syndicated funds have greaterfreedom both in attracting funds and in portfolio building. For UK propertyinvestors the emergence of new competitors, employing new financingmethods, presents certainly a challenge, if not a threat. Furthermore, suchcompetition often enjoys tax advantages denied to UK operators.
To complicate the situation further, as the College’s previous report (CEM,1998) pointed out, UK property companies are faced with the introduction ofnew accounting standards affecting the capitalisation of interest ondevelopment loans and the valuation and depreciation of fixed assets.Changes in the Corporation Tax regime, in particular the scrapping ofAdvanced Corporation Tax, will affect cash flows: a problem for all companies,but more significant for the highly geared. Some compensation might be hadin an extension of capital allowances, but there is little indication that theTreasury will make concessions in this area.
1.2 Aims and objectivesThe aims of the research were therefore to compare the treatment ofdepreciation, tax and accounting of UK property companies with similarcompanies and investment vehicles (including Real Estate Investment Trusts(REITs)) in the USA and EU. The research was designed to determinewhether UK property companies are disadvantaged in terms of the tax andaccounting regimes currently applicable.
In addition, the research had the following related objectives:
n To examine the nature, extent and reasons for direct and indirectoverseas property investment in the UK
n To explain the present legal and regulatory framework governing theaccounting and tax treatment of commercial property investments inthe UK;
n To compare present UK regulation and practice with that currentlyprevailing in the USA and Germany;
n To identify the taxation and financial reporting issues raised by thediffering treatments;
n To compare the effects of the existing treatment of depreciation onproperty development and investment in each of the three countries;
n To summarise the tax advantages of overseas investment in the UK.
3
1.3 MethodologyTo address these aims and objectives, a three-stage methodology wasadopted, comprising:
n Postal questionnaire survey of overseas real estate investors andfinanciers and their UK based advisers. The purpose of this was toextend and update the work undertaken;
n Structured interviews with leading experts in the field; and,
n Focus groups, comprising roundtable discussions with leadingoverseas and UK-based experts.
1.4 Format of the reportThis report comprises three parts as follows:
1.4.1 Background and Literature ReviewThis part of the report examines the contextual background and relevantliterature. In particular, it seeks to establish the main financial reporting andtaxation issues relating to the depreciation of commercial buildings in the UK,USA and Germany.
The background and literature review therefore comprises:
Section 2: which provides a survey and analysis of recent overseasinvestment in the UK property market. In particular, the size and type ofthese flows are established, and the role of taxation and other propertyinvestment determinants discussed against the background of US,German and other foreign property investment in the UK.
Section 3: which examines the financial architecture of real estateinvestment institutions in the USA and Germany. This provides anoverview of US REITs, their evolution and attractions for various investorstogether with German closed and open-end funds.
Section 4: which provides an overview of financial reporting requirementsin the USA, Germany and France, with particular reference to the valuationof tangible fixed assets and the tax treatment of investment properties. Italso examines the relationship between taxable and accounting profits andthe treatment of property depreciation in the UK, Germany and USA.
Section 5: which provides a summary of the main tax advantages foroverseas property investors in the UK. Comparative tax regimes areexamined and OECD data analysed. The effects of taxation oninternational investment flows are also described, and the growth ofvarious types of property investment included.
1.4.2 Methodology and ResultsThis part describes in more detail the research questions posed and theresults of the research. It comprises:
Section 6: which discusses the aims and objectives of the research, andoutlines the three-stage methodology (postal questionnaire, interviews andfocus groups).
Section 7: which provides a summary of the postal questionnaire survey.
4
Section 8: which provides a summary of the interviews.
Section 9: which provides a summary of the focus groups.
1.4.3 Conclusions and SummaryThis provides (through Section 10) the overall conclusions to the report.
5
2 INTERNATIONAL PROPERTY INVESTMENT ANDDEVELOPMENT IN THE UK
2.1 IntroductionThere is no doubt that the deregulation, expansion and integration ofinternational financial markets, together with structural changes in theinternational economic and political systems, have led to the ‘globalisation’ ofinvestment markets.
Although international diversification is a relatively new idea for real estate,however, this is not so for other asset classes. As Eichholtz and Koedijk(1996) point out, in 1774 the first-ever mutual fund was established inAmsterdam. The modern age of international diversification, however, beganin the 1970s, following the demise of the Bretton Woods system (which hadcontrolled regulated capital flows), and further deregulation. These changeswere reinforced by new developments in financial economics, as portfoliotheory provided a conceptual basis (supported by empirical studies) whichshowed that internationally diversified investments could lower portfolio risk(eg. Solnik, 1974).
Therefore, during the 1980s and 1990s international portfolio diversificationhas become increasingly popular, both through direct property investment anddevelopment, and indirect investments, such as property company sharesand REITS.
This section of the report provides the context and background for whatfollows by focusing on:
n the growth of direct and indirect overseas property investment in theUK commercial property market;
n the share of German and US property investors in the UK market;
n the rationale for international investment diversification;
n the attractions of international property investment; and,
n direct property development and joint ventures.
2.2 Foreign direct investment (FDI)
2.2.1 Background and growth of FDIAlthough international property ownership is not new, its growth has been at itsmost rapid during the 1980s and 1990s. Often direct investment overseas hasbeen made by financial institutions, banks or property companies holdingdirect equity stakes in land and buildings on their own, or in joint ventures withlocal partners. Indeed this is part of the rapid growth in FDI since the 1980s.
During the late 1990s inflows and outflows of FDI involving OECD countriesreached unprecedented levels. In 1997, for example, firms from OECDcountries invested $382 billion abroad, over 32% more than the previous year,and the same member countries received $257 billion in new foreigninvestments, up by 19% on 1996.
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The OECD defines FDI as capital invested for the purpose of acquiring alasting investment in an enterprise and exerting a degree of influence on thatenterprise’s operations. This is different from portfolio investment, whichinvolves buying assets to earn a rate of return, without acquiring any control ofthe institution. The control by an investor of 20% or more of the share capital isthe criterion used in the UK.
Historically, despite global outward FDI falling in the early 1990s, there hasbeen a long-term rise in global FDI which has therefore become the engine forgrowth in the world economy. Between 1983 and 1990 global FDI grew at28.9% per annum (three times the rate for world trade and output).Christodoulou (1996) cites the main reasons for this growth as:
n strong economic performance in the 1980s;
n investment prior to the EU;
n strong corporate balance sheet; and,
n deregulation in domestic markets, forex controls and FDI regimes.
The integration of national financial systems into a single global financialsystem is represented by more diversified investment portfolios, largernumbers of firms tapping into foreign sources of funds and the growth ofexpert asset managers on the look-out for arbitrage opportunities (IMF 1998).Gross flows and net flows of capital have increased dramatically since 1970.For example, Table 2.1 shows a 32 times increase in FDI and a 200 timesincrease in portfolio investment since 1970.
Table 2.1 Major Industrial Countries (G7): Gross Flows of FDI and Portfolio Investment($billion)
1970 1975 1980 1985 1990 1995 1996 1997
FDI 14.45 34.25 82.82 75.94 283.24 369.01 357.53 448.32
PortfolioInvestment
27.10 60.93 233.44 329.63 764.34 1162.64 1040.19
Cross-border trading in securities is also an important element of this: forexample in 1975 transactions in bonds and equities were just 5% of GDP; by1997 they were between 1 and 7 times GDP in the major industrial countries.Indeed half of all equity transactions in the EU take place outside the homecountry.
Other facets of this globalisation include the following:
n international issues of equity have increased almost six-fold forcompanies located in industrial countries;
n outstanding issues of international debt securities have also growndramatically: in early 1998 $3.7 trillion worth of international bondscompared with $0.6 trillion in 1985; and,
n forex turnover has increased six-fold since 1986.
In summary, national financial markets have become increasingly integratedinto a single global financial system.
7
Problems and inconsistencies in international data definitions mean that thedividing line between FDI and portfolio investment flow is often arbitrary.Nonetheless, data from the OECD suggests that the United Kingdom is amajor source and host country for FDI (Table 2.2).
Table 2.2 FDI Flows 1990-1996 (Source, OECD, 1996)
Outflows$million
Inflows$million
United States 423,437 United States 336,343UK 186,429 China 156,342France 182,049 UK 139,917Japan 173,671 France 126,390Germany 166,071 Belgium – Lux 71,483
This is supported by 1997 OECD data, which suggests the USA and the UKwere the most prominent source and host countries for FDI, representingalmost one half of inflows and outflows for the OECD area.
Direct investments in real estate are part of FDI (ONS, 1998). Indirect propertyinvestment, through the purchase of equity and debt securities, is counted asportfolio investment, however.
2.2.2 UK National Accounts and International InvestmentPosition of the UK.An examination of the UK’s national accounts reveals that in the period 1987–1997 the UK experienced negative net investment (i.e. UK investment abroadexceeded foreign investment in the UK). Over this period gross investmenttransactions increased significantly: from 1987–1992 total outward investmentaveraged less than £70 billion per annum, but from 1993–1997, £150 billionper annum.
Figures 2.1 and 2.2 show the inward, outward and net flows for direct andportfolio investments. Portfolio flows are seen to be more erratic, the result ofgreater liquidity in stock and bond markets.
Interestingly, the UK has always had a strong portfolio investment presenceoverseas. One explanation of this is the existence of a large pension fundsector in the UK. In 1993, for example, stocks of independent pension fundswere valued at $726 billion (70% of GDP), far greater than any other country.The HM Treasury Report (1996) on ‘Overseas Investment and the UK’ foundthat average pre-tax returns on UK pension funds were 10.8% between 1983and 1993 (higher than the USA, Germany, Japan and Canada in the sameperiod), which is largely due to:
n greater international diversification of pension funds compared to theirforeign counterparts;
n higher regulation in the UK than elsewhere, and
n the long-term nature of their investment strategies.
The International Investment Position (IIP) is the balance sheet of the stock ofexternal financial assets and liabilities, and is a measure of the net financialworth of the UK. In most years, UK overseas assets have exceeded their
8
overseas liabilities, but in 1997 a record net liability of £33.7 billion wasrecorded.
As a proportion of UK assets total direct investment abroad has remainedfairly constant at 13% between 1987–1997 but portfolio investment since 1993has generally comprised about one third of the total assets. For UK liabilities,the split was 10% of value for direct investment, and 25% for portfolioinvestment (Figure 2.3).
The important role of property holdings in direct investment in the UK is alsoshown in Figure 2.4. This shows property holdings as a percentage of equitycapital and reinvested earnings for direct investment both abroad and in theUK. As can be seen, property holdings contribute a more significant proportionto balance sheet value for foreign investors in the UK (i.e. in the range of 7–9.5% for the period 1987–1997) than for UK investors abroad.
2.2.3 Determinants of International Capital FlowsAs the Ruding Report (1992) pointed out, the basic function of the internationalcapital market is to bridge the gap between aggregate saving and aggregateinvestment in individual countries. A country will be a net capital importer ifinvestment opportunities in the country are favourably perceived and/or thenational savings/national income ratio is relatively low.
Capital flows among countries may take the form of portfolio investment ordirect investment. The factors involving these two types of flow are likely todiffer significantly, however. International portfolio investment involves thepurchase of securities issued in a foreign country. Therefore, in the absenceof institutional barriers and with perfect information about investmentopportunities, portfolio investors will tend to invest abroad rather than at homeif (at a given level of risk exposure) the net return to foreign investmentexceeds the net return on domestic investment. In this way internationaldiversification may enable them to reduce the work on their portfolios.
In contrast, FDI flows are likely to be influenced by decisions to exploit specificbusiness opportunities in particular markets. This often occurs when thespecific competitive advantage of a business enterprise dictates organisingproduction through a multi-plant firm and locating a plant abroad rather than athome.
It is therefore likely that there will be a number of factors that influence bothportfolio and direct investment flows. These may include:
n net return differences;
n legislative/cultural differences; and,
n taxation differences.
The same will hold true for real estate investments that go to make up bothtypes of flow. The question remains therefore: how important really is taxationin affecting international investment flows?
9
Figure 2.1 UK Direct investment flows
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Figure 2.2 UK Portfolio investment flows
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Figure 2.3 UK net international position
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Figure 2.4 UK and Foreign Property Holdings
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2.3 Direct and indirect property investment anddevelopment
2.3.1 The size of the marketsThe Economist Intelligence Unit (EIU, 1998) suggests FDI grew by 40%between 1993 and 1995 and now runs at an annual rate of $400bn, of whichmore than 40% is accounted for in the EU. Although it is difficult to compileaccurate data, Eurostat statistics show inward investment in real estate in theEU running at about 10% during the 1980s and early 1990s.
The various players in the international investment market differ in theirmotivations and aspirations. Corporates may be concerned with operational orstrategic factors; short term investors with higher returns than in their owndomestic markets; and longer term investors with portfolio diversification andhigher risk-adjusted returns. In Europe strategies for institutional investorsmay be to outperform the peer group (e.g. Standard Life Investments and thePrudential’s strategy) or to adopt a more Pan-European approach.
In terms of choice, investors need to balance their requirements for direct orindirect assets. The choice lies between acquiring an interest in the freeholdor leasehold of a building and the purchase of the property-backed paper of aproperty investment vehicle. In the one the transaction and management costsare likely to be relatively high and the risks undiversified. In the other taxtransparency is lacking and the equity is more often at a discount to underlyingasset values. In general these options attract different types of investor.
International investors, property companies and other institutions may also beinvolved in direct property developments overseas, particularly through jointventures or equity swaps. A recent example is the announcement of acooperation agreement between Development Securities and Dutch developerMAB. This follows the December 1998 5% equity swap between Spanishproperty company, Prima Immobiliara, and the quoted German group, RSEGrundbesitz. Whilst important, these are, as yet, small-scale mergers ratherthan the creation of new pan-European companies.
The size and extent of the commercial real estate markets show theimportance of UK, France and Germany in Europe (Table 2.3). The relativecontinental positions are shown in Table 2.4.
As far as indirect property vehicles are concerned, Ball et al (1998) suggest auseful classification:
n Equity vehicles, which include:
n property company shares;
n Real Estate Investment Trusts (REITs);
n other collective investment vehicles (such as Property Unit Trustsand Authorised Property Unit Trusts); and,
n securitised single asset vehicles such as PINCS, SPOTS andSAPCOs.
n Debt vehicles such as: Commercial Backed Mortgage Securities(from the USA); and,
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n Property derivatives, such as London Fox (now defunct) and BZW’strio of PICs,PIFs and PINs.
Table 2.3 Global Markets of Commercial Real Estate
WesternEurope
Population(millions)
GDP($ bn)
GDP percapita ($)
Populationper square
mile
CommercialReal Estate
($ bn)Austria 8.1 210 25,864 252 38.6Belgium 8.3 245 24,000 874 43.9Denmark 5.3 173 32,686 322 33.9Finland 5.2 121 23,542 43 21.0France 58.9 1,414 24,011 278 252.4Germany 82.3 2,116 25,727 622 390.0Greece 10.5 120 11,390 210 16.5Ireland 3.7 75 20,416 134 11.7Italy 27.6 1,169 20,293 507 192.4Netherlands 15.7 375 23,864 1,195 65.5Norway 4.4 144 32,685 37 29.6Portugal 9.9 108 10,890 279 14.0Spain 39.3 550 13,980 204 80.1Sweden 8.9 228 25,742 56 42.2Switzerland 7.2 262 36,621 472 54.5Turkey 64.7 198 3,058 213 16.2UK 59.1 1,416 23,945 628 273.2(Sources: Economist Intelligence Unit and Prudential Real Estate Investors)
Table 2.4 Regional Distribution of Higher-Grade Commercial Real Estate
GDP($ bn)
Percentof total
Higher-gradecommercial real
estate ($ bn)
Percentof Total
Asia excl. Japan 2,693 9.8% 312 6.8%Japan 4,103 15.0% 784 17.1%Western Europe 8,956 32.7% 1,576 34.4%Eastern Europe 636 2.3% 46 1.0%Latin America 1,810 6.6% 177 3.9%US and Canada 8,664 31.6% 1,598 34.9%Others 562 2.1% 82 1.8%Total 27,424 100.0% 4,575 100.0%(Source: Economist Intelligence Unit and Prudential Real Estate Investors)
Quoted property companies are one of the most important groups of investors– developers – and are investment vehicles in their own right. ’Superleague’property companies developed after the Dutch became the first to create theidea of an international property company. They did so by taking advantage ofregulations that allowed them to operate with tax transparency, provided theydistributed all their income. Prime examples are Rodamco and Wereldhave.Although this route into property does not offer tax transparency, it does offerthe liquidity of stock exchange trading. Open and closed-end funds alsoprovide opportunities for international investment and REIT-style vehicles havedeveloped in the Netherlands, Belgium (SICAFI) and Spain.
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Figure 2.5 GPR Indices 1983-98
Four important indices for comparing international real estate securities are:
n Datastream’s Global Indices;
n LIFE’s Global Real Estate Securities Index;
n Morgan Stanley Capital International Property Share Index; and
n Saloman Brothers World Equity-Index Property.
Each differs considerably with regard to construction, representativeness,international consistency and performance, but it is clear that they show asubstantially increased global market capitalisation, from £20 billion in the mid-1980s to £438 billion in September 1998.
Figure 2.5, which is derived from the GPR index (at www.gpr.nl), shows thispattern in detail. There is also clearly a cyclical pattern to the global indexshown in the graph with strong growth from 1983–87, but with levelling off andsubsequent slump from 1989–92. Further growth occurred from 1992 but thena further slump, triggered by the collapse in Far Eastern property markets in1997.
Focusing on the European property share market, it is clear that after theslump of the early 1990s a full recovery took place. Real estate portfolios arecurrently valued at pre-slump levels, and as sales of property portfolios nolonger involve write-downs, real estate has become more liquid (GPR, 1998).
Property portfolios are also being traded at a higher rate than before, and thisoften involves the listing of new property companies, which have emergedfrom the portfolios acquired by banks during property-related loan defaults. Inthe view of GPR (1998) this has led to restructuring in many Europeanmarkets. Property companies have changed their strategies to become moregeographically and sectorally focused. The Top Ten European propertycompanies, by size of market capitalisation, are shown in Table 2.5.
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In the UK the combined market capitalisation of listed property companies was£14bn in 1995 (2% of the total UK stock market capitalisation) (IPF, 1995). Atthat date the sector included about 135 individual companies, with the tenlargest accounting for 70% of the sector by value. The early 1990s saw thedisappearance of most developers/traders from the sector that is dominatedby property investment companies with a large institutional investment shareregistration.
Currently European property companies account for about 30% of theworldwide property share market capitalisation, in comparison with the NorthAmerican market that equates to 40% of the total. The larger share is due tothe boom in REITS during 1993 and 1994 in the USA. In the Far East, althoughproperty companies were the largest share of total market capitalisation in1996 at 55%, they have now fallen back dramatically to 24%, as a result ofeconomic crisis there.
Table 2.5 Top Ten European Property Companies (source: GPR, 1998)
Rank Market Capitalisation(US$ Mn) at June 1998
Company Country
1 8743.40 Grundwert-fonds Germany
2 8512.61 Land Securities UK
3 6005.83 DIFA-Fonds Nr 1 Germany
4 5306.21 Brtish Land Company UK
5 5001.69 Grundbesitz-invest Germany
6 4475.68 Rodamco Netherlands
7 4455.05 Despafonds Germany
8 4253.09 Haus-invest Germany
9 3689.09 MEPC UK
10 3002.52 iii-Fonds Nr 1 Germany
The growth of real estate securities is a global phenomenon, as indicated byFigure 2.6. This shows the public real estate market size in billions of $US asat October 31 1997. The type of market varies between investment trusts andproperty companies, as shown by Figure 2.7. For example, propertycompanies dominate in the UK, whereas investment trusts dominate in theNetherlands.
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Figure 2.6 Global public real estate markets (source Jones Lang Wootton, 1999)
Figure 2.7 International real estate securities (source Jones Lang Wootton, 1999)
Investment Trust Property Company
Australia n l
Canada n l
Germany n l
France n
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n Dominant l Small Sector
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2.3.2 Overseas property investment in the UKPerhaps the most comprehensive source of data on direct overseas propertyinvestment in the UK is published by DTZ in their annual ‘Money into Property’report (1998a and 1999).
For example, the 1998 and 1999 reports included a number of importantstatistics, as shown in the following sections.
2.3.2.1 Sources
n During 1997 gross overseas direct investment in UK commercialproperty (including outright purchases of property companies) was£4.15bn, twice that of 1996 and highest annual total recorded. Althoughthis fell to £3.2bn in 1998, it was nearly one-third above the ten-yearaverage (Figure 2.8).
n From 1997 to mid 1998, investment from non-UK sources accountedfor more than 20% of all property transactions by value.
n German investors were the most important in 1998 and havedominated since 1992 with open-ended funds being the dominantplayers. During 1998, however, US investors (30% of overseasinvestment or £990m) formed the largest group.
n US involvement is important in both the indirect and direct markets.The growth in REITS has fuelled this.
n Middle East and Far East investment reached a peak in 1997 (£740Mand £470M respectively). The latter has now fallen back.
n Other important sources of investment include Netherlands andSweden (eg Dutch Rodamco)
Figure 2.8 Overseas Investment in the UK (source: DTZ, 1998a)
2.3.2.2 Loan finance
n There is a growing amount of lending by ‘unauthorised’ overseasbanks, such as the German mortgage ‘Hypothekenbanken’ and state-owned ‘Landesbanken’, that have representative offices or branches inthe UK. These banks had an outstanding debt of $2.8 bn by the end of
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1997, driven by capital raised in the bond markets with low rates ofinterest. A total estimate for all such overseas lending is £4.5 bn.
2.3.2.3 Location
n 1988–96: London purchases were 80% of all overseas investment inUK. However, since 1997 the figure has dropped to 60%. Overseasinvestors are now also interested in the regions, because of limitedinvestment opportunities in London.
2.3.2.4 Sector allocation
n There is evidence of a strong, recent emphasis on retail, away fromoffices – especially shopping centres.
2.4 Investors into the UKThe Germans, Americans and Irish are now major players in the UK propertyinvestment market. The extent and nature of their property investments anddevelopments in the UK are now examined.
2.4.1 German investorsGerman investors have dominated investment from overseas in the UK since1992, driven particularly by the large amount of purchasing power from open-end funds. From 1991–1997 their annual investment in the UK averaged inexcess of £700 million, with totals of more than £1 billion in 1996 and 1997.The DTZ report highlights the extent of deals made outside Central London in1997, for example:
n £56 million purchase of Marlowes shopping centre in HemelHempstead (Despa Europa);
n £36 million acquisition of offices in South West (Baveria Objekt undBaubetruung);
n £100 million development funding of 100 Wood Street, EC2 (Despa).
May and June 1998 brought indications of a German exodus from London,fuelled by Gerald Ronson’s buyout of Deutsche Gesellschaft furImmobilienfond’s (DEGI) central London portfolio, for £430 m. However, otherevidence suggested German funds were still very active in London,strengthened by relative movements in the sterling/deutschmark exchangerate. For example Despa’s £140m forward funding of Helical Bar’s ChiswellStreet EC1 office development.
Field (1994) made a detailed study of German property investment in the UK.He suggests the market is dominated by four main types of investor:
n open-ended property funds;
n private individuals;
n closed-end property funds, and
n commercial banks.
The most important of these are large open-ended funds with low liquidity.Their limited availability to institutional and especially international investorshas made it very difficult to invest in these funds. In addition the ‘bid–ask’
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spread, which is determined by the funds, usually exceeds 5%, making themilliquid and unattractive. These domestic restrictions and adverse investmentconditions in the German real estate market have meant the open-endedfunds have looked overseas for additional real estate investment opportunities.
To maintain their tax-exempt status they have to comply with a number ofregulations that include a minimum cash level of 5% total value and maximumof 49%. They must also keep investment outside Europe to 25% of total value.
The more liquid closed-end funds (the Aktiengesellschaften, or AG) are mainlydevelopers. However, a new trend is the growth of property investmentcompanies which have evolved from property-rich manufacturing companieswhich have shed their original operations while retaining and expanding theirproperty portfolios. These may become the core of the future German propertyshare market. AGs are taxed as an ordinary company and pay 31%–47%corporation tax.
In terms of summarising the basic difference between open and closed-endfunds therefore, the following distinctions apply (Table 2.6).
Table 2.6 Open and closed-end funds
Open-end Funds Closed-End Funds
Funds issue new shares to investors Fund establishes set number of sharesand does not issue new shares
Funds redeem shares when investorswant to sell
Fund does not redeem shares; tradeoccurs on exchange
Shares ‘trade’ at net asset value Shares ‘trade’ at market prices
Buy/sell transaction occurs betweenfund and investor
Buy/sell transaction occurs amongshareholders on exchange
Field (op cit) suggests that the German property investment market isrelatively immature in comparison with the UK, and that the following attributeshave attracted German investors and developers to the UK:
n relatively longer lease lengths in UK than Germany;
n less frequent options to determine a lease;
n attractions of FRI lease in the UK, and
n leasing/transaction costs lower in the UK.
Basing his research on a series of structured interviews, he found that themost important investment criteria included location, covenant strength, yieldand pricing and lot size. He also stresses the importance of a ‘positiveinvestment climate’ in the UK, particularly in relation to relative tax treatment ofincome and capital and relative currency movements.
German investors in the UK, for example, are subject to a tax treaty whichensures that they are assessed for tax in the UK and cannot be taxed anyfurther in Germany on their UK source of income or capital. There are alsolower marginal rates of UK taxation compared with Germany.
