The Build to Rent (BTR) sector has never been busier. The interest to institutional investors is at an all-time high. With almost every week, a new BTR fund with hundreds of millions to invest seems to enter the market. This is, of course, most welcomed with current housing shortages. Housing supply will have to move from 200,000 net units to 300,000 units in the UK to keep pace with current demand, and BTR has the potential to contribute in a much-needed way to reaching such targets. What the market needs is for BTR really to be seen and recognised as offering an alternative supply – seeking a framework allowing it to fairly co-exist with build to sell. In a housing sector offering variety, BTR can be delivered relatively quickly and is not necessarily prone to financial or external cyclical influences which have in the past dampened build to sell levels of activity.
So, what are the most significant hurdles for institutional investors in the exciting new asset class of BTR? From a tax perspective it brings a host of considerations that are just not relevant to investment into commercial property assets. Why? BTR assets are