It is also interesting to note that German banks have been keen lenders onproperty in the UK. The mortgage banks, in particular, have sought to financeloans in the UK through the issue of Pfandbriefe, or mortgage-backed bonds,
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which use a pool of underlying property assets as collateral. This lendingexpansion was assisted by 1994 legislation in the UK which put foreignlenders on an equal footing with their UK competitors by allowing non-UKclients to treat foreign loan interest as a tax-deductible expense. A furtheradvantage of a Pfandbriefe is that it carries an equity rating of 50% asopposed to 100% for all other commercial loans, effectively doubling the returnon equity for the same interest rate margin.
2.4.2 US investorsAs Edgley and Marks (1998) point out, during the early 1990s there was little, ifany, US property investment activity in Europe. The experience of JMB Realtyand Olympia and York, allied with the crash in US real estate market and avast US domestic oversupply with higher levels of debt, concentrated USinvestors minds dramatically. In 1994–95, however, the US market revivedstrongly.
This was reinforced by the Bush administration’s reinvigoration of the $20trillion US real estate sector. Banks and institutions were forced to put theirnon-performing real estate assets into the Resolution Trust Corporation (RTC)and subsequently ‘vulture funds’ were able therefore to pick up distressed salebargains from the RTC.
It was also during this period that the REIT sector expanded dramatically.These are essentially tax-efficient versions of quoted property companies,which are taxed at the shareholder dividend level only. In the early 1960s and1970s these vehicles did not prove popular, but the 1990s saw a rapid growthin a new type of REIT characterised by:
n rigorous disclosure levels;
n conservative gearing levels (35%–40%);
n closer alignment of management and shareholder objectives; and
n ability to offer vendors a deferred CGT liability via UPREIT currency (aform of proxy shareholding in the REIT).
The US markets’ capitalisation of REITS increased from $9bn to $150bnbetween 1990–95, stimulated by tax efficiency, low cost of capital, cheapbuying opportunities and a long-term institutional trend from direct assetownership to indirect vehicles.
Recently the growth of US capital flows into European property have attractedmuch attention. The DTZ report (1998a), for example, cites the following data:
n In the first six months of 1998, the US appetite for direct commercialproperty grew to £460m (one third of value) due to surge in REITS. Ingeneral these were attracted by high yielding property to boostearnings growth, for example:
n Starwood’s purchase of Turnberry Hotel in Scotland.
n Carr America’s acquisition of HQ Holdings (service officecompany).
n Examples of US joint venture schemes are also common: eg MoorfieldEstates / Blackstone–Arundel Great Court (central London officebuilding) purchase for £93m in 1997.
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n In 1998 REIT buyouts of UK-based property companies includedPrologis’ £95 million purchase of Kingspark Developments.
A key question is, however, why should REITs expand into Europe?
This may be part of US global expansion or the fact that US markets lead theproperty cycle. In any event it is important to note the type of USinvestor/developer that is attracted to the UK and Europe.
Research at JLW has categorised US investors in the UK into six maingroups:
n institutions;
n investment banks;
n opportunity funds/private equity funds;
n REITS;
n hotel groups; and,
n developers.
US institutions have been seeking to diversify their asset base and risk profilewhile maintaining higher risk-adjusted returns than would be available in theUS. A few have bought direct assets in Europe but most capital has beenplaced by indirect means. Increased investment in European equity and bondmarket has increased institutions’ understanding of returns, currency hedgingand local market practices. An increase in real estate investments that areperceived to be relatively liquid is therefore expected to follow.
Investment banks have been active in European real estate in three mainareas: buying, lending and advising/underwriting. These banks were alsoamongst the principal catalysts in the booming REIT sector. Initially bankslooked to replicate their US experience in buying distressed portfolios atdiscounts. France initially provided most opportunities. Historically US bankshave been reluctant to compete against German mortgage banks, but with EUproperty markets in various stages of recovery they are now preparing toexpand lending. In the UK, banks have focused on lending on secondary, highyielding assets.
Opportunity funds arose out of the US real estate crash and bought primeassets cheaply. They would then convert to a REIT, go for flotation or trade theportfolio. The process would then start again, and high returns havecharacterised these funds. With the recovery of the US market these fundsturned to Europe, but are now also taking an interest in Asia. The averageopportunity fund typically has $1 bn to invest which, when geared, givesspending power of $2.5 to $5 bn for a set period of up to 7 years and withexpected returns of 20% or more. Examples include Lone Star, MorganStanley and Blackstone.
REITS’ interest in Europe has been driven by:
n the increasingly expensive US market coupled with a search fororganic growth;
n anticipation of increased tenant demand following introduction of theeuro; and,
n a desire to service their tenant base on a pan-European basis.
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The spread of US investment is so wide that it makes it difficult to predictwhere capital is likely to go next. Some funds are clearly opportunistic andcould quickly move to other markets if these offered better returns, whereasothers (such as REITs) seem to be looking longer term. Edgley and Marksoffer two likely scenarios:
n In the event of a crash or stagnation in the US market, US investorswould return to base;
n Improvements in market efficiency in Europe, as the result of lessonslearned from the US, could increase the lure of Europe for Americaninvestors. These changes might include:
n higher quality information flows;
n increased market transparency;
n a culture of tenant orientation;
n greater and more tax-efficient access to public capital markets;
n closer alignment of investor and manager objectives;
n higher levels of liquidity;
n a long term institutional trend away from direct asset ownership;
n selective use of more creative debt instruments; and,
n valuation of property companies in equity markets in line with UScash-flow model as opposed to European model of a discount orpremium to asset value.
At the moment the jury is still out on which of these scenarios is likely in themedium to long term. In any event Parkes (1998) estimates only 8% of a totalof $14bn US investment in Europe from mid-1997 to the end of 1998 was fromREITs. Examples of the US fund transactions are shown in Table 2.7.
In the short term there has been some fallout in the REITs market, because ofvery poor domestic performance in the USA during 1998. Since its peak inJanuary 1998 the NAREIT index was down 20.5% by August 1998. Problemsin the US stock market have clearly taken their toll on REITs, which reflectperformance in the direct real estate market. However, as Cohen (1999a)points out, the fact that REIT shares have performed so badly throughout 1998should not be regarded as a sign that they are structurally flawed, rather thatthere are too many of them.
The developers are particularly interesting to examine. Prime US real estatehas, until recently, traded at less than replacement cost which meant that USdevelopers have looked to Europe with equity backing. Examples include:
n Hines Interests;
n Golub and Co;
n HRO International;
n Tishman Speyer;
n Heron; and,
n Paul Reichmann.
US developers have tended to focus on relatively undeveloped markets suchas entertainment and leisure schemes and retail factory outlets. US
22
developers in the office sector have also been characterised by the ability tooffer flexibility in lease terms in return for higher rent, provided the exit yield isprotected. Examples of such schemes include:
n Akeler Developments; and,
n City and West End Developments.
Both are UK developers who have been backed by Security Capital Global.
Table 2.7 US Funds: European Transactions (1997-98) (source: Parkes, 1998)
Investor TargetAssets
LocalCurrency
AssetType
Date Country
Apollo Real EstateAdvisors
Ober HausReal Estate
Crns 43m Corporate 4/98 Estonia
Lone Star Six Parishotels
FFr 300m Hotel 12/97 France
Blackstone Group Savoy Group £520 m Hotel 5/98 UK
Goldman SachsWhitehall Fund
Castellana280
Pta6.1bn Corporate 8/98 Spain
Blackstone RealEstate Advisors
Arundel GreatCourt
£92.5m Office 5/98 UK
Donaldson Lufkin andJenrette
Maremagnum Pta10bn Retail 5/98 Spain
Donaldson Lufkin andJenrette
ParqueCorredor
Pta2.5bn Retail 4/97 Spain
Morgan Stanley NCCFastigheter
SK3bn Various 12/97 Sweden
2.4.3 Irish InvestorsDTZ’s annual review of UK commercial property investment, ‘Money intoProperty 1999’ (DTZ, 1999a), identifies significant activity by Irish investorsduring 1998. The report estimates investment from Irish sources to havereached £300 million, in the fifteen months to March 1999. Contributing to thisfigure were two major property company take-overs: Green Property’sacquisition of Trafford Park Estates for £146 million, and Dunloe Ewart’sacquisition of Sydney and London Properties for £62.5 million.
Whilst property companies account for the bulk of Irish spending, there hasalso been a substantial number of individuals wanting to invest in UK property.It was to accommodate such demand that CB Hillier Parker’s IRL/UKinvestment fund was set up in 1997, to provide Irish clients with a vehicle toinvest in UK property. Research by Jones Lang Wootton indicates that theemergence of the individual investor in major deals is not unique to the Irish.Their figures show that during the first quarter 1999, private investorsaccounted for 35% of purchases. The availability of cheap finance and highloan to value ratios are allowing individuals to compete with the institutions andlarge property companies for prime property (Seidl, 1999).
23
2.4.3.1 Reasons for the growth in Irish investment
The well documented boom in the Irish economy accounts for the recent influxof Irish investment. With GDP forecast at 7% for 1999, the continuing strengthof the Irish economy has created some very wealthy individuals who arelooking for investment opportunities. Combined with this weight of money, alack of investment opportunity at home has forced investors to look abroad.
The following graph in Figure 2.9 shows the recent outstanding returns fromIrish property investment. These returns are being fuelled by strong occupierdemand, particularly in the office market. According to Property Week, overthe past year office rents rose by 17.2%, retail by 12.8% and industrial by 6.4%(Thame, 1999). With the prime investment market concentrated in Dublin,competition has driven yields down and investors have looked to the UK forbetter returns.
Figure 2.9 Returns from Irish Property Investment compared with other EU countries1989-98
Table 2.8 illustrates the higher returns an Irish investor can expect from aprime UK property. The divergence in yields may be even greater than thesefigures indicate, as a Dublin office purchase in early 1999 set a record yield of4.6%.
Table 2.8 Yields in Dublin and London Q4 1998
Prime Yields %Q4 1998
Dublin London
Office 5.00-5.75 6.00(City)
Retail-High Street 3.75-4.00 5.50(West End)
(Source: Jones Lang Wootton, 1999)
0
10
20
30
40
Ireland Germany Netherlands UK France Sweden
19971998
1989-98
24
A further component in the spending power of the Irish is cheap, availablefinance. As a part of Euroland, interest rates stand at 2.5% and are expectedto fall even further, making it possible to borrow for property investment at 4%.It is estimated that Irish banks lent over £1bn on UK property in 1998; asmentioned above, lenders have been willing to give high loan-to-value enablingindividuals to compete for the best property (Seidl, 1999). Irish investors alsotake advantage of competitively priced money in England: the Irish will oftenborrow up to 75% in sterling, thereby mitigating currency risk.
2.4.3.2 Attractions of the UK Property Market
In addition to higher yields, the Irish look to the UK market for secure,conservative investments. Despite the recent success of the Irish economy,Dublin is seen as more volatile than the established UK investment market.The security of the landlord’s lease with upward only reviews (similar to Irishlease terms), favourable taxation, and familiarity are other factors which makethe UK more appealing than other European destinations.
CB Hillier Parker’s IRL/UK fund targets best quality stock in London andregional cities, such as Glasgow and Edinburgh. The fund, now standing at£20m, has acquired six properties with an average yield of 6.75-8% (Seidl, opcit). Another fund, Everest Properties, is a limited partnership that has raised£40 million from wealthy Irish individuals, and £10 million from the Bank ofScotland’s Dublin based subsidiary, Equity Bank. The fund is looking forsecondary shops in regional centres and market towns, with yields in theregion of 6.5–7.5%. In addition to higher yields, one reason quoted for the Irishmove to England is the expectation that yields will fall if the UK joins the singlecurrency (Estates Gazette, 1999).
2.5 European cross–border investmentMarket reports produced by leading UK firms DTZ (1999b), Healey & Baker(1998) and Jones Lang Wootton (1999), show that during 1997 and 1998cross-border investment in European commercial property continued to rise.
Looking at comparative levels of inward foreign investment, the data availableshows France and the UK as being the most popular destinations. This data islimited to major transactions in the prime commercial markets. The followingfigures do not, therefore, reflect activity in the secondary or residentialmarkets, which is substantial.
Figures from Healey & Baker’s database show that between 1994 and 1997the UK far outstripped any other European country in attracting foreigninvestment. During this period the UK took an average 52.6% of total cross-border investment into Europe, with the remaining European countries,including Eastern Europe, accounting for an average 47.3%. No otherindividual country attained anything approaching the levels of foreigninvestment into UK property. France is shown to be the second mostfavourable destination and the maximum share attained during this period was23.3% in 1996.
A possible change in this pattern is indicated by graphs in Figure 2.10 andFigure 2.11, adapted from Jones Lang Wootton (1999). In 1998, Franceemerged as the main destination for foreign capital into the office sector,attracting twice as much as the UK. The JLW figures also show that for the
25
four-year period from 1994 until 1998, foreign investment in French retail wasalmost twice that of the UK. Despite the surge of interest in French offices,data indicates that, overall, direct foreign investment into the UK in 1998remained greater than France, with £3.2 bn compared with £2.9 bn.
An analysis of the reasons for these levels of international interest will helpilluminate the factors which attract foreign capital to a particular location.
Figure 2.10 European cross-border office investment in 1998
(Source JLW, 1999)
Figure 2.11 European cross-border retail investment 1994-1998
0 500 1000 1500 2000 2500 3000 3500
Germany
Spain
Netherlands
Belgium
UK
France
Euro (millions)
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Belgium
Portugal
Italy
Germany
Netherlands
Spain
UK
France
US$ (millions)
26
Foreign investors dominated the French commercial property market in thethree years prior to 1999, accounting for 90% of total purchases in 1996 (DTZ,1999b) 76% in 1997, and 80% in 1998 (Jones Lang Wootton, 1999). Theleading foreign investors in 1998 were the North Americans followed by theGermans. Table 2.9 shows how their purchases compare with domesticinvestors:
Table 2.9 The three largest purchasers of French commercial property
1998 FFr bn % Total direct investment 29.9 North American 8.3 28German 2.9 10French 6.3 21
(Source: Jones Lang Wootton,1999)
The high percentage of foreign investors in France over the past three years isremarkable, considering historically this figure was in the region of 17 to 20%(Cohen, 1999b). One of the main reasons for this phenomenon lies in theFrench property crash of the early 1990s, when US opportunity funds andinvestment banks, applying a lucrative formula employed at home, bought upFrench non-performing debt. Whilst the domestic investors were inactive andin trouble, the foreigners were acquiring discounted assets with the hope ofhigh returns.
Foreign investment extended beyond loan portfolio acquisitions as highlightedin Healey & Baker’s ‘European Property Investment 1998’. This reported thateconomic recovery in France was gathering pace; with the property marketmoving into the early stages of an upward swing, increasing competitionamong international investors was noted, for what was seen as ‘recoverystock’.
Foreign investors had detected the turn-around in office rents, and, withdemand rising and prime availability falling, significant recovery was predictedfor the forthcoming year. 1998 saw intense interest in the Paris office market,fuelled by rental growth prospects and low interest rates. Indeed, according toJones Lang Wootton, German investors have ‘almost exclusively focused onprime office product in the best business locations’.
Increasing competition for investment opportunities has encouragedspeculative development and refurbishment beyond the CBD, an area whereUS investors have been active. Meanwhile, increasing numbers of Frenchinvestors have returned to the market, often specialising in niche areas suchas office and residential (see JLW 1999).
After offices, prime retail has been the most sought-after sector, with UKproperty companies and Dutch investors leading demand for French shoppingcentres. As with the office sector, the volume of foreign investment wouldhave been higher were it not for limited supply, heightened in the retail marketby French planning restrictions. It is, however, these restrictions which havecreated such demand for French shopping centres, as they are nowperceived to have a premium value attached. Foreign investors have alsobeen active in the warehouse market and in the provinces.
27
2.6 The rationale for international investmentdiversificationSince modern portfolio theory was introduced by Markowitz (1959), manystudies have attempted to model the benefits of establishing diversificationstrategies for portfolio investments. Initial work focused on the potential gainsto be made by combining various stocks within a single portfolio, and showedthat substantial gains could be achieved from international diversification bothin terms of expected portfolio return and risk (eg. Grubel (1968) and Solnik(1974)).
Indeed, the goal of international diversification is to achieve a better risk/returntrade-off than can be achieved by investing solely in one country (Addae-Dapaah and Choo Boon, 1996). In essence, international diversification allowsfor the elimination of non-systematic portfolio risk associated with particularcountries. This is achieved by diversifying across nations whose economiccycles are not perfectly synchronised. As Solnik (1974) pointed out:
‘With as few as forty (international) securities equally spreadamong the major stock markets … the risk for a US investor isless than half of a purely domestic portfolio of comparable size’.
Besides risk reduction, international diversification also offers the prospect ofrelatively higher risk-adjusted expected returns. Solnik and Noetzlin (1982), forexample, show that spreading investments across major foreign marketsreduces risk and increases return.
2.7 International property diversificationOnly relatively recently has research started to examine the diversificationbenefits associated with the inclusion of international real estate within amixed-asset portfolio. Traditionally real estate was perceived as being difficultto monitor in terms of performance, and taxation and ownership complicationsmade it problematic to invest on a large scale. For example, Solnik (1991)suggests the major problems associated with international investmentsinclude:
n lack of familiarity with the overseas market, worsened by a lack ofinformation;
n regulations and restrictions, which restrict foreign ownership or therepatriation of capital;
n liquidity problems in smaller markets or associated pricinginefficiencies;
n perceptions of political and currency risk;
n information gathering and maintaining costs and associatedtransaction costs.
Essentially these problems are associated with information and datadeficiencies within local markets, but are exacerbated by the specificcharacteristics of property.
Although some of the problems may be overcome through joint venturesinvolving local partners, it is certainly true that direct property investment hashigh relative management and maintaining costs compared with indirect
28
property investment. Table 2.10 shows, for example, how transaction costsvary from country to country.
Moreover, the lack of reliable performance benchmarks in many countriesmakes it difficult to measure direct property investment performanceaccurately. Differences in valuation procedures and variations in the basis ofrents also make comparison difficult. In the UK, of course, this is less of aproblem with the development of the IPD index. In other European countriesbenchmarks are less developed, as Table 2.11 shows.
Recent historical data from IPD enables an interesting comparison of totalreturn over two years to be made and over a longer 10-year period. As can beseen, Ireland has outperformed the rest of Europe by a large margin in theshort and long term (Figure 2.12).
29
Table 2.10 Variation in Purchaser’s Transactions Costs (source: adapted from DTZ,1998b)
Country Transfer Tax Agent’s fees Legal Fees VAT
France 4.8% (from18.6%)
1-4% approx 1%(slidingscale)
20.6%(new building)
Germany 3.5% 1-6% 0.2-1.5% 16% (new buildingand/or within VAT
system)
Ireland up to 6% 1% 1% 21% (professionalfees) and 12.5% (onpost-1972 buildings)
Netherlands
6% 1.25%-2% 0.5-1% 17.5% (VAT deductibleonly where occupier ismore than 90% liable
for VAT)
Sweden 3% 1-3% less than0.5%
-
UK 3.5% (if sale is£500000,
otherwise 2%)
1% 0.5% 17.5% (new building)
USA No Federal tax.Low taxes vary
by state andcounty
1-4% By agreement -
30
Table 2.11 European Property Performance Benchmarks (source: Blundell, 1998)
Estimated Valueof Pension Fund
Property (US$ bn)
PublicBenchmark
Since
BenchmarkPlanned
Private Research
Belgium 1.56 - - YES
Denmark 12.24 - - -
Finland 4.29 - - -
France 7.28 - - YES
Germany 46.80 - YES1 -
Ireland 1.82 1969 - -
Italy 63.84 - - YES
Netherlands 57.84 1995 - -
Norway 2.16 - - -
Portugal 0.27 - - -
Spain 0.00 - - -
Sweden 15.68 - YES1 -
Switzerland 60.80 - - YES
UK 17.24 1970 - -
TOTAL 291.82 3 2 3
Data reflects extent of pension fund provision as well as exposure to property. Note that holdings ofinsurance companies, commingled vehicles and property companies are excluded. Sources: WMMercer, Watson Wyatt, IPD, JLW.1 Launched by IPD with local partners in 1998.
Figure 2.12 Total returns 1989-98, 1997 and 1998 (source: IPD)
31
2.8 Advantages of international property investmentThe questions therefore arise:
n If international property investment is fraught with difficulty, why shouldinvestors invest overseas? And, indeed,
n Why does all the evidence point to a growth of overseas investment inthe UK and other parts of Europe, such as France?
Certainly one advantage is the benefit of diversification. So far as directinvestment is concerned, Sweeney’s (1993) work used prime office rentalvalue growth between 1976 and 1988 in a range of world cities to construct‘efficient’ frontiers and examine portfolios on the efficient frontier. Shehighlighted four main centres as forming the basis for an efficient, diversifiedoffice investment strategy:
n Paris;
n Sydney;
n City of London; and
n Toronto.
She concluded that diversification was a viable strategy and that internationalproperty investment provided significant benefits in this respect. Otherresearch by Baum and Schofield (1991) has reinforced such findings.
Other work has shown, however, that indirect international property investmentprovides better diversification benefits than direct investment. Eicholtz et al(1997), for example, used data from 18 international property companieswhich owned an international direct property portfolio, and whose returnsreflected the performance of the direct strategy. These were compared withthe performance of locally operating real estate companies with indirect realestate portfolios. Eichholtz et al suggest that, theoretically, an indirect strategywould be more effective because it is likely that private information will beincorporated more slowly into asset prices than public information, so enablinginvestors to beat the market by using private information. They found in factthat direct investment in foreign property does give a worse risk-adjustedreturn than indirect international property investment, with 7.7% returns forinternational property companies from 1984–95 compared with 10.4% forlocals. The difference of 2.7% return per year is an indication for the cost ofinternational diversification in non-public markets, comprising such factors asovercoming international barriers, getting local contracts and collectinginformation in a foreign country. They conclude that (op cit:13):
‘International investment in real estate should be done indirectlythrough locally operating real estate companies. Institutionaland private investors who want to build up international realestate exposure should buy the shares of domestic real estateinvestment companies at foreign stock markets … by thesame token for investments in their own market real estateinvestors can still invest directly and benefit from theinformation advantage they have there.’
32
Nonetheless, direct property investment in overseas markets has continuedapace. Newell and Worzala (1995) suggest the major factors which have ledto this include:
n favourable exchange rates;
n lack of local property investment opportunities;
n interest rate differentials;
n greater liquidity of overseas property markets;
n tax incentives;
n fewer monetary restrictions;
n political diversification;
n economic diversification;
n perceived comparative advantages;
n substantial growth in available investment funds;
n investment stability; and,
n improved global communication, market information and access toinvestment capital.
These and other motives have been examined empirically in surveys (seeWorzala (1994), Newell and Worzala (1995) and Lizieri et al (1998)).
For example, in a survey of British and Dutch funds, Worzala (1994) foundthat diversification was a primary motive for international property investment,followed by higher yields, and lower risk. Newell and Worzala’s 1993 surveywas sent to 65 institutional investors in Australia, Hong Kong, Singapore,Malaysia and Japan, and it again found portfolio diversification was a key factor(92%), with the other significant factors being:
n higher returns (31%);
n economic and business reasons (31%); and,
n lower risk (15%),
Taxation differences were frequently considered a risk rather than a benefit.Worzala (1994), for example, found that taxation differences achieved thesecond highest number of respondents, who rated it as a very importantproblem.
As far as the other motives of international overseas investment wereconcerned, the following were important:
n returns and yields;
n operational/strategic;
n capital havens; and
n push factors.
Of these, the most important set of factors mentioned by respondentsconcerned returns and yields in the foreign market, which were often related toconditions in the investor’s domestic market. To be able to compete in aforeign market, however, requires an ‘edge’ over domestic companiesbecause of the additional risk premium required on overseas investments.Examples of counter-cyclical investment by overseas investors include UK
33
investment in the USA following the US property crash and German open-ended fund investment in the UK following the UK property crash. Theresearch also suggested that currency risk concerns depend on specificcircumstances: for example, where an investment is for taxation benefits oreconomic differentials, the investor will be concerned to mitigate adverseexchange rate movements.
Interestingly, Lizieri et al (1998) also found that quantitative portfoliooptimisation models were not regularly used, although larger funds had someform of formal methodology based on relative market capitalisation, countryand sector specific risk premium and target rates of return.
Finally, the type of investment vehicle sought was also found to be dependentupon the level of market knowledge and the amount of capital to be invested. A‘staged’ approach to investment was often pursued, with indirect investmentleading to direct investment and equity ownership with strategic alliances andjoint ventures.
2.9 Direct property development and joint ventures in theUKOf course, direct development in overseas markets can also occur. Edgleyand Marks (1998) suggest, for example, that an important share of US inboundcapital into the UK has been from US developers.
Bannon (1998) sees the attractions of direct investment in Europe as:
n higher returns;
n lack of quality products for investors domestically;
n a desire to exploit inefficient markets through better research andefficient financing of investment; and,
n a demand by multinationals for a global real estate service.
In the same way key challenges include:
n differences in local law, regulations and customs;
n language and cultural differences;
n obtaining quality investments;
n minimising tax exposure and currency risk (currency risk can beminimised by borrowing in currency to match asset exposure andlending/SWAPs: this will be reduced with EMU); and,
n repatriating funds – some governments use exchange control laws,withholding taxes and transfer prices.
As far as property development in Europe is concerned, overseas investorshave a number of options:
n direct development;
n forward purchase, where an investor agrees to purchase adevelopment from a local developer; and
n joint ventures, which is the most popular route for developers inEurope.
Partners in joint ventures could include local property companies/developers;landowners and corporate occupiers.
34
2.10 SummaryThis section has shown how rapidly overseas property investment has grownin the UK. In particular it has highlighted a number of key issues:
n German and US investors are key players in the UK propertyinvestment market. ‘New wave’ investors include those from Ireland.
n European cross-border property investment is a growing phenomenonand France and UK have been the most favoured locations.
n Diversification across countries can, in theory, lead to risk reduction,but downside risks of lack of familiarity with the overseas market andinformation constraints are important barriers to overcome.
n Empirical surveys of international property investment have suggestedthat diversification is a major motive for international propertyinvestment. Generally, taxation differences have been considered arisk rather than a benefit.
n Returns and yields in foreign markets are also important drivers toproperty investment.
n Various types of joint venture have developed to tap into these returnsfrom overseas and to overcome lack of knowledge of the foreignmarket.
For these reasons it is important to study the landscape of taxation andaccounting regimes across the USA and Europe to understand better whyproperty companies and other institutions continue to invest and develop in theUK.
35
3 REAL ESTATE INVESTMENT INSTITUTIONS IN THEUSA AND GERMANY
3.1 IntroductionThe previous section highlighted the importance in the UK market of both USand German property investors.
In this section the financial architecture of real estate institutions in the USAand Germany are examined. The discussion covers:
n US REITs (their evolution, attractions for investors and performance inthe US market); and
n German closed and open-end funds (their rationale and financing).
3.2 USA
3.2.1 Real Estate Investment Trusts (REITs)In the UK, interest in American property investment institutions has centred onREITs, mainly because in principle they offer a model for tax-efficientsecuritisation of property which has hitherto been absent in Britain.
In simple terms a REIT is a company dedicated to owning and, in most cases,operating income-producing real estate, such as apartments, shoppingcentres and warehouses. In addition a REIT is a company legally required topay virtually all of its taxable income (95%) to its shareholders each year.
British attempts to extend the investor base through similar equity vehicles (forexample, PINCS, SPOTS and SAPCOs) have met with only limited success.This is partly because they have lacked popular appeal and have not enjoyedthe economies of scale of REITs, but also because they lacked taxtransparency and were launched in difficult market conditions. Recently,however, the UK Treasury has announced it is examining the validity of REITvehicles for the UK housing investment market.
REITs possess a number of advantages over property company shares interms of lot size, liquidity, public trading and price information, together withtax transparency. Generally they have performed well in relation to directproperty investments and real estate operating companies (the US equivalentof property companies) in return terms but their volatility is higher than thedirect market.
The following sections deal with those aspects of REITs which are relevant tothe UK property scene.
3.2.2 The evolution of the REIT structureREITs were developed in the USA principally to allow large numbers ofinvestors, particularly small investors, to acquire shares of stock in a propertyor pool of properties. REITs were created by Congressional Act in 1960, whichprovided changes to tax law to allow REIT income to be non-taxable, providedcertain mandatory basic qualifications are fulfilled (See Appendix 1).
36
DeWeese (1998) identifies three main types of REIT:
n equity REITs, which own and manage income-producing property;
n mortgage REITs, which make and manage property loans; and,
n hybrid REITs, which combine elements of both debt and equity.
These represent one form of property securitisation and are shown in Table3.1. When first created in the 1960s, REITs boomed as one of the fewsources of development and construction finance. They continued in the1970s as essentially a debt investor’s market, inhabited by individuals lookingfor big capital gains, but became tainted by large losses and failures in themid-1970s (Edgley and Marks, 1998).
Table 3.1 The four sectors of the property finance market (source Staveley, 1997)
Private (or Direct) Public (or Indirect)
Equity • private REITS (US)• direct investment• open/closed-ended
funds• private corporations
• equity REITs (US)• property companies• corporate equities
Debt • mortgages• loans to corporations
• mortgage REITs (US)• securities mortgages• corporate bonds• government debt
Their popularity grew again in the 1980s, as property capital became moreplentiful and property prices rose steadily. Indeed, the Tax Reform Act of 1986allowed greater flexibility in management and in the tax environment, which leddirectly to a second wave of REITs dominated by investors seeking taxadvantages. The Act altered the real estate investment landscape in two mainways. Firstly it drastically reduced the potential for real estate investment togenerate tax shelter opportunities by limiting the deduction of interest,lengthening depreciation period and restricting the use of ‘passive losses’.Secondly it enabled REITs to operate and manage income-producingproperties. Originally created to act as real estate mutual funds, REITs havetherefore evolved into operating companies that acquire and manage multi-tenanted real estate.
Legislative changes have also made REITs more attractive investments forinstitutional investors. The structure of the traditional REIT went throughfurther evolution in the early 1990s, as Staveley (1997) has shown:
n In 1992, the UPREIT structure was created to address the problem oftax arising for the transferor on the direct transfer of properties. Thiswas achieved by creating an ‘Umbrella Partnership’ (UP) to act as anindependent entity between the REIT and the Limited Partnership (LP).The UP could accept transfers from the LP without giving rise to a taxliability and as part of the UPREIT structure provided an effective
37
means of raising capital with little or no tax cost. However, thestructure was complex and had some inherent conflicts of interest.
n The DOWNREIT structure was therefore developed to overcomedifficulties with UPREITs and first appeared in March 1994. The maindifference is that, instead of a single partnership which holds all REITproperties, each time new properties are exchanged a new partnershipis formed.
While these partnership vehicles produce tax advantages, they are not withoutflaws – the main one being that before units can be converted to REIT stockthey must be held for at least twelve months, which reduces the liquidity of theinvestment. Indeed, REITs did not grow straight away in the 1990s becausethe US savings and loan crisis and a real estate credit crunch hit commercialproperty hard.
However, many private real estate companies decided the best way to accesscapital through the public marketplace was with REITs. As can be seen inFigure 3, equity REITs have seen the sharpest growth over the past decade.This shows the market capitalisation (or price of shares multiplied by thenumber of shares outstanding, based on year end data) for equity, hybrid andmortgage REITs.
Figure 3.1 Growth of Annual Market Capitalisation in REITs (source: www.nareit.com)
3.2.3 Evolutionary phases of REITsREITs were originally created by legislation in the 1960s to be passive holdingvehicles for real estate, but the law changed in 1986 to enable active internalcompany and property management. During the 1990s, Mueller (1998)suggests that REITs evolved into growth-oriented real estate companies. Toattract investors and to promote revenue growth and increase share price,many REITs have sought faster growth strategies and more real estateacquisitions.
However, REITs are ‘leaky’ in terms of capital because they have to pay out95% of their taxable earnings as dividends, thus making internally generatedgrowth from retained earnings difficult. Mueller argues that the growth rate in‘Funds From Operations’ (FFO) (or net income, excluding gains (or losses)from debt restructuring and sales of property, plus depreciation and
38
authorisation) per share declines from an increasing asset base in the currentREIT format. This occurs as REITs approach the ‘mega-cap’ phase of growth(or more than $4 billion in size). There is therefore a point of diminishingreturns, between $2 billion and $5 billion, where REITs have to increase theirpurchases to a very substantial level just to maintain FFO per share increase.
Mueller also shows how both operating costs and the cost of capital fall for‘small-cap’ ($0–$500 million) and ‘mid-cap’ ($500 million–$1 billion) REITs, butthen level off for larger companies. Moreover, as the market evolves, REITsare changing the means by which they grow in both terms of size (totalcapitalisation) and earnings. The stages of growth are shown in Figure 3.2.
Figure 3.2 Stages of REIT growth (after Mueller, 1998)
As can be seen, the larger the REIT the more likely international real estateinvestment is to occur. Beyond that point, some REITs have bought operatingcompanies with higher profit margins, perhaps even outside the propertysector.
This suggests that the role of REITs in the US property market must be takenwith a touch of realism. Mueller’s work shows that larger REITs will not havethe economies of scale that will necessarily lead to dominance in the realestate industry. Indeed, further empirical data supports this view. As Table 3.2shows, outside the hotel sector (where 81% of the public ownership is by non-REIT corporations) and the regional mall sector, none of the property typesapproach the public ownership levels of other higher fragmented industriessuch as retail and trucking.
The sceptical view of REITs is summarised by Kaiser (1998:3):
PropertyAcquisition
DevelopmentVentureCapital
PortfolioPurchase
Value AddedServices
Buy PublicREITs
InternationalProperty
OperatingCompany
Size (Total Capitalisation)
Tot
al F
FO
Gro
wth
Small-Cap Mid-Cap Large-Cap Mega-Cap
Growth froma Small Base
Operating Efficiencies
Expand Niches
Geographic and/or Property-type expansion
Debt and Equity - Cost of Capital Efficiency
Metamorphosis Point
39
‘ …REITs possess neither the continuous economies of scale,nor a large enough pool of underpriced assets to acquire atrates accretive to FFO earnings growth, nor to present any realbarriers to entry to new real estate entrepreneurs. Mega-REITswill not be taking over the world anytime soon.’
Table 3.2 US Property Market Penetration by Public REITs and Corporations
Property Type % PubliclyOwned
Tenant-occupied private office buildings 3.4
Hotels and motels with more than 20 rooms 17.3
Tenant-occupied warehouses more than 25,000 square feet 3.7
Apartments of 20 units or more 7.4
Regional Malls more than 400,000 square feet 21.9
Non-mall retail properties 9.5
vs Public Ownership of Other Major Industries (based onshare of total sales)
% PubliclyOwned
Primary metals 70
Food Manufacturing 61
Printing, publishing 37
Retail trade 26
Trucking 25
(Source: Ziering, Winograd and McIntosh, 1997)
3.2.4 What makes REITs attractive to investorsDespite the sceptical view of REITs taken by Kaiser (op cit) (see section 3.2.3immediately above), and in particular their size limits, investors see keybenefits in these investment vehicles. The main advantages of REITs are thatthey (DeWeese, 1998):
n address the concerns of investors for alignment of investor andmanagement interest, daily pricing of the investment and liquidity; and,
n by going public, real estate companies can increase their competitiveedge in the market place through:
n access to lower costs capital;
n the benefits of instant diversification and ease of investment;
n the ability to plan for succession;
n increased liquidity; and
n high dividend cover ratio.
Before 1993, REITS were viewed more as fixed income instruments, becausethey were typically traded at net asset value and stock price was a function of
40
dividend yield. Since then REITs have made the transition to being perceivedas operating companies, attracting a premium for the ability of management togrow the assets (Kaplan and McDonnough, 1998). However, unlike otheroperating companies the REIT must distribute at least 95% of its earnings toshareholders, which restricts its ability to reinvest.
The performance of REITs versus investment in stocks and bonds has beenthe subject of research by Rosen and Anderson (1997). They found that in theperiod 1993–1996 REITs became more closely aligned with real estateperformance than stock market performance. However, the correlation withstock market performance was greater during larger movements, both up anddown. Correlation with the bond market was slightly better, except duringperiods of large decline when correlation was almost zero. REITs may besubject to daily shocks in the bond market, but the effect dissipates quickly.
REITs therefore appeared to behave as real estate and represent a gooddefensive mechanism. Mixing REITs with a portfolio of common stocks andbonds could therefore enable investors to improve their risk/return trade-off.However, the downturn in the market in 1998 suggests that many investorshave not yet recognised this advantage, as discussed below.
3.2.5 REITs and the occupier marketSeveral REITs have been established which own only single-tenanted assetsand during 1994–95 acquired in excess of $300m in property occupied bymajor companies, such as credit companies, retailers, electronics and others(Lammert, 1997).
In the US, restructuring single-tenant properties on a net lease basis (similarto an FRI lease in the UK) improves marketability of the investment because itprovides the property owner with a very predictable income stream. However,net or ‘NNN’ leases also give the tenant the right to cancel the lease underspecified conditions. The investor’s primary risks are therefore the:
n tenant’s ability to make rent payments;
n tenant’s right to cancel the lease; and,
n usual real estate risks, such as illiquidity, rent loss, management anddepreciation of the asset.
Property occupiers who convert to net-lease arrangements by a sale andlease-back are also able to use the arrangement as a development vehicle forpurpose built premises. The single-tenant transaction has grown in popularityamong investors and the number of real estate investment companiesspecialising in this type of property has grown in recent years. Somecompanies concentrate on only development-type transactions while othersspecialise in management.
3.2.6 Development of the US REIT marketThe watershed for REIT investment came at the start of the 1990s, with theformation of the Kimco Realty Corporation REIT which demonstrated howlarge portfolios could raise large amounts of capital at lower costs than hadpreviously been thought possible. In 1992 an estimated $18bn flowed intoREITs, more than in the previous seven years combined.
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REITs have since become the dominant purchasers of real estate in the US(DeWeese, op cit). Equity REITs predominate – they represent about 87% ofthe market and own about 35% of all institutional real estate equity. The totalequity market capitalisation of REITs increased sixteen-fold between 1991–1997. Between 1990 and June 1998 the market capitalisation of the REITsector increased from $9bn to $150bn (Edgley and Marks, 1998). Returns toshareholders also increased and reached as high as 36% in 1996 (stock priceappreciation plus dividends paid and reinvested).
The growth of REITs is considered likely to continue in the longer term, due tothe advantages outlined above, despite the recent downturn. In January 1998,after two years of frenzied activity, REITs began to lose favour with USinvestors (Wheatley, 1998). Shareholders who joined at the start of the USproperty market recovery began to wonder where future growth would comefrom, as the market reached equilibrium and moved into oversupply. SomeREITs took on development to boost earnings, only to increase investors’anxiety due to the extra risks involved.
The autumn of 1998 saw REITs hit by falling stock prices on Wall Street and aliquidity squeeze prompted by the global financial crisis. This has led to a cutin available debt and equity funding for new development and acquisitions. Therequirement on REITs to distribute 95% of income also means they cannot optto retain income to fund investment. However, the downturn may be viewed asan adjustment in the market as it moves toward greater maturity. During theliquidity squeeze REITs must concentrate on managing existing assets andinvestors may come to realise their value in providing a steady income streamas part of a mixed portfolio, rather than treating them as growth stocks. This isdiscussed in more detail in the next section.
3.2.7 REIT performance in the US marketIn the years following the 1986 Tax Reform Act, new government rulingsreleased REITs from the obligation to operate through third party contractors,and enabled them to manage their property assets in the same way as otheroperators. Cannon and Vogt (1998) examine the performance, structure andprofitability of the ‘advisor’ and ‘self-administered’ REITs between 1987 and1993. Their evidence suggests that advised and self-advised REITsperformed quite differently. REITs’ performance overall broadly matched thatof the market, but the sub-group of advisor REITs performed below that of themarket, with a lower return than the self-administered REITs.
Lower interest rates in the 1980s created strong growth conditions forsyndicated real estate, and in the early 1990s REITs made impressive gainsin terms of both dividends paid and aggregate share prices. This wasstimulated also by the large public offerings, beginning with that of KIMCORealty Corporation in 1991.
REITs shares also appeared to be less volatile than those of US equities ingeneral. In one study of their volatility REIT betas were found to have declinedsignificantly throughout the 1980s (Khoo, Hartzell and Hoesli, 1993). Thisconclusion was supported by the National Association of Real EstateInvestment Trusts which found that REITs shares fell by only a third of thedecline in the Dow Jones index in the crash of 1987. This decline in marketrisk attracted not only more small investors to REITs, but also institutionalinvestors.
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Further work on risk factors associated with REIT shares was undertaken byGyourko and Nelling (1998). They found that the systematic risk of equityREITs varied with the type of property in which they invested. Betas tended tobe higher the greater the proportion of retail property investments in theirportfolios. A possible reason for this was the percentage lease clause entitlinglandlords to a share in retail tenants’ cash flows.
The authors found no evidence that REIT diversification across property typesor ‘broad geographic regions’ offered significant risk-reducing diversification.However, the systematic risk is lower the greater the number of properties inthe portfolio.
Gyourko and Nelling also confirmed their earlier work which showed that theliquidity of REITs, as measured by their bid-offer spreads, was more closelyrelated to stock market factors than to the liquidity of the underlying propertymarket. Firm size and stock exchange listing determined spreads.
More recently REITs performance has come under close scrutiny. The globalcredit crunch stemming from the collapse of economies in Russia, the FarEast and Latin America has led to US investors pulling out of commercialmortgage-backed securities, which are used as a source of REIT finance.During 1998 REITs recorded a total annual return of –17.5% (Figure 3.3).
Figure 3.3 Equity REITs: Total Monthly and Annual Return 1988-98 (based on NAREITIndex)
13.49
8.84
15.35
35.70
14.59
19.65
3.17
15.27
35.27
20.26
-17.50-20.00
-10.00
0.00
10.00
20.00
30.00
40.00
Jan-
88
Jul-8
8
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89
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9
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0
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91
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92
Jul-9
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95
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96
Jul-9
6
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Jul-9
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To
tal R
etu
rn (
%)
Monthly returnAnnual return
3.2.8 REITS and Institutional Investors
3.3 REITs and institutional investorsRecent growth in the REIT industry has been fuelled by mainly institutionalinvestors. A study by Wang, Erickson and Chan (1995) found that REITstocks with a higher percentage of institutional ownership performed betterthat other REIT stocks with fewer or no institutional investors. It thereforeappeared that the participation of institutions increased the control and
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monitoring ability of shareholders and thus increased the value of REITstocks.
A further empirical study (Chan et al, 1998) tracked institutional holdings ofREIT stocks compared with general stocks during 1984–1995, to assess theimpact of institutional investors on the value of REITs and their financingdecisions. This study found that, at the end of the second quarter of 1995, thecombined REIT holding of the top twenty institutional investors was $10.273bn– that is 46 times the average market capitalisation of REITS. Some largeinstitutional investors had concentrated their investment in the REIT marketand the study concluded that the monitoring and control aspects of thoseREITs must therefore be improving, because institutions normally have theright expertise and are more willing to expend resources to monitor thecompanies they invest in. The study also found that:
n Institutional holdings of REITs stocks increased significantly over time,although the average size of investment made by each institutionalinvestor was smaller for REIT stock than for the stocks of matchingfirms.
n REITs making initial or secondary offerings had a higher level ofinstitutional participation than other REITs in the market.
n Institutions invested more in mortgage and equity REITs than in hybridREITs in recent years. There was also some evidence that institutionspreferred equity REITs over mortgage REITs and also prefer REITsthat have a larger market capitalisation.
n When only a few institutional investors had an interest in a REITsstock, the institutional holding was lower than that in REITs whichattracted diversified institutional investors.
n Although the average number of REITs invested in by each institutionalinvestor increased from 2.57 in 1984 to 10.67 in 1995, the increase inthe level of holding was not that significant when the number of non-REIT firms was also taken into consideration.
n Although each institution on average held less than 2.9% of its portfolioin REIT stocks, an interesting market development occurred in 1995when six institutional investors had almost 100% of their holdingsinvested in REIT stocks only. These are summarised in Table 3.3.Some of the six players traditionally invest in the real estate market,although most institutional investors still hold a diversified REIT stockportfolio.
The benefits for real estate operating companies and institutions in creatinglong term relationships are expanded on by Parsons (1997). For REITs themain benefits are summarised as follows:
Table 3.3 Institutional investors with nearly 100% investment in REITs in 1995
Institution Totalinvested$m
Totalnumber offirmsinvested in
Number ofREITsinvested in
Value ofREITinvestment$m
% ofinvestmentin REITS
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Cohen & SteersCapital Management
1,492 60 57 1,362 91%
ABKB/ La SalleSecurities
913 52 52 878 96%
RREEF Real EstatesSecurities Advisor
191 20 20 191 100%
Heitman/PRASecurities
199 28 28 199 100%
AMB Rosen RealEstate Securities
Not given
Allstate LifeInsurance Company
Not given
n Lower cost of capital – REITs that have a strong following ofinstitutional investors can achieve a lower cost of debt and equitycapital and a premium valuation on the corporate enterprise, whichgives them an advantage over competitors.
n Share price stability – Share price volatility over time tends to belowered by a broad following of institutional investors, especiallypension funds and foreign institutions, because these organisationsgenerally use their position with specific REITs to attain long termstrategic objectives rather than short-term trading goals.
n Consistent source of expansion capital – A REIT that fulfills itsstrategic objectives and meets investor expectations can generally relyon its following of institutional investors for future capital-raising events,which reduces the time and cost involved in raising expansion capital.
n Multiple transactions – Several types of transactions can becompleted between REITs and large institutional investors, as shownin Figure 3.4. This can include transactions where the institutionexchanges direct property ownership for shares. Large institutions,especially insurance companies, are also often interested in investingin debt as well as equity.
n The ‘Lead Steer’ effect – Generating interest from a select group ofinstitutions can often result in others following the lead of theirinstitutional peers.
n Source of acquisitions – Large institutional investors pursuing astrategy of converting directly held property to shares can provide aready supply of property to those REITs which make appropriatepurchasers.
n Long term relationships – Building long term working relationshipsbetween the decision makers within institutions and the REITmanagement team can facilitate multiple transactions and improve thespeed of transactions.
The main REIT investors are shown in Figure 3.4. The key success factor forREITs in managing an institutional investor programme is understanding thedifferences between the different types of investor and the nuances employedby each institution in managing real estate securities. The characteristics of
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the main institutional investors are also described by Parsons (1997, op cit)as:
n Mutual funds are the largest category of REIT investors and tend tolook for high growth, income and diversification. They usually have arelatively high level of stock rotation and are characterised by rapidbuy/sell decisions. Mutual funds were never direct holders of realestate and lack potential for property ventures and exchanges. Theyare the most critical group for establishing the daily valuation of REITshares.
Figure 3.4 The main REIT investors
Source: Parsons (1997)
n Real estate investment advisers were spawned by the EmploymentRetirement Income Securities Act 1974 and provide investmentmanagement services to public and corporate pension funds,foundations and endowments. Many offer research driven investmentstrategy for investing across national geographic markets and coreproperty types, plus specialty real estate such as hotels and healthcare.
REITReal EstateOperatingCompany
DomesticPension Funds
Internally Managed
Pension FundsReal EstateInvestmentAdvisors
InsuranceCompanies
Foundations Endowments
ForeignInvestors
MutualFunds
TransactionPreferences
Common stock accumulationPrivate placementsJoint VenturesProperty sales/exchangesRated REIT paperSecured mortgages
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Figure 3.5 REIT institutional investors - Simon DeBartolo Group
[Source: Parsons (1997) / Technometrics/Bloomberg-January 14 1997, MacGregor Associates]
n Foreign investors hold 5–10% of the common shares of the largeinstitutionally favoured REITs. To date, Dutch institutions have beenthe most active foreign investors in the US REIT market. A special taxtreaty between the US and Holland means Dutch investors canrepatriate their dividends without attracting the typical withholding tax.Investors from Germany, the UK and France are also becoming moreactive.
n Insurance companies – most insurance companies invest in REITsas an integral part of their real estate investment strategy. In the US,many insurance companies are reducing their direct holding of realestate to comply better with risk-based capital rules adopted by theinsurance industry. This has included selling large portfolios of realestate to REITs. Insurance companies represent high-priority investorsfor REITs because they engage in diverse investment activities.
n Pension plan sponsors – most large pension plan sponsors havenow entered the REIT market and involvement is expected to growquite rapidly. Historically they have been the largest annual investors indirectly held real estate. In 1997 they owned $130–140bn of direct realestate equities and were estimated to hold approximately $5bn of USREITs, exclusive of joint ventures. There are three main types ofpension plan sponsors:
n Public funds dominate the market – 32 of the top 50 funds are stateor teacher retirement funds.
n Corporate pension plans have traditionally invested in direct realestate and are now also major participants in the REIT market.They typically elect to use the services of an experienced realestate investment manager with REIT capability.
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n Foundations and endowments represent a smaller segment of themarket and typically have portfolios of less than $5bn. Most are toosmall to make major direct investments and have tended to investin real estate operating companies as an attractive alternative.
Although pension fund participation in REITs has expanded rapidly, a numberof challenges remain for these investors (Parsons, op cit):
n Market size: The equity capital market for REITs, at $100bn, is stillrelatively small to attract a large scale entry by pension funds. In theshort term, real estate securities are therefore unlikely to replace directinvestment.
n Liquidity: Most REITs are relatively thinly traded and pension fundadvisers are therefore concerned that REITs are not as liquid asoriginally believed. However, interest in REITs appears undiminished,because the benefits of liquidity are ranked below other considerationssuch as strong management and excellent yields.
n Underwriting the management team: Pension funds have learnedthe need for thoroughly evaluating the REIT management team prior toinvesting. A REIT with a solid real estate portfolio may still founder ifmanagement lacks the ability to handle the operational aspects ofrunning a public company.
n Measuring performance: A growth confidence in performancemeasurement is needed and has the potential to accelerateinvestment in REITs, particularly through broader acceptance of theNAREIT index.
n REITs and portfolio management: It appears that there is nomutually accepted model for the role of REITs in the context of a largeinstitutional investment portfolio. Many pension fund professionals haveexpressed a need for additional research to educate the investmentcommunity about the role of REITs in portfolio management.
3.4 US small investors and real estateUS society does not enjoy the same sort of social welfare provision as UKsociety. US individuals therefore have to make greater provision forthemselves by way of pensions, employment, sickness and retirementbenefits. Those born in the post war ‘baby boom’ are now contemplatingretirement, resulting in a massive flow of investment into mutual funds.
As reported by Block (1998), the number of mutual funds that mainly invest inREITs grew from 6 to 34 between 1992 and 1997, and their assets increasedfrom $342m to $11bn. Mutual funds have never held real estate direct (seesection 3.2.8 above) and target equities, primarily REITs (Fredman, 1995).Most have diversified holdings in many States and a few have global interests.Other investments include stocks in real estate related companies, such ashouse builders, building supply manufacturers and industries with substantialreal estate holdings.
The literature suggests that direct participation in REITs by small investorshas not taken off to any great extent, but could be set to do so.
In 1995, Fredman (op cit), Professor of Finance at California State University,recommended that mutual funds represent the ideal route for small investors
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to include, say, 5–10% of real estate in their investment portfolio, as part of anIndividual Retirement Account (IRA) or other sheltered retirement account.Individuals could invest directly in assorted REITs and the primary advantageswould be that they could focus on the property type or geographic areaexpected to expand and also bypass the expenses of a mutual fund. However,Fredman (op cit) suggested that for the individual the disadvantagesoutweighed the advantages by a wide margin, in that:
n REITs are highly specialised and relatively complex. It is harder forsmall investors to select several good REITs than it is to choose blue-chip stocks.
n The management of a REIT is very important. Judging the capabilitiesof REIT management benefits from industry experience and contactswhich are generally not available to the small investor.
n Investing in REITs involves similar risks to investing in small stocks.Small companies, including REITs, tend to be more volatile than largercompanies. REITs are also less liquid. The diversification andprofessional management offered by a mutual fund therefore makessense for the average investor.
n Fund managers are also at an advantage in relation to investing inREITs because they:
n get the first choice of IPOs (Initial Public Offerings) beforeindividuals have a chance to buy, because funds buy shares insuch large quantities;
n can achieve sufficient diversification across property types anddifferent geographic areas, by investing in several REITs;
n have the ability to shift their invesment strategies among propertytypes and geographic areas with changing economic conditions;and,
n can purchase REITs at institutional brokerage rates, giving them atransaction cost advantage over the small investor purchasingdirect through a broker.
Block (1998) takes the view that while mutual funds currently represent a costeffective route to real estate for the small investor, over time investors’ needswill become more complex and many will want to become more personallyinvolved. They will want to time their transactions for tax reasons and they willuse individual stockbrokers and financial planners to help them review specificinstruments. As investors become more knowledgeable and their holdingsincrease, they will want to diversify into REITs direct. This will be facilitated bygrowth in the REIT sector and an increasing number of companies goingpublic, accompanied by an increase in the number of brockerage firmsexpanding their coverage of REIT investments. The liquidity of REITs istherefore expected to continue to improve, drawing more investors into themarket.
3.5 Small investors and international investingA series of articles produced for the American Association of IndividualInvestors in 1995 examined the benefits for small investors of diversifying intoforeign investments. To produce meaningful diversification benefit, at least10% asset allocation overseas was recommended. Generally country factors
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outweigh industry specific factors in determining stock prices. A ranking ofmarket price volatility in 24 countries placed the UK as the next lowest volatility(at 1.06) after the US (at 1.00), whereas Germany ranked at 1.47 and Franceat 1.57. The UK also ranked more highly than others in Europe as a countrywhere unique country factors were more important than global factors indetermining stock prices. A ranking of 30 industry sectors also identified realestate investment as being more highly influenced by country factors thanindustry factors.
A difficulty for small investors is that equity valuations and investment yieldscannot be readily compared across global boundaries.
3.5.1 REITs in EuropeThe downturn in the US market has affected investment by REITs in the UKand other parts of Europe.
As reported by Parkes (1998), in the 18 months since the spring of 1997 USinvestors have spent some $14bn in Europe in 90 deals. To date, REITsinvestment in Europe has often been targeted at sectors less favoured bytraditional investors – for example, the residential sector.
Parkes (op cit) expects that the mainstream UK market will see little USinvestment because the UK is further ahead in the economic cycle, and thatmost money will go to continental Europe. However, investing abroad involvescomplex legal and tax issues and it remains to be seen how tolerant USinvestors will be towards European markets. The aspect of the UK market inwhich US investors might take more interest is private property companies runby entrepreneurs who have innovative ideas and are looking to expandbusiness.
Furthermore, the decline of the euro against both sterling and the US dollar,and the absence of the expected investment inflows into the new currencyareas, suggest some lack of investor confidence. In the short term, at least,there has been no surge of new money into Euroland.
3.5.2 Valuing REITsUS Securities and Exchange Commission regulations do not currently requirean independent valuation of REIT property on acquisition, sale or for updatingasset values (DeWeese, 1998). Most REITs perform only internal valuationsas part of due diligence on acquisition or disposal and do not routinely obtainperiodic updates. This is mainly because REITs staff are skilled in valuationand know their markets. When buying and selling, time is generally of theessence and too short to obtain an independent valuation.
Traditional methods of evaluating public companies (e.g. price-to-earnings andprice-to-book ratio) are inappropriate for REITs because:
n reported earnings are significantly affected by depreciation chargesdue to the high ratio of real estate to total assets; and,
n book value quickly becomes out of date due to the cumulative effect ofprior depreciation charges that may bear no relationship to the realworld value of the assets.
REIT share prices are quoted daily, like all companies whose stocks arepublicly traded. However, REITs unique method of financial reporting creates
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something of a barrier between the REIT community and broader financialmarkets (Staveley, 1997). Investors do not understand the FFO (Fund FromOperations) standard and educating investors represents the biggestchallenge to REITs in attracting new capital.
The main methods used by Wall Street securities analysts to measure theworth of REITs stock are based on (DeWeese, op cit):
n the equity value of the REITs underlying assets (or the net asset value(NAV)), expressed as a dollar amount per share;
n multiple funds from operations or FFO (companies’ reported netincome in accordance with Generally Accepted Accounting Principals(GAAP) + depreciation +/– other accounting items); and
n multiple funds available for distribution (FAD) (= FFO – recurring, non-revenue-enhancing capital expenditure +/– straight-lining of rents).
NAV is the market value of real estate and other assets less liabilities. Marketvalue is usually based on the capitalisation of net operating income (NOI) fromproperty at a single overall capitalisation rate. Adjustments to reported NOI areusually made by analysts because of the way REITs report income andexpenditure under GAAP. The main adjustments relate to:
n property transactions in the last quarter;
n to reflect investors’ interest in prospective NOI, not just historic NOI;
n to reflect whether rent increases are accounted for by ‘straight-lining’or ‘step-ups’;
n whether tenant improvements (and other non-recurring expenditure) iscapitalised or dealt with as an expense; and,
n where the REIT manages its own property but reports propertymanagement expense as a corporate expense below the NOI line.
Problems in valuation can occur because the working definition of NOI and themethod by which it is developed are imprecise (Francis, 1998). The mainissue revolves around how tenants’ improvements are treated in thecalculation (in the US tenants’ improvements are improvements made by thelandlord in preparation for a new tenant, sometimes referred to as buildout andfit-up). The Dictionary of Real Estate Appraisal (Appraisal Institute, 1993) isvague about the inclusion of reserves for replacement and a recent survey ofinvestors (Francis, op cit) found there are multiple methods for calculating NOIin common use, and hence for calculating the overall capitalisation rate(OAR). Increased appraisal accuracy and confidence could therefore bebrought about by introducing certainty in the practice of defining NOI and OAR.
NAV is also not necessarily the most appropriate method of valuing a REITbecause:
n it values the underlying assets rather than the going concern; and,
n as now conducted, it does not comply with Standard 6 – MassAppraisals and Reporting. This is mainly to do with the assumptionsmade about whether property assets would be sold in bulk orindividually, and how much account is taken of individual geographicmarkets – which in turn affects assumptions about capitalisation ratesand periods to sell.
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DeWeese therefore recommends other appraisal methods to add validity toREIT valuations, particularly DCF analysis coupled with the examination ofcomparables, which would address timing and geographic issues. However,changes in valuation methods depend on appraisers being able to convinceWall Street that market based analysis can improve the quality of REITvaluations.
3.6 Germany
3.6.1 Closed and Open-End FundsTwo of the most important investment institutions in Germany are closed andopen-end funds. The distinction between them is discussed in Volhard et al(1998).
Closed-end property funds (usually in limited partnership form) are suitable forproperty investments which are profitable only if financed predominantly withequity funds. Schemes to date have yielded 4–6% on equity, with the incomebeing usually tax-free in the early years. The relatively high after-tax yield hasattracted investors to this partnership form, where holdings start at DM20,000.
In contrast, open-ended property funds were intended originally as a vehiclefor small investors to participate in a diversified portfolio of real estate, butsubsequently attracted institutional investors requiring special funds for smallinvestor groups. They offer tax transparency, but are subject to bankingsupervision. They have a two-tiered structure: an investment managementcompany and a legally separate fund of assets comprising funds contributedby investors, and investment made by the company on behalf of its investors.
Strict rules also govern:
n permitted investments;
n minimum number of properties (10);
n relative size of investments;
n borrowings; and,
n financial reporting and disclosure.
An investment company may establish a special fund provided it has no morethan 10 investors which are not individuals and the certificates issued are nottransferable without the company’s consent. This makes for tailor-made realestate funds for single or small groups of investors able to influenceinvestment strategy of the fund through representation on its investmentcommittee.
Special funds benefit from reduced supervision and reporting requirements,reducing the cost of managing them. The investment companies cantherefore charge lower fees while the investors enjoy the same tax benefits asnon- individual investors in public funds.
3.6.2 Other sources of property financeThere are a number of other sources of finance for property in Germany whichinclude:
n mortgage banks, or ‘hypotheken’
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n savings banks, cooperative banks and commercial banks
The mortgage banks provide long term finance – for up to 30 years, subject toa rigid regime laid down in the Mortgage Bank Act, on commercial as well asresidential property.
Refinances are made by issuing mortgage bonds (or Pfandbriefe) which, bylaw, must have more than adequate collateral and whose terms must strictlymatch the terms of the corresponding loans. This results in ‘excellent creditratings’. Such banks are limited to two kinds of business: mortgage loans andmortgage bond issues, and loans to/guaranteed by ‘public law institutions’,refinancing with communal bonds. Since 1988, Bank Act finance may beprovided for properties outside Germany.
Savings banks, cooperative banks and commercial banks are publiccompanies which are authorised to issue debenture bonds and similarsecurities for refinancing property. Savings and cooperative banks financemedium/large commercial property projects and savings banks are second inimportance to mortgage banks in long term loan markets secured on property.Commercial banks lend in conjunction with affiliated mortgage banks andprovide designer financial packaging, which they supervise, for the largerprojects. The borrower benefits by having to deal with only one partner. Shortterm lending or bridging finance also enables borrowers to obtain long termfinancing contracts more advantageously, giving more flexibility to exploit longterm rates or sell on completion.
Finally, building societies, although of lesser significance than mortgagebanks, can, through the Building Society Act 1991, finance commercialproperty developed in conjunction with residential projects or to provide localservices in residential areas.
3.6.3 Types of financeThe difficulty of placing securities (e.g. mortgage bonds) in the late 1980s ledto shorter terms, from 25–30 years to 5 or 10, with negotiation on renewal withthe borrower on the expiry of each period. The borrower’s risk was paramountas there was no legal obligation for creditors to renew and no guarantee thatinterest rates would not be higher.
Sinking fund loans are the standard form of mortgage bank and buildingsociety provision. Tax advantages arise if the borrower does not take up thefull amount of the facility immediately. If he can lock into the lender’s interestrate terms for the remainder of the loan in times of rising interest rates, furtheradvantage is gained, but for this privilege a standby fee is charged.
3.6.4 Financing criteriaIn order of priority, the factors governing the size of the credit are:
n the value of the property;
n the use to which the property is put; and,
n the creditworthiness of the borrower.
Three types of property valuations are recognised:
n Asset value – based on location, accessibility to transport routes,quality of neighbourhood, infrastructure, and the level of localdevelopment.
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n Productive value – based on the rent the building will commandallowing for maintenance and management expenses. The versatilityof the building increases its value, thus increasing the importance ofmulti-purpose buildings (combined office/'clean’ industry buildings).
n Lending value – 60% limit, based on asset and/or productive values –on mortgage banks’ lending if loan is to qualify as collateral formortgage bond issue. Higher percentages are possible wherealternative refinancing arranged. The law requires all credit institutionsto obtain the annual accounts and auditors’ reports of commercialborrowers before making an advance.
3.6.5 Securing property loansTraditionally property finance is full recourse. Besides collateral the creditoralso has a direct claim on the borrower, who remains fully liable for paymentof all amounts under the agreement.
The property serves as collateral, and there are two types:
n mortgages, which revert to the owner on settlement of debt, and
n land charges, which remain with the creditor independently of theexistence of any claim (i.e. after the claim has been settled). Such aland charge may be used as collateral for other loans, or assigned toanother creditor. The borrower may have the land charge cancelledonly when all his outstanding obligations have been cancelled.
3.6.6 Other forms of financingReal Estate Holding Companies (a tax-efficient vehicle established or acquiredby a foreign investor for investing in a property) are also common in Germany.The property is financed by a loan from its shareholders. Interest on the loan isdeducted from the rental income generated by the company, thereby reducing,if not completely eliminating, income tax for a number of years.
In property leasing arrangements, the capital is usually supplied by banks,which are also the lessors’ shareholders. The different models include ‘buyand lease’, ‘sale and lease back’ and ‘bring in and lease back’. With the last ofthese the building is brought into a leasing real estate holding company inreturn for the grant of shareholders’ rights and is then leased back to thelessee.
3.7 Summary and ConclusionsThis section has highlighted key features of US REITs and German closedand open-end funds. In particular, it has highlighted major issues, whichinclude:
n REITs possess a number of advantages over property companyshares in terms of lot size, liquidity, public trading and price informationtogether with tax transparency.
n The liquidity of REITs is a key characteristic and is higher than thedirect market.
n Previous research suggests there are diminishing returns for REITs interms of their evolution. A metamorphosis point occurs beyond which
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funds from operations’ income declines from an increasing assetbase.
n REITs are the dominant producers of real estate in the USA, and equityREITs dominate with about 87% of the market. REITs have been lessactive in Europe.
n In Germany closed-end property funds (usually in limited partnershipform) have proved successful in property investment when financedfrom equity funds.
n Open-end funds offer tax transparency but are subject to bankingsupervision. They have a two-tiered structure comprising aninvestment management company and a legally separate asset fund.
n Other sources of finance in Germany are important, includingmortgage banks (or ‘hypotheken’) and savings banks.
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4 INTERNATIONAL FINANCIAL REPORTING TAX ANDDEPRECIATION REQUIREMENTS
4.1 IntroductionThe last section examined the financial architecture of US REITs and Germanopen and closed-end funds in detail.
Such vehicles have evolved within differing environments as regards:
n financial reporting requirements;
n the relationship between taxable and accounting profits and thetreatment of depreciation; and,
n tax treatment.
In this and the following section, the characteristics of these environments isexamined in more detail. This section begins by highlighting the internationaldifferences in financial reporting requirements in different countries andexamining the impact of harmonisation. This leads into an examination of thetax treatment of property depreciation in the UK, Germany and USA and isfollowed by a discussion in Section 5 of the main tax advantages for overseasproperty investors in the UK.
4.2 IASC and the Fourth DirectiveInternational differences in financial reporting are far-ranging and in someareas fundamental. For this reason European regulatory systems and bodieshave evolved which include: Federation des Experts Compatables European(FEE), International Federation of Accountants (IFAC), and InternationalAccounting Standards Committee (IASC).
The IASC is particularly important because it sets international accountingstandards. The International Accounting Standards Committee (IASC) aims to:
n formulate and publish standards to be observed in preparing financialstatements;
n promote their improvement and world-wide acceptance;
n promote harmonisation of regulations, standards and procedures infinancial reporting.
The EU’s Fourth Directive is also important to consider as it covers public andprivate companies in all EU countries. Its articles include reference tovaluation rules, formats of published financial statements and disclosurerequirements, but it does not cover consolidation, which is contained in theSeventh Directive.
4.3 Valuation of fixed assets and investment propertiesIn fact neither asset valuations formats nor disclosure have been completelystandardised as a result of the Directive.
As Nobes and Parker (1998) point out, there is great international variation inthe predominant basis of valuation and the degree to which there isexperimentation and supplementation with alternative measures. In countries
56
with detailed legal rules and an overlap of tax and accounting regimes, suchas Germany, strict valuation rules apply. In the case of Germany this is thehistorical cost basis, which links with the German concern over inflation.
At the opposite end of the spectrum is the Netherlands where Dutchcompanies have used replacement cost as the basis for valuation in periodsof high inflation. The UK lies somewhere in between the two with a variety ofmethods adopted.
This has occurred despite the fact that the Fourth Directive states that ingeneral fixed assets should be valued at historic cost in financial reports(Article 32). Essentially, the EU Fourth Directive represents a compromisebetween the rule-based, tax driven continental system of financial reportingand the more permissive Anglo-Dutch approach to regulation. As such theDirective allows for flexibility in its adoption in individual countries according totheir different reporting and taxation regimes.
The Directive incorporates the concept of the ‘true and fair view’ as apredominant principle in the preparation of financial statements (1973).
Articles 31–33 relate to the valuation of fixed assets and include the followingprovisions:
n Whichever valuation method is used, the benchmark is historical cost.It must be either shown on the face of the accounts or calculable fromthe notes to the accounts.
n Article 35 requires systematic depreciation of fixed assets over theiruseful economic lives.
n Member states may permit or require supplementary or main accountsto be prepared on other bases such as current cost.
n Revaluation of fixed assets to be accompanied by a balancingrevaluation reserve.
Articles 35 and 36 cover the valuation and disclosure requirements in detail.
The Directive also contains provisions for value adjustments, allowingmember states to sanction alternative valuations in company accounts (byway of derogation from Article 32) based on:
n replacement value;
n current value accounting;
n revaluation of tangible fixed assets.
IAS 16 (Accounting for Property, Plant and Equipment) was amended in 1993to allow revaluation as an alternative treatment to the benchmark historicalcost method.
Similar lack of harmonisation occurs in relation to investment properties.
For example, in the UK SSAP 19 defines investment properties as those notowner-occupied, and allows their annual revaluation to net realisable valuesunder the ‘true and fair’ override of the 1985 Companies Act.
In this context the concept of systematic depreciation (i.e. the allocation ofhistorical or current cost) is irrational, so FRS15 does not require it. Theconflict that this creates between the standard on the one hand and the FourthDirective and Companies legislation on the other remains unresolved.
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Apart from Ireland, no other EU countries have adopted this treatment ofinvestment properties, and they ‘might not envisage such a flexibleinterpretation of the law’. The divergence in national approaches to theinvestment property valuation problem owes something to differences in thesource and nature of their legal systems.
4.4 The evolution of international differences inaccounting and financeIn the UK and USA the traditional source of corporate finance has been equityshare and loan capital provided by large numbers of private investors. Morerecently it is the institutional investors which have provided the lion’s share.
In Italy and France it is the state or banks that are the significant providers,along with family businesses. In Germany banks both lend to companies andhold equity in them, often with a majority share. Control is exercised directly orthrough proxies, and both banks and state nominate directors. The core ofGerman business, the Mittelstand, is financed by the ‘owner families’.
This difference in financing and control methods has repercussions forfinancial reporting under the two systems. In the Anglo-Saxon system,widespread share ownership by individuals and institutions who do not havedirect access to internal information creates pressure for full disclosure, ‘fair’reporting and auditing of accounts. The current dominance of the institutionalshareholders adds weight to this pressure.
By contrast, in Germany and France, banks, government and families havedirect access to the financial information of the businesses they control, sothe need for published information is not so urgent. External financial reportingexists primarily to meet the requirements of government, as tax collector andeconomic manager.
Although the pressure for financial transparency has not equalled that in theUK and USA, the French, Italian and German governments have legislated forfuller corporate disclosure, and their reporting systems have moved nearer tothe Anglo-Saxon model.
4.5 Legal differencesFurther differences have been accentuated by the law. In continental Europe itis Roman law which forms the basis of many commercial codes, which arecharacterised by their detailed but abstract rules for accounting and financialreporting. Both the nature of regulation as well as the type of detailed rulesapplied in a country are influenced by the nature of the legal framework.
In France, Belgium, Spain, Portugal and Greece the accounting rules aredetermined by ‘accounting plans’ (for example, the ‘plan comptable’ in France)run by government committees. In Italy a commercial code contains legalinstructions on accounting, and in Germany company accounting is almost abranch of company law.
In the UK, case and common law are more dominant than statute law inshaping the rules of accounting and financial reporting. Common law is lessabstract than codified law and looks for answers to specific problems. It doesnot provide all-embracing prescriptive rules governing company behaviour andfuture financial reporting. To a large extent, therefore, accounting and financialreporting in the UK have remained free of legal controls. Instead, it is the
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generally accepted accounting principles evolved by the accountancyprofession which control accounting. Where governments do intervene toimpose disclosure or other accounting requirements, they tend to follow bestpractice rather than create it. This is the model which has been adopted inIreland, the USA and most of the former UK overseas territories, such asCanada, Australia and India.
4.6 Harmonisation and standardisationHarmonisation is the process of increasing the compatibility of accountingpractices by setting bounds to their degree of variation, as distinct fromstandardisation, which uses the imposition of a more rigid and narrow set ofrules. The most serious obstacle to further harmonisation lies in thefundamentally different accounting practices found in the different memberstates. There are differences within each of the broad groups, Anglo-Saxonand Franco-German, to say nothing of the more fundamental differencesbetween them.
The conflict between the two systems is at the centre of the debate on thepurpose of financial reporting. It hinges on the basic ‘dichotomy between theshareholder / fair view presentation and the creditor/tax/conservativepresentation’. Further movement towards harmonisation therefore depends onprofound institutional and attitudinal change within each of the statesconcerned.
Whether these differences need to be closed is another question. One view isthat the form of financial reporting practised in each state should meet itsinstitutional requirements. On the other hand, it can be argued that in acommunity with a common currency, embarked on a policy of furtherconvergence of its institutions, it would be inconsistent to have diverseaccounting systems and reporting methods. To encourage inter-state capitalmovements alone it is necessary to have a flow of financial information in astandardised form on companies in different parts of the EU.
4.7 The treatment of tax and depreciation in the UK, USAand GermanyIt is possible to make groupings of tax systems in a number of ways, but onlysome are of relevance to financial reporting.
For example, Nobes and Parker (1998) divide EU countries into ‘classical’ and‘imputation’ systems of corporation tax. In classical systems dividends are notdeductible in the calculation of taxable income but are fully taxable forrecipients. Imputation systems are where recipients of dividends have someof the tax paid by a corporation on the income out of which dividends are paid.
However, it is the degree to which taxation regulations determine accountingmeasurements which is important to bear in mind, as is shown by the issue ofdeferred taxation, caused by timing differences between tax and accountingtreatments. In the UK and the Netherlands (and the USA) this has causedmuch debate, but not so in France and Germany. In the latter the tax rules arethe accounting rules: for example, in Germany the commercial accounts(Handelsbilanz) should be the same as the tax accounts (Steuerbilanz),hence the term ‘Massgeblichkeitsprinzip’ (or ‘bindingness’). Nobes and Parkerdistinguish two groups of countries therefore based on the concept ofcorporate financing (Table 4.1).
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Table 4.1 Classification based on corporate financing (after Nobes and Parker, 1998)
Anglo-Saxon Franco-German
Strong equity marketMany outside shareholdersLarge auditing professionSeparate accounting rulesExamples:
n UK
n USA
n Australia
Weaker equity marketCore, insider shareholdersSmall, auditing professionTax dominates accounting rulesExamples:
n Germany
n France
n Italy
4.8 Treatment of depreciation
4.8.1 Depreciation PracticesA comparison of the depreciation allowances on buildings is given in Table4.2. Theoretically a neutral depreciation system would provide depreciation fortax purposes corresponding as closely as possible to economic depreciation,which takes into account the wearing out of assets, as well as obsolescence.If this objective is not achieved, effective tax rates will vary between assetsand for the same kind of asset over time. Because the measurement ofeconomic depreciation is difficult, standardised depreciation rules are used.The annual account of depreciation on a given asset (and hence itsdepreciation rate) is influenced by the choice of useful tax life of the asset.
A variety of systems are used worldwide, but the most frequently usedmethods are straight line (equal allowances over the length of the tax life of theasset) and declining balance (e.g. as a fixed percentage of depreciated bookvalue). The former is more generous than the latter, so declining balance isgenerally provided at higher rates than straight line, and where countries givecompanies a choice about which method of depreciation to adopt, thedeclining balance is usually 2 to 3 times the straight-line rate. Some countriesalso allow for periodic revaluations of assets which affect the depreciationbase.
As far as buildings are concerned, the straight-line method is the morecommon depreciation method, although some countries (e.g. Belgium and theNetherlands) allow both methods. Incentives may also be granted and cantake the form of accelerated depreciation, by allowing depreciation at a higherrate in the early years of an asset’s life.
Table 4.2 Summarises depreciation systems from buildings in OECD countries (OECD,1991).
Rate of depreciation inpercent
Country Depreciation Switch-over*
SL DBAustraliaAustria
SLSL
Nona
2.54
--
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BelgiumCanadaDenmarkFinlandFranceGermanyGreeceIcelandIrelandItalyJapanLuxembourgNetherlandsNew ZealandNorwayPortugalSpainSwedenSwitzerlandTurkeyUKUnited States
SL/DBDBSLDBSLSLSLSLSLSL
SL/DBSL
SL/DBSLDBSL
SL/DBSL
SL/DBSL/DB
SLSL
Yesnanananananananana
Yesna
YesnanaNoNonaNoYesnana
3-5-
6/2-5
2.5-108245
2.2-4.32-43.32 -53
1.5-50.5 x DB
44
3.2
2 x SL4-9------
3 x SL-
2 x SL-7-
2.5 x SL-
7-82 x SL
--
* Switch over from declining balance to straight-line not vice versa.Symbols: SL: = straight-line; DB = declining balance; na = not applicable.
4.8.2 Depreciation PolicyIn June 1988 the European Commission issued a Draft Directive onharmonising the rules for the determination of the corporate taxable base in allthe domestic systems of the member states. However, this was withdrawn inMay 1989. No harmonisation of the concepts of depreciation or the valuation offixed assets within the EU has taken place since then.
However, the Ruding Committee (1992) did make certain recommendationsregarding depreciation:
n A Directive should be made proposing historic costs as the basis fordepreciation, which would also allow a free choice for the taxpayerbetween declining-balance and straight-line depreciation for alldepreciable assets other than buildings. Declining-balancedepreciation rates should not exceed three times the rates applicablefor straight-line depreciation. At the same time, all special depreciationrules with an incentive effect should be abolished.
n Harmonised rules for depreciation of buildings and the minimum andmaximum depreciation rates for assets; and,
n Uniform tax treatment for depreciation of goodwill and other intangibleassets.
These recommendations were not taken up, however, and, as Meussen(1999) points out, Ruding’s current stance is relatively low key. Ruding (1998)argues that tax competition within EMU member states is acceptable as longas the single market’s function is unaffected, and so only some degree ofharmonisation is necessary.
Meussen (op cit), however, suggests that unharmonised valuation anddepreciation of fixed assets within the EU is still an important issue,
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particularly in view of the introduction of the euro, which will create greatermobility of people, capital and enterprises. As the European market becomesmore transparent, different rates in income and corporate tax will attractattention, and the differing depreciation rules may be perceived by some aspart of the landscape of harmful tax competition. Meussen goes on to suggestthat accelerated depreciation should be restricted to commonly agreedmargins, and that pre-defined rates should apply in all EU states together witha lower valuation rule.
An example of this is provided by depreciation. In the UK the amount ofdepreciation charged is determined by FRS15, which requires thatdepreciation should be allocated so as to charge a fair proportion of the costor valuation of the asset to each accounting period in relation to the service theasset provides. Choice of the most appropriate method of depreciation foreach asset is left to management, subject to a requirement to allocate theexpense fairly. Nobes and Parker (1998) observed that, under the formerstandard SSAP12, injunctions on depreciation were not always meticulouslyobserved.
Indeed, in the UK the amount of depreciation for tax purposes is quiteindependent of the accounting figures. The depreciation of tangible fixedassets shown in a firm’s financial reports is a matter to be determined by thefirm’s accounting policies, which are constrained only by the requirements ofCompany Law and accounting standards. The capital allowances for differenttypes of tangible fixed asset which may be set against a firm’s CorporationTax liability are fixed by the Finance Acts and apply to all firms, whatever theiraccounting policies. In theory these operate as investment incentives subjectto the Treasury’s overrriding requirement to raise revenue. The two schemesof accounting and tax are separated in the UK, therefore, with no subjectivityallowed with tax allowances, but full room for judgement in financialdepreciation charges.
At the opposite end of the spectrum, in countries such as Germany, taxregulations set out the maximum depreciation rates to be used for particularassets, and are generally based on the expected useful life of assets.
Accelerated deprecation allowances may also be available which, if claimedfor tax purposes, must also be charged in the financial accounts – in the UKthe charge against profit would not be considered ‘fair’ but would be ‘correct’or ‘legal’.
In summary, the concern with depreciation varies from a fairly precisespecification of rates and methods to be used (as in most countries), to aninterference only where charges are unreasonable (as in the Netherlands).Moreover, accounting and tax depreciation must be kept the same in Franco-German countries but not in Anglo-Saxon-Dutch countries. The treatment ofdepreciation rates and methods for depreciation of fixed assets are nowsummarised in more detail.
4.9 The UKIn the UK, the system of capital allowances has evolved as a means ofencouraging certain types of investment by postponing taxation paid by acompany in proportion to the investment it carries out. There is, of course,complete separation of this scheme from the depreciation charged bycompanies against accounting profit. Unlike other countries, the UK does notgive depreciation tax allowances for most commercial buildings.
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Since 1986 the system in the UK has been very simple:
n most assets receive writing down allowances of 25% on a reducingbalance basis, and
n industrial buildings receive a 4% writing down allowance on a straight-line basis.
Maas (1998) outlines the different treatments accorded to dealing andinvestment companies.
4.9.1 Dealing companiesThese are not entitled to claim capital allowances in respect of expenditure onproperties held as trading stock because s.159(1) of the Capital AllowancesAct 1990 states that any sum deducted in the computation of trading cannotbe classed as capital expenditure (which attracts the capital allowances).
Where a tenant pays a premium for the lease of a property held as tradingstock, he is entitled to claim capital allowances. For an industrial building thismeans that the lease is treated as a sale of the interest for the amount of thepremium. For commercial property (office or retail) incorporating equipmentthat has become a landlord’s fixture, for which neither the landlord noranybody else has been able to claim capital allowances, the lessee is treatedas having incurred capital expenditure on it equal to the share of the premiumattributable to the fixture.
4.9.2 Investment companiesThe Capital Allowances Act of 1990 sets out the current rules on capitalallowances affecting property interests. For UK property investmentcompanies the most important provisions are those relating to:
n plant and machinery;
n industrial buildings;
n commercial buildings in Enterprise Zones; and
n equipment used in the management of property.
4.9.3 Plant and machineryA significant percentage of the purchase price of a modern commercialbuilding relates to items that are recognised as plant and machinery. Theshare of expenditure on such a building that is attributable to qualifying assetsin this group can be set against Corporation Tax liability as a capitalallowance. The proportion of the purchase price of a modern buildingconstituted by qualifying plant and machinery varies widely. For a late 1970soffice block without air-conditioning, the figure averages 12%. For a modernair-conditioned building, the proportion will be much higher.
Such capital allowances apply equally to buildings purchased second-handand those newly constructed.
It has not proved easy to arrive at a formal definition of plant and machinery.However, since 29 November 1993 there have been substantial statutoryrestrictions on what items of plant and machinery in a building qualify forallowances.
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Machinery presents few problems of definition. In a property context it includessuch items as:
n escalators;
n lifts;
n heating installation; and,
n air conditioning.
Capital allowances can be claimed in respect of plant and machinery used inconnection with a property company’s management of its investments.
The leasing of plant and machinery, other than in the course of a trade,attracts capital allowances. Such allowances will also be made where abuilding is let and the plant and machinery installed is included in the lease.
The current capital allowance is at 25% on the reducing balance ofexpenditure on qualifying plant and machinery. Since 25 November1996 thewriting down allowance on expenditure on long-life assets (original estimatedlife at least 25 years) contracted after that date has been restricted to 6% paon the reducing balance. For contracts prior to that date, implementation willnot begin until 2001.
This treatment of long-life assets is restricted to industrial and specialistbuildings. The philosophy underlying its introduction was that the 6%allowance on the reducing balance of plant would just balance the 4% straight-line industrial buildings allowance. The objective was to remove distortions inthe tax treatments of plant and the buildings in which it was housed, makingthe investor’s choice between them tax-neutral. After the first seven years,however, the long-life asset allowance becomes less attractive than the IBAs,with the extra relief given in the early years being completely clawed back inthe next eight.
Balancing charges and allowances can arise. For example, the charges incases where the sale proceeds of an asset exceed the written down value ofall the plant and machinery in a building; the allowances, where the proceedsfrom the sale of the building which are attributable to the plant are below itswritten down value.
The Cole Brothers case 1982 resulted in Inland Revenues accepting wiringand trunking to a wide range of apparatus in a commercial building asallowable plant.
4.9.4 Industrial buildings (IBs)IBs are defined according to their use. Outside of specialist buildings theircommon denominator is that a trade is carried on in them, not a profession orvocation. Buildings used wholly or partly as a shop, office or any supportingpurpose to these are excluded from the definition.
Maas (1998) emphasises that it is the use to which a building is put, not theuse to which the taxpayer puts it, that determines whether it is an IB. Ataxpayer (as owner/landlord) might derive rental income from a buildingprovided that the occupier (tenant, sub-tenant or licensee) uses it for aqualifying purpose.
If less than 25% of total expenditure on a building does not qualify as an IB butthe rest of it does, the Revenue agrees capital allowances on the whole of thebuilding. Expenditures on the building are measured at historical cost. Thus a
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1999 office extension to a 1987 IB is unlikely to be under 75% of the totalexpenditure on the building at historic cost.
4.9.5 Commercial buildings in Enterprise Zones (EZ)Allowances are based on IBA rules, with 100% initial allowances or lower atthe taxpayer’s option with a 25% writing down allowance. The expendituremust be contracted within 10 years of an EZ’s creation. A purchaser of an EZbuilding can claim 100% allowance within 2 years of first use, providing it isthe first sale after first use.
No clawback of allowances is allowed if the building ceases to be used for thequalifying purpose. Unexpired allowances continue even if the qualifying use isdiscontinued during their currency.
4.9.6 Reform of capital allowances in the UK?In the UK suggestions for the reform of capital allowances have included:
n extending them to commercial buildings (such as offices and shops);and
n basing them on current cost accounting depreciation.
However, the former is regarded as too expensive and detrimental toinvestment in manufacturing industry. Moreover, the latter suggestionbecomes less relevant in periods of low inflation.
Capital allowances apply to plant and machinery installed in buildings, and tothe fabric of certain qualifying buildings. In one sense such allowances mightbe regarded as concessions or compensation for the (accounting) cost ofdepreciating these assets. Regarded in this way, there appears to be a casefor extending capital allowances to all commercial buildings that are subject todepreciation in a company’s accounts. However, although all commercialbuildings suffer depreciation in a general sense, unless the properties are heldon short leases property companies do not make provision for this in theiraccounts. Hence no tax concession is warranted.
A further problem is that capital allowances on plant and machinery might beconsidered by some as generous in the extreme: for example, lifts and heatingsystems. There can be little doubt that Treasury decisions on tax allowancesdistort investment flows into property, and an examination of alternativetaxation models based on overseas practice could give useful insights intotheir effects.
4.10 USAIn the USA, there are depreciation ranges for different assets. Normally, fixedassets are written off for tax purposes using the ‘modified accelerated costrecovery system’. The most common type involves 3, 5 or 7 year classes,which are depreciated on the declining balance basis, using twice the straight-line rate. Interestingly the US position on accounting for investment propertiesdiffers markedly from the UK: no special treatment of investment properties ispermitted, nor are revaluations.
Greer (1997) summarises depreciation allowances in the USA as follows:
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n Cost recovery tax allowances for buildings and land improvement overperiods are specified in the Inland Revenue Code.
n Applies to assets held for ‘income or business purposes’. Emphasis ison ‘intent’ to produce income (e.g. a tenant may not actually occupythe premises providing the intention exists).
n Legislators adjust the recovery period from time to time with noapparent regard for the life of the asset. Their criteria seem to be thefiscal requirements of government (recovery periods lengthened) orthe desire to stimulate investment (recovery periods shortened). Thecurrent recovery period for non-residential buildings is 39 years; forresidential buildings (for which at least 80% of gross rents must befrom residential tenants), 27.5 years; and for land improvements, 15years.
n For land development, taxpayers may accelerate depreciation by 150%declining balance method, which permits larger allowances duringearlier years offset by smaller allowances later (e.g. for the first fiveyears the allowance would be 150% x 1/15 = 10% on a reducingbalance, with the taxpayer reverting to straight-line depreciation of theremaining balance over the remaining 10 years, i.e. 10% pa).
n Extensions and improvements to real estate must be capitalised. Theyare then written off through depreciation allowances, as with theoriginal recoverable cost, but on an entirely separate recoveryschedule.
n Transaction costs of acquisition and disposal are also added to the taxbase.
n Realised gains or losses may be treated as ordinary income or ascapital gains for tax purposes. If treated as the latter, the tax treatmentis different, with losses offset against ordinary taxable income only to alimited extent.
n Gains on disposal are treated as ordinary income when they resultfrom:
n ‘recapture’ of depreciation or cost recovery allowances. Prior to the1986 tax changes investors could opt for accelerated depreciationallowances; and,
n selling assets held for resale as part of the ordinary course ofbusiness, i.e. dealer properties.
n Gains realised from the sale or taxable exchange of non-dealerproperties and of properties used for operational purposes, which areheld for more than 12 months, are treated as capital gains, ‘unlesscharacterised as recapture of depreciation or cost recoveryallowances’.
n Where losses on assets have occurred, however, a distinction intreatment exists between gains made on the disposal of operationalproperties – termed Section 1231 assets in the US Internal RevenueCode – and the gains made on investment properties. Gains on thesale of Section 1231 assets are treated as capital gains to the extentthat they exceed losses on the sale of other Section 1231 assetsduring the same taxable year; losses (net of offsetting gains) aretreated as reductions in ordinary income for the year. Rented real
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estate held for more than a year and which the owner activelymanages is also classed as a Section 1231 asset.
n The distinction between gains treated as capital gains and thoseregarded as income for tax purposes is important because the formerin most cases are taxed more lightly. Where the taxpayer’s marginalrate of tax is less than 28%, then the applicable rate on his ordinaryincome is applied to the long term gains. Where his marginal rate isabove 28%, the gains are taxed at 28%. There is also an upper limit onthe size of the capital losses that can be deducted from ordinaryincome during any one year.
4.11 GermanyIn Germany depreciation rates are specified by tax law. Straight-line andreducing balances are available, but straight line is mandatory for buildings.Depreciation is, in general, allowed in the case of tangible and intangible fixedassets with a useful life of more than one year, and is based on acquisition orproduction costs (KPMG, 1998).
Taxpayers may switch from the declining balance method to the straight-linemethod but not vice versa, and rates under the declining balance method maynot exceed three times the applicable straight-line rate, or 30%, whichever isless. Except for buildings, depreciation rates are not fixed by statute; however,the Federal Ministry of Finance publishes guidelines of useful lives.
Typically accepted straight-line rates are:
n new buildings and factories: 4% over 25 years (built post 31 March1985)
n offices and residential: 2% or 2.5% over 50 years (4% in 1985 andsubsequent years, where the building permit was applied for after 31March 1985)
n plant and equipment: 5% to 20%
n machinery: 10% to 20%
n motor vehicles: 20% to 25%.
Special depreciation allowances are also available (Ernst and Young, 1997).Examples include:
n new real estate in former East Germany: 22% in first year (27%,residential)
n modernisation of used property in former East Germany: 42% ofmodernisation costs in first year and balance over 9 years.
4.12 Summary and ConclusionsThis section has highlighted key features, which include:
n International differences in financial reporting are far ranging, and, insome areas, fundamental. This has important ramifications for thevaluation of fixed assets and investment properties.
n Harmonisation faces obstacles in overcoming differences betweenAnglo-Saxon and France-German systems of practice.
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n A variety of depreciation practices operate worldwide. In the UK, thesystem of capital allowances has evolved as a means of encouragingcertain types of investment by postponing taxation paid by a companyin proportion to the investment it carries out.
n In the USA, there are depreciation ranges for different assets.Normally, fixed assets are written off for tax purposes using the‘modified accelerated cost recovery system’. The most common typeinvolves 3, 5 or 7 year classes, which are depreciated on the decliningbalance basis, using twice the straight-line rate. No special treatmentof investment property is permitted in the USA, nor are revaluations.
n German depreciation rates are specified by tax law and straight-linedepreciation is mandatory for buildings. Depreciation is allowed in thecase of tangible and intangible fixed assets with a useful life of morethan a year and is based on acquisition or production costs.
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5 TAX ADVANTAGES FOR OVERSEAS INVESTORS IN UKPROPERTY
5.1 IntroductionIn the previous section of the report, financial and accounting differencesbetween countries were highlighted as being a critical set of factors inunderstanding how real estate institutions operate in their own country andwhat are they faced with when they operate overseas.
Taking these arguments a stage further, this section of the report discussesthe main tax advantages for overseas property investors in the UK and inparticular focuses on:
n comparative tax regimes;
n the effects of taxation on international investment flows;
n tax regime for UK property companies;
n offshare and other vehicles in the UK; and,
n direct and indirect overseas investment in the UK and tax advantages.
5.2 The UK as a tax havenFor investors who are neither resident nor ordinarily resident in the UK andwho carry out property investment, the UK represents a ‘tax haven’. Acompany can be set up in the Channel Islands or Isle of Man and thatcompany could purchase the property and sell the same free of all UK taxation(Soares, 1996). In addition, the rental income can be protected by appropriateborrowing, which can be from a non-UK source and can be paid gross to thelender provided certain minimal conditions are satisfied. A range of capitalallowances is also available.
As far as resident companies which invest in real estate in the UK areconcerned, they are chargeable to corporation tax on their worldwide profits,being charged by reference to total income earned from all sources in thecompany’s accounting period, including chargeable capital gains.
If the investor is non-resident and is a trader, then it will usually be the casethat the profits from land deals will have arisen in the UK. The non-residentinvestor who carries on a trade in the UK through a branch or agency istherefore liable to corporation tax on the income and chargeable gains fromthe branch or agency. However, double tax treaties may provide protection, or,alternatively, the non-resident investor simply provides funds to a UK companyobtaining the issue from the UK company as a discount bond. This can bepaid gross overseas and will comprise a deductible debit in the books of theUK company.
Soares (1996) summarises the position for non-resident overseas investors inthe UK, as shown in Table 5.1.
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Table 5.1 Overview of UK Property Tax for Overseas Investors
NON-RESIDENT AND NON-ORDINARILYRESIDENT IN THE UK
CAPITAL GAINS – tax haven
TRADING – treaty relief or discount bonds
RENT – shelter with interest, capital allowances andshort lease premiums
5.3 Tax policy issuesTax reform on corporate profits has been a major concern for developedcountries in recent years. Corporate tax systems have been criticised on anumber of grounds (OECD, 1991):
n their alleged adverse effects on domestic savings and investment;
n the fact that distortions in international capital allocation may occur;
n their complexity; and
n the lack of neutrality between corporate investment and the authoritiesof unincorporated enterprises.
The increasing globalisation of capital flows and the creation of the singleEuropean market have added to the pressures for a greater degree ofharmonisation of taxation regimes. As we have seen, taxation is an importantdeterminant of investment behaviour and this applies to real estate as muchas it does to the other forms of fixed, capital investment.
At an international level, governments have to consider not only the design oftheir domestic tax systems, but also how different systems interact. There aretwo broad sets of policy issue:
n protecting the revenue yield from taxes on profits and ensuring a fairshare of the international tax base; and
n maintaining a favourable tax climate for inward investment, andavoiding an outflow of domestic capital.
Over the last two decades organisations such as OECD have developed'ground rules' to reconcile their policy issues internationally. Rules havedeveloped, for example, concerning the allocation of taxing rights betweensource and residence countries and to agree transfer pricing for tax purposes.In the EU the Ruding Committee (1992) has also been active in promoting agreater debate over tax policy issues. In particular, the possibility of 'taxarbitrage' and 'treaty shopping', as a result of greater mobility of financialcapital between countries with different tax treatment for investors andinvestments, has caused concern, because of the impact on tax revenue-raising capacity and economic efficiency.
Indeed, the Ruding Committee suggested that divergent corporate tax withinEU countries caused distortions to investment decisions made bymultinational firms, and that a common system of taxation within the EU
70
should be used to narrow the gap between the most and the least favouredregions.
Internationally, therefore, key policy issues that have caused concern include(OECD, op cit):
n Questions of distribution: how can policy makers ensure an equitabletax treatment of foreign compared to domestic investments?
n Questions of resource allocation: how can tax systems be designed tominimise distortions in capital allocation?
n Questions of credit and exemption: should a system of capital exportneutrality (CEN) or capital import neutrality (CIN) be maintained?
n Questions of equality: how can problems caused by 'unfair' or 'harmful'tax competition between countries be resolved?
5.4 Comparative Tax RegimesThe question of how and whether corporate profits should be taxed is clearly amajor issue for debate. Indeed, most OECD countries have undertakenreform of one sort or another to their corporate tax system. Empirical studiesillustrate this fact in some detail.
For example, building on an earlier OECD (1991) study of corporate taxation,the Institute of Fiscal Studies (IFS, 1997) carried out an analysis of theevolution of corporate income taxes in 10 OECD countries (Australia, Canada,France, Germany, Ireland, Italy, Japan, Spain, UK and USA) over the period1979–1994. They found that the dominant trend in tax reform was a loweringof tax rate, combined with extending the tax base through a reduction indepreciation allowances.
The IFS study focused on manufacturing investment, but the findings areimportant to note in the context of the current research. For example, usingthe measures Effective Marginal Tax Rate (EMTR) and Effective Average TaxRate (EATR), it was shown that over the period 1979–1994 it was more costlyfor foreign investors to invest in a country than it was for domestic investors todo so. For example, Figure 5.1 shows the changing pattern of EMTR over theperiod. EMTR is the effective rate of tax applied to a marginal investmentproject and measures the difference between the pre-tax rate of return earnedby the company on a marginal investment project and the post-tax rate ofreturn earned by the investor.
In the graph the ‘source’ country is the country into which an investment ismade and the ‘residence’ country is the home country in which the companyis based. The term ‘domestic’ refers to a UK investor investing in the UK. Thusin the years shown it has always cost less in tax terms for foreign companiesto invest in the UK than for UK companies to invest overseas. However,domestic investors investing in the UK have always had the lowest tax rates.Similar patterns emerge in the USA and Germany, but, as can be seen,Germany and USA appear during this period to offer less attractive taxregimes than the UK.
Similarly, the net present value of depreciation allowances at the discount ratefor domestic investment, financed by retained earnings, were calculated forthe same period. This is shown in Figure 5.2. This shows that the system ofdepreciation allowances for the UK and USA are less attractive than that ofGermany over the period 1979–94.
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Figure 5.3 shows the ‘tax wedge’ or impact of taxation on a range ofinvestment in buildings, plant and machinery and inventories. This shows thatover the period the UK tax regime has again been more attractive to investorsthan the USA and Germany.
This picture is also reinforced by a Federal Ministry of Economics study(1996), which used a computer model to compare German tax burdens withFrance, UK and USA over a ten-year period. The German tax burden was thehighest, which results from the relatively high proportion of taxes based onincome (i.e. corporation tax, solidarity levy and trade tax on income). Togetherthey lead to a charge to profit taxation 42% higher than in France, 37% higherthan the UK and 23% more than the USA.
The decline in overall corporate taxes is also supported by a KPMG survey(KPMG, 1999), which showed that on 1 January 1999 developed countries inthe OECD had an average corporate income tax rate of 34.8%. Indeed, overthe past 4 years the average corporate tax rate among OECD countries fell by3%. Since 1996 the average corporate tax rate in EU countries has also fallenby 3% to 36%. Figure 5.4 shows the relative corporate tax rates for the EU andUSA.
It is also useful to compare the relative tax burdens in countries. A valuablesource of data here is the OECD's Annual Revenue Statistics, which was alsoused in Currie and Scott's (1998) survey of commercial property stamp duty.Under category 4400 (Taxes on Financial and Capital Transactions), whichincludes stamp duty, the tax taken in this way as a percentage of both totaltaxation and GDP can be calculated. The result for 1996 is shown in Figure5.5 and Figure 5.6. However, using line 4000 in the OECD data ‘taxes onproperty’ (which includes the 4400 category plus other recurrent and non-recurrent taxes on the use of ownership of property, including real estate andfinancial assets) produces a different pattern. This shows that property tax asa percentage of total tax and GDP is higher than in any other EU country(Figure 5.7 and Figure 5.8).
It is not altogether clear why the pattern should be so different. Currie andScott (op cit) suggest that the UK's lack of depreciation allowances on non-industrial property may be responsible, but this is not certain. Going behindsuch 'macro' level figures to examine the tax differences of domestic andforeign property investors in the UK is very important therefore.
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Figure 5.1 Effective marginal tax rates
0
10
20
30
40
50
60
70
Ger
man
y 19
79
1984
1989
1994
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A 1
979
1984
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197
9
1984
1989
1994
Tax
Rat
e (%
)
Domestic EMTR
Source EMTR
Residence EMTR
Figure 5.2 Net present value of depreciation allowances
0
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f D
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Figure 5.3 The ‘tax wedge’
-2
-1
0
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Figure 5.4 Corporate tax rates
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ly
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y
Cor
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te T
ax R
ate
01-Jan-98
01-Jan-99
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Figure 5.5 Taxation on capital / financial transactions as a percentage of total taxation,1996 (source OECD)
Figure 5.6 Taxation on capital / financial transactions as a percentage of GDP, 1996(Source OECD)
0.00
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Spai
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gium
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Italy
Per
cent
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Figure 5.7 Property taxation as a percentage of total taxation, 1996 (source OECD)
Figure 5.8 Property taxation as percentage of GDP, 1996 (source OECD)
0
0.5
1
1.5
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a
Per
cent
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5.5 Effects of taxation on international investment flowsAs the work of Nielsen and Sorensen (1991) and the Ruding Committee (opcit) shows, changes in corporation taxation can have a significant effect onportfolio capital flows through their impact on the domestic level of interestrates and stock prices. Furthermore, portfolio investment will be affected bypersonal taxes on capital income and economic theory suggests how this canoccur.
For example, as indicated in Table 5.2, a rise in Corporation Tax (CT) rate willlead to a decline in net capital imports. A higher Corporation Tax rate lowersexpected future net dividends, thereby reducing the market value of sharesand discouraging corporate investment. Reducing shareholder wealth meansshareholders will increase their savings, and so falling investment andincreased savings leads to a fall in domestic interest rates, leading to smallercapital imports and far higher capital exports.
Table 5.2 Likely Effects of Taxation on Net Imports of Portfolio Capital in Short orMedium Term (source: Ruding Commitee, 1992)
Effect on PersonalTax onInterestIncome
CorporationTax
PersonalTax onDividends
PersonalTax onCapitalSales
InvestmentIncentive
Investment + - - - +Saving - + + ? ?
Net Capital + - - ? (-) ? (+)Imports
*NB. Signs in brackets indicate most likely effects.
Empirical studies in the field of international portfolio investment haveattempted to determine whether the tax effects suggested by economic theorydo occur in practice. However, such studies face the problem of studying whatare essentially volatile flows in relation to a variety of investors with differenttax positions.
Anecdotal and informal information, however, suggests investment incentiveshave influenced inflows directly (Sinn, 1988). For example, the huge capitalinflows into the USA in the early 1980s were driven by the US EconomicRecovery Tax Act of 1981, which introduced an investment tax credit of 10%and a very generous system of depreciation allowances, termed the'Accelerated Cost Recovery System'. The combined effect was toimmediately write off all investment expenditure. Domestic private investmentand domestic average interest rates rose sharply, as did net capital imports,mostly in the form of Portfolio Investment. Other studies by Bounberg et al(1990) and McClure (1989) suggest tax policies and capital flows are linked.
Portfolio capital flows tend therefore to display dramatic responses to shortterm changes in net returns but FDI usually involves longer-term factors.Empirical studies of taxation and FDI fall into three main groups:
77
n simulation studies;
n econometric studies; and,
n survey studies.
Simulation studies (such as that by Horst, 1977) are based on thepresumption that models can be developed which reproduce or explain a setof economic data for a given country in a given year. Such studies useelasticities to measure the impact on FDI of changes in tax rate.
Although simulation studies have proved valuable for analysing the impact oftax changes, they are usually limited to 'single country, single year' studies.Econometric studies, however, are based on statistical analysis of time-seriesdata covering many years and/or analysis of cross-sectional data coveringseveral countries. Such studies have frequently focused on the USA, reflectingthe greater availability of data in that country. The studies of Hartman (1984),Boskin and Gale (1987), Young (1988) and Slemrod (1990) suggest that thereis some evidence of a negative effect of US Corporation Tax on FDI into theUSA, but that the precise quantitative effect remains uncertain. Altshuter et al(1998) use data from the US Treasury corporate tax files for 1984–92 to showthat, in the latter part of the period, allocation of real US capital abroad hasbecome sensitive to differences in host country taxes. This mirrors thefindings of earlier cross-sectional studies of US investment by Hines and Rice(1994) and Grubert and Mutti (1991). Similarly, Cummins et al (1996) foundthat international investment flows were sensitive to taxation: the adjustmentcosts of investment were 5%–10% per unit of investment expenditure, whichis a significant amount.
Econometric studies, however, often suffer from a lack of relevant and reliabledata as well as the difficulties of quantifying qualitative factors, such aspolitical risk. Studies have also therefore used survey methods, based onquestionnaires to elicit information from executives in multinationals as to theimportance of various factors determining their choice of investment location.However, this type of study should be viewed with some degree of cautionbecause the questionnaire may invite a particular type of answer and repliescould reflect an ex-post rationalisation of the investment decision, or simplythe desire to have low taxes. The potential for non-response bias must alsoalways be borne in mind.
Results from surveys, such as Devereux and Pearson (1989) and Wilson(1991), suggest the international corporate tax system does influence FDI. Interms of particular aspects of the tax system Devereux and Pearson foundthat corporation tax rates were most important, followed by withholding tax anddepreciation rates.
The Ruding Committee (1992) also carried out its own EU-wide survey andfound the following results:
n Taxation does have a significant impact on the location of real estateinvestment activities (47% of respondents).
n Taxation has even more impact on the financial and legal structure ofcompanies, and some 78% of respondents claimed tax was always orusually a major factor in determining the location of a financial centre.
n Taxation is important in determining how profit is repatriated to a parentcompany.
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n Compliance costs and tax planning costs are far greater for foreign-source income than for domestic-source income.
The committee also went on to suggest that while some degree of taxconvergence had occurred in the EU, this was mainly due to the downwardconvergence of interest and inflation rates rather than the action of the taxauthorities.
More recently, a major survey by Deloitte Touche (1996) of 350 globalcompanies found that 80% of investors are influenced by tax issues wheninvesting (ie locating commercial, industrial or HQs) overseas, although tax isnot the most important factor when making an investment decision. Otherfactors which impact on investment decisions include economic incentives (iegrants, which are more important than tax incentives), political and economicstability and a strong currency. For those influenced by tax advantages in theEU, low tax rates were considered to be the most influential, although otherfactors such as high depreciation rates and tax-free reserves were alsoimportant. Indeed at the time of the survey the low Irish Corporation Tax rate(10%) was the most important tax incentive to investors.
However, it would be wrong to infer from such studies that taxation is the onlyfactor to influence FDI. As Deutsche Bundesbank (1997) reports:
‘Differences in taxation unquestionably play a major role in thelocational decisions of internationally operating enterprises.International tax comparisons are a very complex matter, however,which usually cannot be captured by single indications.... It is at leastnecessary to take into account as well the depreciation rules, thepossibilities to set up untaxed pensions, the valuation rules andoptions under tax law. Furthermore, the profitability of an investment inanother country depends not only on the tax system of the country inquestion but also on the interaction of the respective tax systems inthe investor country and in the target country, in the form of fundingand the type of investment’.
5.6 UK tax regime for property investors – an overview
5.6.1 Traders and investorsIt is important to explore the distinction between dealing and investmentcompanies because this affects the UK tax treatment of property transactions.For example, a company that is neither resident nor trading in the UK is notchargeable to capital gains. Conversely, a company trading in the UK in realestate would either be charged to corporation tax through its UK branch oragency, or charged under certain anti-avoidance legislation, which taxes, asincome, the gains on disposal.
Property owners holding property as an investment rather than trading stockwill also be entitled to relief for the gain attributable to retail price inflation.
The UK’s system of capital allowances may also benefit overseas investors,but not dealing companies.
5.6.2 Withholding taxesRental income paid to overseas investors is subject to a withholding tax(deducted by tenant or managing agent).
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5.6.2.1 Individuals
For non-resident individuals, net rental income is subject to withholding tax atthe basic rate of income tax. This may cause cash flow problems, somanaging agents are appointed to receive the gross rent. All allowableexpenses and deductions are made in UK by the agent, and the net income ispaid to the overseas landlord on which the withholding tax is then levied.
5.6.2.2 Companies
For non-resident trading companies, a withholding tax on gross rental incomeat the small companies Corporation Tax (CT) rate less deductible expenses isapplicable. When a non-resident company acquires the property thenstandard CT rate is payable, although a relevant double tax treaty may meanthe lower rate is paid.
5.6.3 Interest relief for offset against rentThe Finance Act 1994 made it possible to borrow from a non-resident lenderwithout paying withholding tax on the rental income at source. Previouslegislation meant that interest had to be paid to a UK bank or to a UK branch ofan overseas bank and ‘back-to-back’ loans were essential to relieve the rent oftax. Overseas property investors can, however, manage to purchaseinvestment property in the UK and avoid tax on rent by offsetting the intereston borrowings against rent.
5.6.4 Double tax treatiesThe rapid increase in world trade, trading blocs and multinationals meant thatsome mechanisms were needed to prevent industry and firms being taxedtwice, or at different levels, for the same or related activities. This led to thedevelopment of double taxation treaties after 1945, which closely paralleled thedevelopment of other international organisations such as OECD, GATT andNAFTA.
The OECD model treaties in particular seek to define such issues as:
n the scope and taxes covered together with legal entities and theirdefinitions;
n criteria for tax residence in the contracting state;
n the degree of permanence required for a legal entity to be trading ‘in’ asopposed to ‘with’ a contracting state.
n what is meant by immovable property, because such property willnormally be taxed only on the basis of local law (Iex situs); and,
n specifying the exact method by which double taxation is avoided ineach member state through tax exemptions or tax credits.
Clearly no contracting parties intend to create potential tax loopholes, and inany case most tax treaties include anti-evasion/avoidance instruments.However, the effective employment of such provisions is almost impossiblebecause companies are separate legal entities subject to benefits anddisadvantages of their jurisdiction of registration. Imposing general rules wouldgo against the grain of free trade; therefore, ‘treaty shopping’ benefits areavailable and legal weapons for foreign property investors to exploit. Such
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benefits may be used in the following ways (Spencer-Higgins and Smith,1998):
n taking advantage of the way in which ‘movable’ and ‘immovable’property is taxed;
n ‘time discrepancies’, when deals struck before changes to tax treatiesare carried through under an existing system;
n maximising tax exemptions and credits especially through the use of aholding company for foreign investments; and,
n treaty ‘sandwiching’, whereby the presence of tax treaties between twocountries creates the opportunity to take advantage of a third party’sexisting tax treaty as a ‘sandwich’ between the two countries.
Double tax treaties, can, of course, offer substantive benefits. For example,German resident investors in UK real property will be exempt from German taxon UK rental income, although the income can be taken into account indetermining the rates of tax on other taxable income. This can make directinvestment very attractive to a German resident investor because of the higherGerman tax rates. Indeed, it has recently been announced that the Germangovernment plans to extend from 2 years to 10 years the period in which CGTcan be levied after an acquisition. Since CGT is not the subject of a double taxtreaty between Germany and the UK, this charge may have a marginal impacton German property investment in the UK.
5.7 Offshore and other vehicles in the UKThe UK’s tax system enables foreign investors to purchase property throughan offshore vehicle and remain outside the UK tax net. This is just one,however, of a number of vehicles which overseas investors may use. Theyinclude:
n UK limited partnerships;
n off-shore unit trust;
n off-shore company;
n off-shore authorised property unit trust; and
n UK company.
Each has varying tax advantages and disadvantages.
US investors have also exploited the tax advantages of UK propertyinvestment through the use of a variety of vehicles. Limited partnerships, ‘S’corporations and limited liability partnerships have been used successfully.For example, in the USA limited partnership model US investors invest or dealin UK land through an overseas limited partnership (Figure 5.9). As profit hasarisen in the UK it will be liable for the basic rate of tax, or higher rates ifindividuals are behind the partnership. The UK–USA tax treaty governs itstreatment but if the land transaction receives an investment transaction itshould remain free of CGT.
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Figure 5.9 USA Limited Partnership (after Soares, 1996)
US INVESTORS
LIMITED PARTNERSHIP
UK LAND (INVESTMENT/STOCK)
5.7.1 Limited partnershipsThe idea of ‘unitising’ property is not a new one. For many years propertyspecialists have debated how best to enable owners of buildings to have a‘share’ in the ownership of the freehold, and to provide a tradable investmentmarket which is tax transparent.
Indeed, the whole issue of property unitisation was examined in the InvestmentProperty Forum’s (IPF 1995) report on property securitisation. Essentially,property unitisation requires:
n units – investors must receive a percentage share of a property’sincome flow and capital value in proportion to the investor’s share;
n marketability – shares must be able to be traded;
n trouble-free management – investors would prefer not to be concerneddirectly with this issue;
n no past history – the tax treatment of purchase/sale should beindependent of previous purchase/sale;
n tax transparency – the tax treatment of income and gains should berelated solely to the investor.
Table 5.3 below sets out the main investment vehicles currently available andtheir respective advantages and disadvantages.
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Table 5.3 Property Investment Vehicles: A comparison
Vehicle Tax Quoted sharesunits
Availability Restrictions onpropertyinvestment
plc 4 4 none
ITC no CGT invehicle
4 4 Max 30%
Co-Ownership transparent 4 none
Limited
Partnership
transparent (not yet but cfDublin StockExchange)
4 none
PINC transparenton income
4 none
PIC transparenton income
4 none
SAPCO 4 none
SPOT none
APUT no CGT invehicle
20% tax rate
4 4 spread requiredand liquidity
OEIC 4 not suitable
REIT (USA) transparent 4 not in UK not available(Source: D J Freeman & Co, 1997)
Limited partnerships have become increasingly popular in the UK as anattractive option to solve the problem. Indeed, in the UK in the last 2 years, 34limited partnerships have been launched comprising some £5.2 billion ofaggregated gross value.
Limited partnerships have a long history in the UK, dating back to the LimitedPartnership Act of 1907. A limited partnership enables a pool of investors tocome together into partnership, investing together in one or more assets:partners are limited in number to 20 but also limited in liability, whilst at leastone, the general partner, has unlimited liability. This creates a passiveinvestment with tax transparency. As Butler (1999) points out, their principalcharacteristics are:
n investors are limited in their liability to the investment made;
n the number of partners within a limited partnership cannot exceed 20,although any of those individual limited partners could be separatelimited partnerships, in effect creating ‘feeder’ partnerships;
n investors cannot participate in the management of the partnershipwithout losing limited liability status, and so they are required to bepassive and without control. Ways of overcoming this barrier arethrough an investment committee as, alternatively, or joining investorsin the ownership of the general partner;
n they are tax transparent;
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n they are deemed to be collective investment schemes within theFinancial Services Act 1986 and so must be required to be operated byan entity regulated under that Act;
n management of the assets of the partnership rests with a specialmanager;
n there must be at least one general partner who manages thepartnership and has unlimited liability.
Limited partnerships established in the UK usually have a pre-determined lifeof between 6–10 years. Recently launched limited partnerships include:
n Level Lease Retail Partnership (regional shopping centres) – £500million
n Industrial Property Investment (Industrial) – £200 million
n PDFM Property Partnership (Mixed) – £165 million
n Industrial Partnership (Industrial) – £150 million
n MWB Leisure Food (Leisure) – £150 million.
Schemes where such partnerships have operated successfully includeWhitegate Shopping Centre in Croydon and the new Bluewater Shoppingdevelopment in Kent.
Limited partnerships are also the most common form of collective ownershipof property in the US. While they have some drawbacks (often a lack of directinput in management of the partnership affairs), it is commonplace that thegeneral partner is the ‘real estate expert’ to whom investors turn for advice. USinvestors therefore gain the twin benefits of:
n limited liability (very important in US context); and
n direct taxation (may allow for significant loss and depreciationallowances, as well as eliminating a level of taxation).
However, it should be stressed that the limited partnership form was abusedgreatly in the 1960s and 1970s, and as a result the regulation and tax rulesgoverning their use have been tightened in the USA.
5.8 Direct overseas investment – tax advantages in the UKA paper by Etienne Wong of Clifford Chance (1997) compares the returnsfrom investing in property under the different tax regimes that apply in France1,Germany, the Netherlands, Spain and the UK.
The comparison is made by reference to an investment scenario as follows:
1 This analysis was carried out when transfer tax in France was 18.6%
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The property investment:
n 6-year old building;
n fully let, one tenant;
n yearly rent = €5 million;
n rent fixed for 10 years.
The investor:
n a corporate investor (P);
n P buys for €50 million;
n no borrowing;
n P holds of 7 years;
n P sells for €90 million ;
n no expenses for purchase/ongoing management/enhancementor sale.
An analysis of the total after tax returns for foreign and domestic investors inthe different countries produces the results shown in Figure 5.10. This showsthat the highest return is achieved by a foreign investor in the UK and thelowest by a domestic investor in Germany.
The main differences are accounted for as follows:
n Tax on rents for resident investors is comparable in the UK (31%),Spain (35%) and Germany (30%), but German non-residents pay at ahigher rate (42%) as against the UK (23%) and Spain (25%).
n Tax on disposals by UK residents is 31% and could be nil for non-residents. Similar levels apply in Spain and the Netherlands, but inGermany, while residents are taxed at 30%, non-residents pay 42%.
n Differences can also arise due to:
n investing directly or using a local subsidiary;
n the withholding of tax;
n VAT treatment of property;
n depreciation relief.
The main features of each country’s tax regime are:
UKn Tax rates relatively low.
n The effects of taxation can be mitigated through capital allowances andborrowing at least part of the purchase price, whether the investor isUK-based or foreign.
n Depreciation is not allowed against buildings, other than industrialbuildings, hotels and ‘enterprise zone’ buildings.
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n VAT is not generally a significant cost, as it can usually be recovered,but care needs to be taken in relation to tenants which do not have fullrecoverability (e.g. banks).
Figure 5.10 Comparison of After Tax Returns
Netherlands
n In principle, the tax treatment of foreign investors is the same asDutch-based investors.
n Through creating a series of subsidiary companies (the ‘Double Dutch’structure) a seller can avoid transfer tax on the purchase by aninvestor.
n VAT is not generally a significant cost as it can usually be recovered,but care needs to be taken in relation to tenants which cannot recoverat least 90% (e.g. banks, for whom VAT will be a real cost).
France
n Generally foreign and domestic investors are subject to the same ratesof tax, but a foreign investor can be subject to several additional taxesfrom which the domestic investor is exempt, eg the withholding taxes(the scenario assumes none of the additional taxes apply).
n The effect of taxation can be mitigated through the use of:
n capital allowances, which are generally restricted to depreciation ofthe building and not the land;
n other allowable expenses; and,
n borrowing at least a portion of the purchase price.
n VAT legislation is primarily beneficial to the investor as it almosteliminates transfer taxes and is normally recoverable from the Statewhere the investor is subject to VAT.
0 10,000,000 20,000,000 30,000,000 40,000,000 50,000,000 60,000,000 70,000,000
UK
Netherlands
France
Spain
Germany
Total after tax return in euros
Domestic Investor
Foreign Investor
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Spain
n Although rates of taxation applied to foreign and domestic investors arenot the same, the net effect of taxation is quite similar.
n Domestic investors can mitigate the effect of taxation through:
n borrowing at least part of the purchase price against a mortgage;and,
n the deduction of certain expenses, which in Spain are not passedto the tenant.
n Foreign investors are not entitled to deduct mortgage interest againstrents received, but will often acquire real estate through a foreigncompany which will hold shares in the Spanish property-owningcompany.
n VAT is generally not a significant cost where the investor can recoverVAT, but where VAT does not apply, transfer tax can become material.
Germany
n A foreign investor faces much higher total tax liability on its rentalincome and capital gains than a German investor, because:
n a foreign corporation investing directly from outside Germany willalways be subject to 42% corporation tax;
n taxable income for a German corporation, if distributed, is onlytaxed at 30% – although shareholders could be liable for up to 53%personal income tax, the 30% corporate tax can be creditedagainst this; and,
n capital gains to German and foreign corporations at the point ofwinding-up are subject to a preferential treatment at half the normaltax rate.
5.8.1 Indirect overseas investment – new investmentvehicles?It is also useful to compare average tax charges for a sample of Europeanproperty companies (Table 5.4). As shown, five French companies feature inthe ten companies with the highest average tax charge. It is significant thatDutch property companies have significantly lower tax charges, due to theirtax-free Dutch property investment company status.
Table 5.4 Average Tax Charges (after SBC Warburg Dillon and Read, 1998)
Highest LowestCofinimmo Belgium 63.7 Urbis Spain -7.5Immobel Belgium 45.5 Unibail France -1.1Metanoploi Italy 42.8 VIB Netherlands -Intershop Switzerland 38 Schroders Intnl. Netherlands -SFL France 36.7 Prima Spain -Silic France 35.9 Wereldhave Netherlands 0.1Klepierre France 34.7 Castellum Switzerland 0.3GFC France 33.5 Rodamco Netherlands 2.3Vallehermoso Spain 33.3 Bail Investisse France 5.6UIF France 31.9 Diligentia Switzerland 7.5
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Indeed, as SBC Warburg, Dillon and Read (1998) point out, if pan-Europeansectoral property specialists emerge over the next few years, they are likely toadopt one of the tax-efficient statuses available (e.g. SICAFI or Dutchinvestment company status). It is also possible that companies specialising inother countries could move their domicile to take advantage of these and othertax advantages. As their report states (op cit:2):
‘We expect a new breed of large, liquid, pan-European sectoralspecialists to emerge, concentrating on one sector of theproperty market across Europe, to complement our currentideal of “country funds” which concentrate on one specificgeographic region.’
This view was backed up at the Urban Land Institute's European Real EstateInvestment and Finance Conference in Paris in February 1999. It is interestingto note that already we have seen the growth of international equities fundsinvesting in quoted property securities (two examples in 1998 were thoselaunched by Morgan Stanley and Henderson Investors). Markets will judgewhether these are equity-linked investments, or whether the performance ofthe funds reflects the underlying changes in direct property.
This distinction, in fact, depends on the tax treatment of quoted propertycompanies: for example in the UK these are subject to corporate income andCGT, while shareholders also pay tax on dividend income and CGT on sharessales. In contrast, Belgian Société d’Investissement Immobilière à Capital Fixé(SICAFIs) are not subject to the same ‘double taxation’ and so their relativelyhigh dividend payment is much closer to the income return generated by directproperty. SICAFIs, however, are limited in their borrowings and the level ofdevelopment they can undertake, and so are closely related to US REITs. Forexample, they cannot have more than 20% of investments in a single propertyand borrowings are limited to a maximum of 33% of assets. They must alsodistribute at least 80% of profits to shareholders (see Appendix 2). At themoment, however, the UK continues to lack a tax-efficient form of quotedproperty company.
There are currently eleven listed SICAFIs in Belgium with a total marketcapitalisation of €2.35bn and a total portfolio value of €2.54bn. These areshown in Table 5.5 below, which lists the SICAFIs in order of marketcapitalisation and portfolio value.
SICAFIs benefit from fiscal transparency and are closely modelled on USREITs. For example, there is no depreciation of portfolio buildings and they areexempt income tax if at least 80% of earnings net are paid as dividends (afterprovision for renovation and repair).
An existing company that wishes to convert into a SICAFI must pay an ‘exittax’, which amounts to half the normal corporation tax of 20.85%, levied onlatent capital gains at the time of conversion.
The debate over the most efficient legal structure for SICAFIs continues inBelgium. Technically a SICAFI can take the form of a SCA/CVA (e.g. Befimmoand Wereldhave Belgium) or SA/NV (e.g. Confinimmo and Retail Estates).The advantage of the former is the greater degree of main shareholder controlover management, although it is perceived as being less transparent than anSA/NV.
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Table 5.5 Belgium SICAFIs (as at 29 June 1999)
SharePrice(€)
LatestNAV(€)
PremiumTo
NAVRentalYield
GrossDiv
Yield
NetDiv
Yield
ExpectedNet Div
(€)Pay-outRatio
MarketCap
(€ bn)FreeFloat
PortfolioValue
(BFr bn)OccupRate
Age(years)
DebtRatio
Cofinimmo 108.30 95.35 13.58% 7.78% 5.38% 4.56% 4.91 98.4% 0.77 48.3% 35.6 98.2% 9.5 28.4%Befimmo 68.05 55.97 21.58% 8.01% 5.85% 4.96% 3.28 85.2% 0.51 52.2% 22.1 98.0% 9.0 28.0%Wereldhave Belgium 53.00 51.60 2.71% 7.33% 5.93% 5.03% 2.66 94.8% 0.28 32.3% 10.2 75.6% 5.9 0.0%Cibix 44.70 40.63 10.02% 7.63% 6.03% 5.10% 2.22 89.9% 0.16 50.8% 6.7 100.0% 11.7 20.8%W&D De Pauw 22.75 21.15 7.57% 8.93% 5.23% 4.44% 0.50 90.0% 0.15 46.9% 7.5 98.0% Na 25.0%Leasinvest 56.20 51.11 9.96% 7.80% 6.30% 5.37% 3.06 89.3% 0.14 54.2% 6.9 100.0% Na 22.0%Siref 47.90 37.00 29.46% 8.70% 6.99% 5.94% 2.36 95.0% 0.10 71.4% 3.8 99.4% 4.8 26.4%Retail Estates 31.50 25.51 23.48% 9.00% 6.40% 5.44% 1.71 99.3% 0.07 93.0% 3.0 98.8% 9.5 30.0%Warehouses Estates 29.50 24.81 18.90% 9.05% 6.89% 5.82% 1.80 91.5% 0.06 45.0% 2.4 98.8% 12.4 22.4%Perifund 24.00 25.00 -4.00% 8.07% 6.56% 5.57% 1.05 85.0% 0.05 91.6% 2.6 92.6% 6.9 27.1%Home Invest 38.20 34.46 10.85% 7.86% 4.97% 4.97% 1.92 100.0% 0.04 59.4% 1.7 95.5% 8.1 13.4%OLO 10 Years 4.80% 4.08%Average 13.10% 8.20% 6.05% 5.20% 92.6% 58.6% 96.0% 8.6 22.1%Dividend yield based on the expected annualised dividend on a pro rata temporis basis. Latest published NAV’s. For Confinimmo, Retail Estates and Wereldhave Belgium:NAV’s ex-dividend.
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According to a recent Generale Bank research report (1999) SICAFIs continueto remain attractive for both institutional and retail investors, although marketsentiment has become more cautious with the recent increase in Belgianbond yields. Increasing IPOs and investors’ concerns over higher interestrates have led to a dampening of interest in more recent SICAFI offerings.Several features of the SICAFI market should be highlighted:
n The premium-to-NVA has fallen from about 30% in mid-February 1999to 13% in June. Perifund is the cheapest SICAFI, currently trading at adiscount of 4% (unique in Belgium).
n The liquidity of SICAFIs is limited, but improving. In March 1999, forexample, Confinimmo switched from the semi-continuous to thecontinuous segment of the forward market, joining Befimmo. Indeed,as Table 5.6 shows, Confinimmo is the most liquid SICAFI in valueterms.
Table 5.6 Average Daily Volume – SICAFIs
Fund AverageDailyVolume
Numberof shares
Daily % SharePrice
DailyVolume(€)
Befimmo 3,200 7,549,042 0.042% 68.05 217,760Cibix 1,900 3,519,895 0.054% 44.70 84,930Confinimmo 3,500 7,101,881 0.049% 108.30 379,050Home Invest 2,100 1,103,362 0.190% 38.20 80,220PeriFund 2,400 1,896,459 0.127% 24.00 57,600Retail Estates 1,500 2,282,982 0.066% 31.50 47,250Siref 2,500 2,081,464 0.120% 47.90 119,750Warehouses Estates 1,600 2,028,860 0.079% 29.50 47,200W&D De Pauw 3,800 6,640,000 0.057% 22.75 86,450Weredhave Belgium 2,300 5,234,636 0.044% 53.00 121,900
Table 5.7 European Pension Funds: Real Estate Weightings, 1998
Belgium 5%
Denmark 8%
France 0%
Germany 13%
Italy 40%
Netherlands 7%
Spain 0%
Sweden 8%
UK 2%
As the Investment Property Forum report on property securitisation (IPF,1995) pointed out, the lack of tax neutrality for listed property vehiclescontinues to be a stumbling block for the development of securitised equityinvestment vehicles and expansion into the market. The report suggestedextending the ability of Investment Trusts to invest exclusively in property andallowing Authorised Property Unit Trusts to convert to tradable open-endedinvestment company status whilst maintaining tax neutrality.
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Such developments should be set against the declining direct propertyweightings by pension funds and insurance companies in the UK. Forexample, UK pension funds’ investment in property was 12.7% of their total in1980 but only 4.9% by 1995 and 2.0% in 1998 (see Table 5.7).
This is probably the result of illiquidity, lack of price transparency and moreintensive management, compared with other asset classes.
Equity vehicles have therefore tended to be relatively more attractive forinstitutional investors, but the UK continues to suffer a disadvantage in termsof the vehicles available. The IPF (op cit) identified a number of criticalsuccess factors for investment vehicles, based on overseas experience,which include:
n tax neutrality or comparability with direct property ownership;
n liquidity, related to the size of vehicle, its management and informationintegrity and general stock diversity;
n transparency of corporate and individual property information;
n sound regulatory environment;
n diversity of asset backing;
n management quality;
n asset allocation benefits for fund managers.
As the report concludes (IPF, op cit: 37):
‘Tax neutral, stock exchange traded and well-regulated,securitised pooled property vehicles are becoming anincreasing feature of overseas property markets. Theirabsence in the UK places Britain (sic) at a relativedisadvantage, and in the longer term threatens to underminestability in a sector which is of great significance to the widereconomy.’
5.9 Summary and conclusionsThis section of the report has highlighted key issues, which include:
n For investors who are neither resident nor ordinarily resident in the UK,and who carry out property investment, the UK represents a ‘taxhaven’. This relates to capital gains, trading and rent.
n Previous research has found that corporate tax rates in the developedworld are declining. USA, France and Germany have higher corporatetax rates than the UK.
n OECD data provides a conflicting picture for the UK. Although the UKis relatively lightly taxed in terms of taxation on capital/financialtransactions as a percentage of total taxation, property tax as apercentage of total tax and GDP is higher than in any other EU country.
n Although taxation is an important factor in determining the pattern ofinternational investment flows, other incentives, such as political andeconomic stability and a strong economy, are also critical.
n The UK’s tax system enables foreign investors to purchase propertythrough an offshore vehicle and remain outside the UK tax net. Suchvehicles include limited partnerships and offshore unit trusts.
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n Future property investment vehicles in Europe may mimic the taxtransparency characteristics of REITs or SICAFIs. SICAFIs offer theadvantage of not being subject to ‘double taxation’, in contrast to UKquoted property company shares.
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6 SUMMARY OF RESEARCH QUESTIONS ANDMETHODOLOGY
6.1 Research questionsThe literature review has highlighted several important issues:
n the expansion of overseas property investment and development in theUK and the reasons for its growth;
n the availability of tax allowances and other tax advantages for overseasproperty investors and developers in the UK;
n the growth of direct investment vehicles used by overseas propertyinvestors in the UK;
n the future direction of indirect investment vehicles available for quotedproperty companies;
n the future impact of the euro and harmonisation of accountingstandards on the landscape of pan-European property companies andinvestors.
In short, the aim was to address these two related questions:
n Do foreign investors enjoy tax advantages over indigenous companieswhen investing in UK property?
n If inequalities exist, how can UK property companies redress thebalance and compete in the future?
6.2 MethodologyTo address these aims and objectives, a three-stage methodology wasadopted, comprising:
n Postal questionnaire survey of overseas real estate investors andfinanciers and their UK based advisers. The purpose of this was toextend and update the work undertaken.
n Structured interviews with leading experts in the field; and,
n Focus groups, comprising roundtable discussions with leadingoverseas and UK-based experts.
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7 QUESTIONNAIRE SURVEY
7.1 IntroductionThis chapter presents the results of the postal questionnaire. Details of theinterviews and focus group, which took place after preliminary analysis of thequestionnaire responses, are discussed in Chapters 8 and 9.
Postal questionnaires were sent to overseas real estate investors, financiersand their UK-based advisors. Two different questionnaires were produced –one aimed at UK real estate companies and a second targeted at overseasorganisations (these questionnaires are reproduced in Appendix 3). Thischapter examines the responses from the survey and is divided into foursections:
n response rates (section 7.1);
n results from questions asked exclusively to overseas organisations(section 7.2);
n results from questions asked exclusively to UK organisations (section7.4);
n results from the common questions (sections 7.5 and 7.6).
Each section presents an overview of the results. Further information and datacan be found in Appendix 4.
7.2 Response ratesOf the 235 questionnaires sent to organisations in Germany, Netherlands andUSA, 25 were returned, representing a response rate of 10.5%. A further 27questionnaires were dispatched to UK property companies, of which six werereturned – a response rate of 22%. Questionnaires were targeted at identifiedindividuals and organisations active in real estate investment but were notevenly distributed across countries.
To boost the response, recipients were contacted by telephone one monthafter questionnaires were sent out. This resulted in additional returns, but alsohighlighted that a number of the companies approached no longer invested inreal estate, or, more specifically, UK real estate. From the follow-up work it isestimated that between 15% and 30% of questionnaire recipients did notinvest in UK real estate, depending on their country of origin. This would implythat the appropriate survey population was between 165 and 200, giving aresponse rate range of between 12.5% and 15%.
Table 7.1 identifies the countries where the main clients of the individualrespondents are based and shows that the respondents were well distributedbetween North America (41%) and continental Europe (39%).
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Table 7.1 Country of origin of respondents
Country of origin Frequency PercentageUSA 11 35%Germany 7 23%UK 6 19%Netherlands 5 16%Canada 2 6%TOTAL 31 100%
7.3 Overseas responsesOf the 25 overseas responses, 64% came from open-ended funds (mainlyGerman), private equity funds (all US) or real estate companies. Dutchclosed-ended funds represented 12% of responses. One US developer andone US investment bank responded, as did two Canadian pension funds.
7.3.1 Direct real estate investment and taxationTable 7.2 shows the location of real estate investments under the control ofthe survey respondents. The UK is by far the most popular investment locationfor direct real estate investment according to the survey (76% of respondentshold direct real estate assets in the UK). However, France and Germany arealso important markets, with 44% and 40% of respondents respectively havinga presence in each country. In contrast, indirect investment was used less,but the UK remained the most popular country (25%). France (21%),Netherlands (12%) and Sweden (12%) were also used by a number of therespondents. Overall 20% of respondents claimed to be investing in direct andindirect European real estate markets.
Table 7.2 Location of real estate investments owned or managed by respondentorganisations
Country Direct real estateinvestment marketpresence (%)
Indirect realestate investmentmarket presence(%)
UK 76 24France 44 24Germany 40 4Netherlands 32 12Spain 32 8Italy 20 8Belgium 20 8Sweden 12 12Denmark 8 4Austria 4 0Finland 4 8Luxembourg 4 4Portugal 4 4Greece 0 0Ireland 0 0
Over two-thirds of the organisations had invested directly into the UK officemarket, and just under half had invested directly in UK industrial real estate(Table 7.3). However, only 44% had invested directly in retail properties.
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Table 7.3 Breakdown by sector of UK direct real estate investment from overseas
Sector PercentageOffices 68Industrial 48Retail 44Hotels 16Residential 12Warehousing/Logistics 8Leisure/Pubs 8Nursing Homes 4Bare Land 4
7.3.2 Factors influencing direct investmentRespondents were asked to select the attractiveness of a variety ofinvestment determinants that they may consider when allocating funds todirect real estate investment in the UK. The mean responses are shown inFigure 7.1 and are measured on a scale of 1 to 4, where 1 represents 'notattractive' and 4 represents 'very attractive'.
Figure 7.1 Attractiveness of investment determinants in the UK for overseas investors.
1 = unattractive; 4 = very attractive.
All of the factors attracted a mean response in excess of 2.5, with theexception of foreign currency risk. Business culture and language wasconsidered the most attractive, with liquidity and UK lease terms alsoconsidered very attractive.
The importance attached to business culture and language is somewhatpuzzling. Although 11 respondents were from the USA, 14 were based in otheroverseas countries, so a US-biased response is not the reason. An
1.00 1.50 2.00 2.50 3.00 3.50 4.00
Foreign currency risk
Taxation efficiency/holding structures
Position in real estate cycle
Taxation regime
Current economic background
Rental value growth
Capital value growth
Maturity of market
Standard lease terms/obligations
Liquidity on sale
Liquidity of market
Business culture and language
Mean response
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alternative, and more likely, reason is that the UK has an established largerproperty profession with an international reputation and this is taken asforming part of the ‘business culture and language’.
Although the taxation regime was considered attractive, it does not rank highlyin comparison to others. This is confirmed by a supplementary question whichshowed that all overseas respondents felt taxation was not the single mostimportant factor for the allocation of funds in direct real estate in any EuropeanUnion country.
The UK taxation regime was an attraction, but not a primary considerationwhen allocating funds in an overseas market.
The survey also examined which components of the UK tax regime were mostattractive. Double tax treaties were selected as the most attractive of the eightcomponents, with capital allowances and capital gains tax rules also scoringhighly (Figure 7.2).
Stamp duty was considered by overseas investors to be unattractive. This isinteresting, as the UK government has announced further plans to increasestamp duty in the UK.
Figure 7.2 Attractiveness of UK taxation components to overseas investors.
1 = unattractive; 4 = very attractive.
The relative attractiveness of the UK's taxation regime to an overseas investorwill be determined by comparison with their local regime. Overall 47% ofoverseas respondents thought their own country's regime was less attractivefor foreign investors than the UK and 42% thought it was more attractive.However, this hides major national variations. For instance, 86% of Germanrespondents felt that the German tax regime was less attractive than the UK's,
1.00 1.50 2.00 2.50 3.00 3.50 4.00
Stamp duty
Witholding tax on interest payments
Witholding tax on rents
Transfer pricing rules
Corporate tax rate
Capital (depreciation) allowances
Capital gains tax rules
Double tax treaties
Mean responses
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whereas 50% of North Americans believed that the US/Canadian tax regimeswere more attractive than the UK's.
7.3.3 Forms of real estate investmentDirect development was found to be the most common form of direct realestate investment by overseas investors in the UK, used by 45% ofrespondents (Table 7.4). This is closely followed by the use of joint equityvehicles (40%). In terms of indirect real estate investment, limited partnershipswere the most popular investment vehicles and 37% of respondents had usedthem. Investment trust companies were the least popular, having been usedby only one respondent.
Table 7.4 Use of direct and indirect investment vehicles by overseas investors.
Direct investmentDirect development 45%Joint equity vehicles 40%Forward purchase 35%New company establishment 35%Outright purchase of companies 30%
Indirect investmentLimited partnerships 37%Listed real estate companies 32%Co-ownership schemes 25%Investment trust companies 5%
7.4 UK responsesOf the six questionnaires returned from UK organisations, one third wereinvolved in investment management, while two thirds offered investmentadvice to clients. UK recipients were asked for their views about how the UKreal estate investment is perceived by clients based in the USA, Germany andthe Netherlands. Only general observations can be made from this data due tothe small number of responses.
7.4.1 Direct real estate investment and taxationRespondents were asked to rate each investment characteristic on a scale of1 to 4, where 1 is not attractive and 4 is very attractive. Responses were splitby country and the average scores are shown in Figure 7.3.
These results closely follow the responses gathered from overseas. Businessculture and language, liquidity (for European clients) and UK lease terms allranked highly. Again foreign currency risk is seen as unattractive to overseasinvestors. Taxation factors are once again considered attractive, but otherfactors are considered more important. All respondents felt that taxationissues were not the single most important factor for overseas investors. Thisagrees with the overseas survey. The most important factors suggested byrespondents are detailed in Table 7.5.
A similar pattern of responses emerged amongst UK and overseasrespondents when asked about the attractiveness of tax components (Figure7.4). Double tax treaties and corporate tax rates both ranked high in the eyes
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of UK investment managers and advisors, as did capital allowances. Stampduty was considered unattractive.
Figure 7.3 Attractiveness of investment determinants for American, Dutch and Germanclients of UK investment managers/advisers.
1 = not attractive; 4 = very attractive.
Table 7.5 The most important factors for allocating funds in UK real estate investmentsuggested by UK respondents.
USA Germany Netherlands• Secure income • High initial yields • Good returns• Attractive yields • Security of income • Attractive yields• Prospects for a yield
shift• Prospects for a yield
shift• Prospects for a yield shift
• Business culture • Lease structure • Security of income• Availability of
opportunities• Lease structure
• Pricing
1 1.5 2 2.5 3 3.5 4
Foreign currency risk
Rental value growth
Liquidity on sale
Position in the real estate cycle
Current economic background
Taxation efficiency/holding structures
Taxation regime
Capital value growth
Liquidity of market
Maturity of market
Standard lease terms/obligations
Business culture and language
Inve
stm
ent c
har
acte
rist
ics
Mean response
USA Germany Netherlands
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Figure 7.4 Attractiveness of taxation components for American, Dutch and Germaninvestors in UK real estate as viewed by UK investment managers/advisers.
1 = unattractive; 4 = very attractive
7.5 Indirect real estate investmentThe commentary so far has focused only on those questions askedexclusively to each of the two survey groups. However, there were a numberof core questions common to all the survey respondents. These responsesare now examined.
Figure 7.5 Perceived deficiencies in UK indirect real estate investment market.
1 1.5 2 2.5 3 3.5 4
Absence of a regulatory environment
Limited asset banking
Poor performance
Management quality
Lack of tax neutrality orcompariability with direct ownership
An ample supply of capital alreadyavailable
Illiquidty of available vehicles
Def
icie
nci
es in
UK
ind
irec
t re
al e
stat
e in
vest
men
t m
arke
t
Mean response
1 1.5 2 2.5 3 3.5 4
Stamp duty
Withholding tax on interest payments
Withholding tax on rents
Transfer pricing rules
Capital (depreciation) allowances
Capital gains tax rules
Double tax treaties
Corporate tax rateT
axat
ion
co
mp
on
ent
Mean response
USA Germany Netherlands
1 = unattractive; 4 = very attractive
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Figure 7.5 shows the pattern of responses to a question about deficiencies inthe UK indirect real estate investment market. The most important deficiencywas the illiquidity of currently available vehicles. Lack of comparability withdirect investment opportunities also featured as a deficiency, whereas lack ofa regulatory environment was less of a problem.
7.6 European real estate issuesThe questionnaire raised a number of issues affecting European real estateinvestment following the creation of the euro on 1st January 1999. Of therespondents, 89% felt that reduced foreign exchange activity would haveimportant or very important implications for cross-border investmentcompetition. 59% felt that greater regional specialisation of real estateinvestment markets would be important, leading to a new geography ofEurope. A single Europe-wide interest rate was also seen as important or veryimportant by 67% of respondents, as this would allow real estate to becompared to equity or bonds.
In terms of European tax harmonisation, 83% agreed or strongly agreed thatsuch a policy would reduce the importance of tax differences across Europefor real estate investment decisions. Two-thirds of respondents (66%) felt thataccounting diversity for real estate in the EU is not a barrier that would raisethe required rate of return on international investments. There was alsosubstantial agreement that there would be a rapid growth in pan-European realestate companies over the next 2 to 3 years (90% agreed or strongly agreed).Further, 67% agreed that liquidity and tax transparency in the UK indirectmarket should be increased to make it more attractive to overseas investors.
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8 INTERVIEWS
8.1 IntroductionA series of structured face-to-face interviews were carried out during October1999, which provided the opportunity to explore issues in much greater depth.When selecting interviewees, the objective was to obtain the insight ofspecialists from a variety of perspectives. This produced the following sample,
n a US developer currently active in the UK and Continental Europe
n a real estate specialist from a leading legal firm;
n a real estate finance specialist from a leading accountancy firm;
n a real estate investment specialist from a leading surveying firm;
n a property investment specialist from a UK retail bank;
n a real estate finance specialist from a leading surveying firm;
n a finance specialist from a US property company.
Interviews were conducted informally with the questions based on a guidequestionnaire. The following report summarises the views expressed,indicating the areas of consensus and controversy.
8.2 The UK as a favoured location for overseas investment
8.2.1 The overseas investorsThe dominant investors in Europe have been the US open-end funds andproperty companies. The funds are largely return-oriented and are typicallylooking to buy returns at 7-8%. They have found it difficult to secure suitableinvestments offering these returns in Germany, and in the UK they have facedlow initial yields. The opportunity funds in particular have found these returnsinadequate, and have recently shown more interest in France and Italy.
Germany has been a disappointing market for its own investors. ManyGerman open-ended funds have found returns insufficient to match liabilities.Unlike the Americans, however, they have maintained a strong presence in theUK, where German investors still constitute the largest overseas group.Among other European investors in UK property, the Dutch and the Swedeshave been important. From outside Europe, investors from the Middle Eastand Asia–Pacific region have been the main players.
Apart from the open-ended funds, there has been steady inward investment byprivate individuals, particularly from the European mainland. In spite of all thepublicity that has been associated with them, REITs have not been significantinvestors in the UK.
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8.2.2 Attractions of the UK real estate marketFor most interviewees, the attraction of the UK market, cyclical factors apart,lay in its liquidity, security and favourable tax regime. All agreed that inwardinvestment was essentially market driven.
US investors favoured the UK market as being nearest their own in terms ofavailability of information, and the clarity and practicality of the legal system.The view was that the further East one went, the less clear things became:
‘Compared with other EU countries, everything in the UK ismarginally easier.’
The UK long lease was especially interesting for the German funds, whoseobjectives were long term secure cash flow.
Another important factor in channelling investments to the UK has been therelative immaturity of European property markets. With the exception ofHolland, they lack sophistication. One feature of this has been the dearth ofquality research material, comparable with that available for the UK market.
The relative attractiveness of the UK market naturally varied with theobjectives of the investor. US investors generally had a pan-Europeanapproach. They were looking for opportunities where they could create andmanipulate value, rather than for the bond-type income provided by the UKinstitutional lease. This was leading them to Eastern Europe and parts of theMediterranean
Conversely, for Middle Eastern investors, London was particularly favoured forits long term, stable market.
Many of the interviewees spoke of the attractions of the London market, notjust for overseas investors, but also for UK-based companies and funds. Itssize and liquidity were not matched elsewhere in Europe.
8.3 The role of Taxation in the investment decision, andthe perceived view of the UK tax regime
8.3.1 The relative importance of taxationWhilst the interviewees placed differing emphasis on the relative importanceof taxation, there was general agreement that it had a secondary role indetermining the direction of investment flows. Such cross-border flowsdepended on the position of the host country in the business cycle and theobjectives of the individual investor. For most investors, an improvement in therisk/return profile, greater liquidity and diversification came above taxavoidance on the scale of priorities.
As one interviewee put it:
‘The question is: are the property fundamentals right? then I’ll thinkabout how I will get in there, and what tax avoidance mechanisms Iwill put in place.’
Although a country’s taxation regime was unlikely to influence the direction ofan investment, an onerous taxation system could operate as a disincentive.The French regime has been particularly inhospitable. One illustration givenwas that of a US investor who had to achieve an average gross return of 15%
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on a French property in order to deliver the same after-tax return back in theUS that would be given by a 13% gross return in the UK. The figures werequoted for a holding period of 3 to 4 years.
A US developer offered another view of the deterrent effect of taxation:
‘It’s harder to do business successfully on the Continent. Thereforethe markets are less interesting. Across the board, the tax and legalsystems are just less attractive, more agonising to do businessthere. If you look at a scale of relative ease, the US is much easierthan Britain, and Britain is a lot easier than the Continent.’
For him the effect was critical:
‘It is a deterrent, as the barrier for investment and the commitmentof resources is higher on the continent. That is why we started inBritain. Investment costs and risks are much higher on theContinent, so we have to be that more certain….We were muchmore intimidated about doing business on the Continent than inBritain.’
In general the UK taxation regime was seen as being more favourable thanthat of other West European countries, but less favourable than that of the US.The exemption from taxation of capital gains was the most frequently quotedreason for the UK’s popularity.
There was a minority view, however, that the UK was not a particularly benigntax domicile. It imposed a withholding tax on rental income, similar to thatwhich existed in most other European countries, and the permitted level ofgearing required to avoid it was also similar.
Most interviewees expressed the view that positive factors, propertyfundamentals such as the market cycle, the returns, liquidity, lease length andincome security, are the ultimate driving force. Tax and legal issues areimportant and may have a negative effect, but ultimately they are not thecritical decision variables. Their relative importance for different groups ofoverseas investors varied. They were probably more important for theAmericans than for the Germans, but for all interviewees it was the marketfactors which predominated.
8.3.2 The importance of stamp duty for transaction costsFor one observer, transaction costs in the UK, such as professional andregistration fees, information costs and stamp duty, were regarded as beingthe cheapest in Europe. There was concern that the gap between the level ofcosts in the UK and that of other European countries was narrowing.
Stamp duty was a major tax problem for the Americans. It is not only the shortterm opportunity funds that are deterred by it. US companies and institutionswhich take a longer view are concerned that it adds substantially topurchasing costs, which typically could amount to 5.25%. The reaction hasbeen either to revalue a property to 5.25% more, or to bid 5.25% less for it.Either way the effects are unpalatable.
The problem is worse for opportunity funds since the transaction cost has tobe amortised over a shorter holding period than that of the institutions andcompanies. They therefore become less competitive in bidding for properties.For them the playing field slopes in the opposite direction. As one intervieweeremarked:
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‘A property held for just two years has to recover 2.5% per year justto stand still.’
8.4 Overseas ownership structures and investmentvehicles operating in the UK
8.4.1 Tax-efficient vehicles and structuresTo reduce the impact of tax on their foreign investment returns, investors haveresorted to a range of investment vehicles. A number were identified duringthe course of the interviews.
Among private US investors the tax transparency of the limited partnershiphas made it a popular investment vehicle. The general partner in thisarrangement might set up a limited company to achieve limited liability, andthe partnership then finances it with a loan. The effect is to allow some rentalincome to be offset by the interest payments on the loan so that some of thereturn goes back to the US as interest. The scheme does not allow theinvestor to avoid tax leakage altogether. US revolving taxes will cut into anydistribution of surplus rent income over and above that for which the interest isallowed.
As one interviewee remarked,
‘It’s not very nice, but it’s palatable.’
This structure was similar to the one outlined by a member of the secondfocus group. Its benefits are explained in more detail in the focus group report.A Europe-wide withholding tax on interest payments to foreign investors wouldclearly affect the benefits conferred by this structure.
A second tax-efficient route for north American investors in Europe is thedouble Dutch BV structure. This comprises a Dutch BV holding companyinvesting in a Dutch BV project specific company. Below that is a country-specific special purpose vehicle. To dispose of the property means selling thespecial purpose vehicle in order to repatriate money efficiently.
Holland has a particularly generous taxation policy on distribution of income toforeign investors. There is a 25% withholding tax on dividends, part of whichmay be recovered through a tax credit against liability for Dutch income tax.Dividends paid to qualifying entities in other EU states are exempt from thedividend withholding tax. There is no withholding tax on interest paid to foreigninvestors.
By structuring their tax system in this way the Dutch authorities have createda favourable climate for inward investment, and have generated revenue fromthe small amount of tax on incomes flowing through Holland. The effect hasbeen to draw some investment to the Dutch market that might otherwise havenot gone there.
More recently, a Luxembourg structure has been gaining in popularity. Thishas been taking the form of either a Luxembourg–Dutch vehicle or a doubleLuxembourg structure. This trend has been in line with recent Luxembourg taxpolicies to attract inward investment.
In the UK limited partnerships have emerged in property, partly as aconsequence of the search for a viable tax-transparent vehicle. They haveproved to be eminently suitable in this role. They have been presented as
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vehicles in which the investor will have a tradable interest and can thereforeterminate the arrangement as he chooses, depending on the specific terms ofthe partnership.
The German open-ended and closed-ended funds are both tax-efficientvehicles. The closed-ended funds offer the greater tax advantages, but, in theabsence of a secondary market, do not enjoy the same liquidity as the open-ended funds.
Overseas property companies and high net worth individuals have set up taxtransparent vehicles, based on the models described or similar ones, whichconfer benefits in their own countries. These entities will employ thetechniques used by other investors, such as internal debt and offshorestructures, to minimise their UK tax liability.
Such vehicles do have their disadvantages, however. One interviewee pointedout that the tax transparency of a REIT actually rendered it tax-inefficient wheninvesting outside its domestic market, since there was no domestic taxationagainst which to credit any overseas tax liability.
8.4.2 Indirect investmentMost interviewees believed that there was a trend away from direct ownershipof property, to indirect investment. In some cases this was occurring notthrough the purchase of shares in listed property companies, but through thepurchase of the companies themselves. US funds in particular had adoptedthis approach.
Two distinct strategies were identified in relation to the purchase ofcompanies. One was to liquidate the company assets over time, where it wasbelieved that the shares were acquired at a price significantly below the assetvalue of the company. The second was a longer-term approach. Underpinningit was the belief that the company was undervalued, but that there existedprofitable assets and management to exploit them. The company waspurchased with the intention of providing capital to work the assets and addvalue.
8.4.3 The competitive environment of the UK listed propertycompanyThe interviewees were asked whether the UK-listed property companysuffered a competitive disadvantage resulting from those forms of foreigncompetition which enjoyed greater tax benefits.
There were a number of different views on this problem. On one level the UKcompany was regarded as being disadvantaged due to the fact that it wastaxed twice and paid capital gains tax. On another level, it was the inability ofthe UK companies to raise capital and have a liquid market in their shares,which placed them at a disadvantage with larger overseas investors,particularly the US private equity funds. This failure to raise capital arosebecause the UK companies were not of a sufficient critical mass to be ofinterest to the equity markets.
Another view saw the overseas threat arising more from organisational issuesthan from differences in structure, funding or taxation. The property marketwas becoming more client driven, and overseas investors, particularly theAmericans, were responding to this through active management of their
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portfolios, providing the type of flexibility that tenants required. UK companiesneeded to respond to this type of innovative competition if they were to survive.
UK companies were not without advantages. Their knowledge of the marketand management expertise were important countervailing factors against theperceived tax advantages of the competition.
8.5 Development of a UK tax-transparent, tradable propertyinvestment vehicle
8.5.1 The future of UK securitisationSome interviewees felt that the limited partnership was going to be muchmore widely used because of its tax transparency. Its main shortcoming wasthe restriction on the number of partners. One view was that this restrictioninherently restricts liquidity and renders the vehicle less attractive than a fullytradable security. For this reason it was not the panacea for the existingproblem. From the legal perspective, the limited partnership was seen to begood for one-off investments, but there were no current structures that werelikely to produce an entity that small investors would find easy to enter andexit.
The current barrier to the development of other types of vehicle was seen tobe the Treasury’s attitude. It was thought that growth in the form of a numberof small-sized vehicles would not improve liquidity since there was nosecondary market to ensure easy exit.
There were fundamental differences between the UK investment market andthose of other European countries such as Germany. Continental countries donot have the big pension funds that exist in the UK. Instead they have a rangeof authorised investment structures for tapping retail savings, such as theGerman open and closed-ended funds. These provide a simple and cheapway for individuals to invest in real estate.
Looking at the overseas models, shortcomings were noted with vehicles suchas the SICAFI and the REIT. It was noted that such vehicles performed well ina buoyant market, but in a depressed property market they were much morevolatile than the underlying asset.
The existing UK vehicles, the SAPCOs, SPOTs and PINCs, have not beenpopular, nor have they offered neutrality. APUTs have offered taxtransparency, but have also lacked market appeal.
8.5.2 The potential consequences for the UK market ofintroducing securitised vehicles.The US experience was quoted as an example of what might happen if atradable tax-transparent vehicle were to emerge in the UK. Whilst somecompanies considered converting to obtain the tax advantages, there weresignificant disadvantages such as the operating restrictions and the inability toretain earnings. The most likely scenario was that companies would becomeinvolved in the indirect market, in parallel with their direct investments.
Models for this already existed, where companies had set up limitedpartnerships to give them wider access to funds and to generate fundmanagement fees, while the company continued to undertake developmentand refurbishment under its traditional structure. An example of this is Lend
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Lease, which is becoming a global investment fund manager but retains adevelopment arm. There is, however, a possible conflict of interest with suchan arrangement. Other interviewees predicted similar developments of parallelstructures which would have a sectoral or regional focus.
8.6 ConclusionThe main themes that emerged from the structured interviews aresummarised below:
The attractions of the UK real estate market, and the significance of theUK tax regime in attracting overseas investment:
n The UK remains a favoured location for overseas investment in realestate, but the emphasis is changing, with the US opportunity funds, inparticular, moving more towards mainland Europe.
n There are certain distinctive characteristics of the UK market whichgive it an edge over other Western European countries, the mostimportant ones being transparency, ease of doing business, and lowerentry costs.
n Whilst these attributes encouraged investment, they were not the maindrivers. It was market factors, such as the business cycle, investmentreturns, liquidity and security which ultimately drove the investmentdecision.
n If these fundamentals were attractive enough, then in most casesadverse ‘environmental’ conditions, such as higher taxation or acomplex legal system, could be overcome or their impact minimisedthrough the use of certain legal and financial devices.
Overseas structures and vehicles operating in the UK, and the positionof the UK listed property company compared with overseas investors:
n The dominant overseas groups currently active in the UK were theGerman funds and the US opportunity funds. Other entities includedoverseas quoted property companies, and high net worth individuals.
n These overseas investors did have advantages over the UKcompanies because:
n they did not pay capital gains tax, and were able to shelter rentincome by using offshore structures and internal debt;
n it was in their ability to raise capital in their domestic markets thatwas perceived to give such vehicles an advantage over their UKcompetitors.
n The major problem facing UK-listed property companies was theirinability to raise capital and enjoy an active market in their shares.
n In operational terms, whilst the indigenous company did have superiorknowledge of the local market, some of the innovative, flexibleapproaches to property management displayed by the US investorscould pose a threat if the UK companies failed to respond to a moretenant driven market.
The development of a UK tax-transparent, tradable property investmentvehicle, and its impact upon existing UK-listed property companies:
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n There was no expectation of imminent changes in legislation to allowthe development of a UK vehicle comparable with those available in theUS or Continental Europe.
n The increased use of the limited partnership was predicated, although,with its current limitations, it did not provide a vehicle by whichinvestors, particularly small investors, were able to enter and exit themarket at low cost. The barrier to progress was the government’s viewthat a secondary market did not exist for such vehicles.
n Major differences between the UK and other European investmentmarkets were noted. The institutions remained the dominant investorsin the UK, whereas a variety of investment vehicle types existed on theContinent.
n With regard to the impact that a UK tax-transparent, tradable vehiclewould have on the existing quoted property sector, the viewsexpressed were generally positive. The most likely scenario predictedsaw the existing companies operating parallel structures, continuingwith development and refurbishment activities through the traditionalcompany structure, but at the same time exploiting the opportunities(such as accessing funds and earning fees) presented by the newvehicle.
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9 FOCUS GROUPS
In addition to the questionnaire survey and interviews, focus groups were usedto explore the relationship and interaction of key issues through structuredgroup discussion. Two focus groups were held in November 1999.Participants were carefully selected to provide a representative sample fromthe property investment market. A total of 21 investment experts took part,including representatives from:
n 4 UK property companies
n 1 UK institution
n 3 fund managers
n 5 banks (UK and overseas)
n 1 leading accountancy firm
n 1 leading legal firm
n 3 leading surveying firms
n representative body.
All participants were senior level executives, providing extensive experience inthe UK and overseas property investment market.
Two main questions were put to the participants:
n Do foreign investors enjoy tax advantages over indigenous companieswhen investing in UK property?
n If inequalities exist, how can UK property companies redress thebalance and compete in future?
The focus group moderator posed a series of subsidiary questions in order toguide the discussion, out of which the following themes and views emerged:
9.1 The UK as a destination for overseas investmentOverseas investors currently active in the UK real estate market
US investors were seen as the dominant group. This included opportunityfunds and a number of pension funds such as Teachers.
Whilst the Germans were acknowledged as large investors, of late they hadbeen less active than previously due to the euro and currency fluctuations.
Over the past two years:
n the Irish had emerged as reasonable sized investors;
n Middle Eastern investors continued to be present; and,
n there was a re-emergence of Far Eastern investors.
Other nationalities mentioned were the Dutch, Israelis and Swedish.
There had been a small number of institutional vehicles in limited partnershipstructures, bringing together a number of international investors, but this hadtailed off due to currency concerns.
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Factors driving overseas investors to invest outside their domesticmarkets, and the varying objectives and characteristics of overseasinvestors
It was difficult to generalise about the reasons why investors looked overseas,because different investors had different profiles and objectives.
Changes within the country of origin can create waves of overseasinvestment. Examples of this include a lifting of regulatory constraints, whichwas apparent with the Germans, and before them the Swedes, whenexchange controls were lifted.
The German open-ended funds had a lot of liquidity and were finding it difficultto achieve reasonable returns in their own market. When looking abroad, theytend to look for income capital preservation, with bond type characteristics.
Much of the American investment was seen to be return driven, with a lot ofthe recent US interest being in the form of highly geared opportunity funds andshort term cycle play as opposed to longer term institutional money. Becausethe US market was so large and so deep, US investors could meet most oftheir requirements, including diversification, at home. They invested abroad toobtain 20% plus returns. A further characteristic of US investors was theirinterest in buying businesses rather than assets. This trend has also raisedthe importance of management. As foreigners entering a new market, theyregard a strong management team, who know how the local markets work, asvery important.
The American investor’s view as to what constitutes real estate goes beyondthe retail, office and industrial sectors to include leisure, hotels, residential,serviced offices and a whole raft of other sub-sectors which are becomingestablished as real estate investments. To the Americans the ‘niche’ aspect isimportant. It is not only the Americans who are return driven, although the term‘American’ is often used as shorthand for opportunity funds which seek 20%IRR, and there are other nationalities (Australians and some Europeans) whoare also seeking high returns and making similar types of investments.
Driving the current influx of Irish investment was the current level of wealthgeneration in Ireland and access to cheap finance. There have also beenlegislative changes in Ireland, with the withdrawl of tax advantages for propertyinvestment, that may be contributing to the increase in overseas investment.
Israelis were motivated by a yield play, and the levels of Middle Easterninvestment were seen to be dependent upon oil prices.
There was strong agreement that portfolio diversification was not a factorwhich drove overseas investment. A phenomenon identified by severalparticipants was rivalry or competition within some groups of overseasinvestors. In some instances, foreign investors of the same nationality hadcompeted against each other for UK property. There was a view thatdecisions could be influenced more by competition from back home thanconditions in the UK market.
The financing methods employed by overseas investors active in the UK
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The most distinctive feature of financing was the model adopted by privateinvestors as opposed to institutional investors. Private investors tended tomake more use of the offshore company, heavily geared to shelter all UKrents, and to take a capital gain without tax.
Is the UK regarded as a favoured location compared with otherEuropean real estate markets?
In general, property investors will primarily invest in their own country. It maybe true to say that the UK is a favoured foreign destination, but it will not befavoured above the investor’s own country.
US investors tended to:
n take a pan-European view, rather than looking at individual countries;
n view the UK as part of Europe and look throughout Europe; and
n look at macroeconomic and property cycles – the determining factorwas where a particular country was in the market cycle.
Currently the UK was a bit more mature and further along in the cycle thanother markets were perceived to be. Consequently the view amongst theopportunity funds is that the potential for gain has moved on from the UK andindeed from Europe. Many of the funds were therefore bypassing Europe andheading for Asia.
The view of one American contributor was that US investors did not fullyappreciate the benefits of the UK market place in terms of investing;furthermore, they would not be concerned with these benefits as they tendedto be return driven, rather than looking at risk and diversification. Americansinvested in global real estate funds, whereas European investors tended to bemore narrowly focused.
European investors, understandably, did differentiate within Europe, andcertain characteristics of the UK property market were seen as factors thatmade the UK more favourable than other European locations.
The UK lease, which is much longer than anything available in mainlandEurope, was particularly appealing to the Germans, who seek long term,bond-like income. Transparency and liquidity were also important in attractingoverseas investment. The UK market was also easy to get into and easy toget out of and was therefore subject to waves of foreign investment, forexample the Swedes and Japanese in the 80s, followed by the Americans andGermans in the 90s.
Familiarity of culture and language was a significant factor, particularly withrespect to Irish investors. In other markets it would be harder to sourceprofessional advice. In terms of the euro, Britain’s present independence fromthe currency was regarded in a positive light by Irish investors.
The position of the UK listed Property Company
Strong views were expressed about the inequalities that currently existbetween property and other asset classes. In particular the variation intransaction costs was seen as damaging to the UK property company – forexample, the 3½% stamp duty, compared with ½% or lower for trading inequities or bonds. It was this which prevented property from competing on alevel playing field:
‘Anything that distorts the comparison between property and otherforms of asset classes is something we resist, and resist strongly.’
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The level of stamp duty was seen as reducing liquidity. In the competitionbetween competing asset classes, the high transaction costs and illiquiditywas blamed for driving institutional interest from the property market. Theunequal treatment of property was not limited to stamp duty; with respect tocapital allowances and plant and machinery, property was not treated in thesame way as some other industries. It was suggested that if the governmentwanted to use stamp duty as a means of controlling the housing market, atwo-tier system could be introduced with different rates for commercial andresidential property, as in the business rating system.
It was a common view that the preferential treatment of other asset classesover property was more of a threat to the listed property company than foreigncompetition:
‘It’s the inequalities between the competing asset classes within thedomestic tax structure that’s rather more important than theinequalities with any foreign investors coming in…’
One view saw the ‘institutionalising’ of direct and indirect ownership ofproperty as a ‘prime distortion’. The institutions were insisting on a tax-efficientvehicle for indirect ownership comparable to their direct holding. The questionwas why property companies should be viewed any differently from otherquoted companies they invest in, where they were in effect paying tax.
9.2 The future of the quoted property companyA further problem identified was the very small scale of the quoted propertysector within the overall stock market, and the difficulty in raising the profile ofthe sector amongst analysts. Again the lack of liquidity was seen ascontributing to the difficulties, and there was a feeling that owning assets washaving a detrimental effect:
‘Part of the problem is that we have assets, and there is a realfeeling that to be valuable in the stock market these days you mustget rid of your assets.’
Whilst there was a view that many institutions saw no future for the quotedcompanies, other participants envisaged ‘a huge future for the quoted propertysector’ in the opportunities presented by privatisation and outsourcing ofgovernment and corporate real estate. The key to future development was toget more liquidity into the market, and similarities in market treatment:
‘Isn’t it the point when we talk about REITS and SICAFI’s … theAmerican and Belgium versions of getting investment into themarket … our version in the UK is through the quoted propertycompanies .… That’s not to say it hasn’t got a future, it’s there, a bitlike the REITS, they’ve been there 30 years and suddenly they getpicked up and used and then they sink back a bit and are not sopopular. In a way that’s what’s going to happen to the quotedproperty company as well.’
9.3 ConclusionThe general consensus of the participants on several issues allow thefollowing conclusions to be drawn:
The UK as a location for overseas investment
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n The diverse motives and objectives which drive investors make itdifficult to generalise as to whether a country is a favoured location,and why.
n The US opportunity funds, which have recently been very active in theUK, are less influenced by the idiosyncrasies of the UK market than itsposition, along with other potential investment locations, in the marketcycle.
n For other investors there are definite characteristics of the UK marketwhich make it more attractive than other destinations.
n Overall, whilst many potential destinations may be considered in termsof market cycle and return, the UK does appear to have attributes overand above these considerations.
This results in consistently higher levels of foreign investment than otherEuropean destinations, particularly long term investment:
‘… any international market that an investor would think of as havinga core portion of the portfolio, it would be the UK, rather than otherswhich might be more tactical plays to get the returns.’
The future of the UK quoted property company
n The main problem for the UK quoted property sector was notcompetition from abroad but inequalities within the domestic market,through the preferential treatment given to other competing assetclasses.
n The higher transaction costs relating to property were seen asparticularly unfair, and were regarded as contributing to a lack ofliquidity in the market which deterred institutions and other investors.
n Despite the current pessimism amongst institutions as to the future ofthe quoted property sector, opportunities were identified which couldbe exploited through the skills and experience of the sector. The taskwas to eradicate the inequalities and improve liquidity.
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10 CONCLUSIONS
This research project has focused on two major questions:
n Do foreign investors enjoy tax advantages over indigenous companieswhen investing in UK property?
n If inequalities exist, how can UK property companies address thebalance and compete in future?
Our working hypothesis has been that UK property companies suffer from aninequitable tax system that largely favours their overseas competitors in theUK market. To test this hypothesis would require us to examine whether, forthe majority of transactions occurring over a period of time:
1. A foreign competitor was able and willing to outbid a UK propertycompany for an investment property.
2. The ability to outbid the UK competition was attributable principally to atax regime which gave an overall relative advantage to the foreigninvestor.
To research the first of these would necessitate taking a structured sample ofproperty transactions for the selected period and examining the agenda of theparties concerned. Since this would require investors to reveal sensitivefinancial data, which were unlikely to be forthcoming, it was not seen as apractical approach to the problem. The alternative methodology was to takethe views of investors and property professionals on both questions. Thesample of property people we took was representative of the range of interestsoperating in investment markets.
In the course of answering these questions the study has examined:
n the nature and extent of overseas investment into UK real estate;
n the reasons why investors choose the UK;
n the importance of taxation in the investment decision;
n the tax treatment of UK and overseas investors;
n the type of investment vehicles currently operating in the UK;
n the status and performance of the UK listed property company.
Based on the evidence of the literature review, the postal survey, theinterviews and the focus groups, the following conclusions may be drawn.
10.1 Global investment trends and the growth ofcompetitionWhen considering the nature and extent of overseas investment in UK realestate, it is important to view it in the context of global investment trendsacross all asset classes. Chapter 2 highlighted the rapid growth of foreigndirect investment (FDI) throughout the 1980s and 1990s, and examined thefactors which have led to the globalisation of investment markets. Theemergence of this single global financial system has resulted in ‘morediversified investment portfolios, larger numbers of firms tapping into foreignsources of funds and the growth of highly sophisticated asset managers onthe look out for arbitrage opportunities’ (IMF 1998).
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The development of international property investment, direct and indirect, hasbeen part of this wider trend, and consequently competition in this market hasgrown.
10.2 The UK as a destination for overseas investmentLooking at the source and destination of international investment flows, Table2.2 (page 7) suggests that the USA and the UK were the most prominentsource and host countries for FDI between 1990 and 1996. The popularity ofthe UK as a host for overseas investments across asset classes is reinforcedby statistics compiled by the surveying industry, which shows that over thepast four years the UK real estate market has far outstripped other WesternEuropean countries in attracting overseas capital.
The results of the postal survey further confirm the position of the UK as afavoured destination for real estate investment. 75% of overseas respondentsheld direct real estate investments in the UK, compared with 46% in France,the next most popular location.
10.3 The determinants of overseas investmentIn attempting to explain why the UK property market has attracted such a largeshare of overseas investment, this report has drawn together previous studieson the determinants of international capital flows, in addition to undertakingprimary research to discover the motives for cross-border investment.
Work undertaken by Worzala (1994) showed diversification, higher returns,economic and business development, and lower risk as the key factors. Taxdifferences have generally been seen as a risk rather than a benefit.
Chapter 5 of the literature review examined evidence on the specific impact oftaxation on investment decisions. Overall, the findings implied that investorswere influenced by tax issues, but they were not the most important factor.
The postal survey showed that for overseas investors, whilst the UK taxregime may be attractive, a country’s tax regime was not a primaryconsideration when allocating funds for investment. Factors considered to bemore attractive than taxation included:
n business culture and language;
n liquidity;
n lease terms;
n capital growth;
n maturity of the market; and,
n rental growth.
This result was strongly supported by the views that emerged from the focusgroups and structured interviews. Here the general consensus was thattaxation was not a prime influence in determining the direction of overseasinvestment, and although a particularly onerous regime might act as adeterrent for some investors, they could devise ways of overcoming such abarrier.
Both the interviews and the focus groups stressed the diverse motives andobjectives which drive investors. German funds were particularly attracted bythe UK’s institutional leases. US opportunity funds were less interested in the
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idiosyncrasies of the UK market than its position in the market cycle. Privateinvestors in the Middle East looked for market stability. Other investors lookedprincipally for growth or liquidity There was almost universal agreement thatinvestment was market driven, not tax driven.
10.4 The tax treatment of UK and overseas investors.Chapter 5 reviewed the literature on taxation regimes, the effects of taxationon international investment flows and the structures designed to limit theimpact of tax. The difficulty with such comparisons was the wide range ofvariables. Investor status, investor objectives, tax regimes and individualtransactions all varied widely across an international property marketcharacterised by inadequate information and differing legal arrangements.
The general view arising from the interviews and focus groups was that theUK tax regime, as it affected property investment, does contain certainfeatures favouring foreign investors. Two in particular were raised repeatedly:the absence of a tax on capital gains made by foreign investors, and the rulesrelating to thin capitalisation, which were seen to be more tightly drawn in theUK than in two other countries.
10.5 Tax-efficient vehiclesWhatever view is taken of the UK as a tax-friendly location, foreign investorsare able to devise vehicles for minimising their tax exposure whichevercountry they choose. The US private investor can use the double Dutchstructure for investments in Spain. For France there is the Delaware system.Large companies like PRICOA can acquire real estate by buying up thecompanies that own them. On this last point many members of the focusgroup had on occasions considered buying the company owning an individualproperty, rather than the property itself. The fact that they did not was probablybecause the consequential costs would have exceeded the savings on theproperty transaction costs.
If the UK does offer favoured tax treatment to incoming investors, it is not theonly country to do this. Although admittedly it is a smaller market, Hollandoffers a number of significant concessions to the foreign investor. The mostimportant of these are:
n A location for intermediate holding companies, the purpose of which isto reduce withholding taxes on passive income streams.
n An extensive tax treaty network.
n No withholding tax on interest payments abroad.
n A tax credit on the dividend withholding tax to set against otherliabilities.
The Netherlands is therefore seen as a tax-efficient base for investment.
To summarise on the tax advantages enjoyed by overseas investors: whilstcertain components of the UK tax regime favours overseas investors, othercountries also had regimes which encouraged foreign capital. Furthermore,investors could employ a range of financial and legal devices to overcome orminimise unfavourable taxation in most countries. These findings are
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consistent with the survey results, which suggest that overseas investors arein the UK for reasons other than tax.
10.6 Overseas competition, and the status and performanceof the UK listed property company
10.6.1 Competition as a global phenomenaIt is important to appreciate that whilst the UK takes the largest share of cross-border investment compared with other European countries, it is not unique inattracting significant levels of foreign capital. The postal survey showed thatafter the UK, France and Germany were important markets, with 44% and40% of respondents having direct real estate holdings in each countryrespectively.
Statistics from DTZ and Jones Lang Wootton have shown that, whereasforeign investment into the UK between 1997 and 1998 accounted for morethan 20% of all property transactions by value, in 1998 foreign investment inFrench commercial property accounted for 80% of total purchases. Thesefigures are borne out by the focus groups and interviews. The UK is popularbut many investors, particularly the US opportunity funds, are taking a morepan-European view in their search for higher returns.
Although the UK attracts the largest share of cross-border investment, it couldbe argued, in the light of the high percentage of overseas investors in theFrench market, that other markets are subject to as much if not morecompetition from overseas investors.
10.6.2 Competition within the UKThe next question to address is the effect of this overseas capital on thedomestic investor. Is there competition, and if so what form does it take?
There are a number of non-tax factors which influence the investmentbehaviour of foreign investors. Where these are combined with the UK’sattractions as an investment market to draw overseas funds, then competitionis intensified and prices are bid up. The following factors are judged to raisethe level of competition in the UK market:
n The weight of money regularly flowing into the large open-end fundswhich obliges them continuously to find new outlets. Combined withthe other attractions of the UK market, its long leases, its stability andliquidity, this will exert an upward pressure on prices.
n Lower borrowing and capital costs on the Continent linked with a lowerinflation rate are likely to depress required rates of return. Germanbanks and the open-end funds offer rates below those operating in theUK. For German investors this adds to the other attractions of the UKmarket.
n The increase in the number of players in the UK market in the 1990s.Investors from the US, Continental Europe, the Middle East, morerecently the Far East and Ireland are involved in the UK market. Withno corresponding increase in the number of investment properties onthe market, bidding for any property has become more intense.
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Weighing against this competition were the advantages enjoyed by the UKproperty company and the benefits conferred on the UK market by theoverseas presence. The domestic companies were seen to have the benefitof superior knowledge of the local market, whilst the liquidity created by theforeign capital benefited the domestic companies, possibly neutralising othercompetitive advantages the foreigner might have.
One interesting view to emerge was a perception that the threat from theoverseas investor tended to be in operational rather than financial terms. Theproperty market was becoming more tenant led, and the overseas investorwas responding to this through the introduction of more innovative, flexibleapproaches to property management. The indigenous UK companies were indanger of losing out if they failed to respond to these changes.
10.7 The domestic threat: market distortions, andinequalities between asset classesPerhaps the most interesting finding to arise from the primary research is thestrongly held view that the major problem facing the UK-quoted propertycompany arises not from overseas competition but from the differentialtreatment of asset classes within the UK. As a focus group participant put it:
‘It’s the inequalities between the competing asset classes within thedomestic tax structure that’s rather more important than theinequalities with any foreign investor coming in…’
The property industry appears to be more concerned about the effects ofraising stamp duty on property than about preferential treatment for overseasinvestors.
There were two main arguments put forward on this.
Firstly, the discriminatory treatment of property distorted investor choicesbetween different asset classes. There was now a wide gulf between propertytransactions taxed at 3½% and share deals which paid ½%. The continuingpopularity of shares clearly owes something to their lower transaction costs. Itis difficult to reconcile a policy resulting in such a distortion with a governmentobjective to improve the efficiency of markets.
Secondly, higher transaction costs further reduce the liquidity of the marketsince it takes a longer holding period to amortise them at an acceptableannual rate. The decline in liquidity again reduces the efficiency of the market,affecting all investors, domestic and foreign.
The inability of the UK companies to raise capital and have a liquid market intheir shares was also a recurring theme throughout the interviews and focusgroups. One reason for the difficulty of raising equity was that propertycompanies remained small in size and the sector lacked the critical mass tobe of interest to the equity markets. A consolidation of the sector into a smallernumber of large companies would go some way to address this problem.
Another issue was the existence of inequalities, in particular unequaltransaction costs. Such inequalities distorted markets and were the cause ofeconomic efficiency.
The other task was to improve liquidity. The general consensus of contributorswas that this would be improved by the introduction of a tax-transparentvehicle, but there was no consensus on the form it should take. Although morewidespread use of the limited partnership was predicted, the shortcomings of
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this vehicle and the other European models were underlined. It was alsoquestioned whether the UK had a retailer base capable of sustaining interestin securitised property vehicles, given the other investment options available.
10.8 ConclusionReturning to the original questions, it is clear that overseas investors do enjoytax advantages over UK-based companies. As the findings demonstrate,however, such advantages are not the reason why overseas competitionexists in the UK, nor is this competition the main threat facing the UK quotedproperty sector. The problems of the sector are domestic and it is within theUK investment market that the answers must be sought.
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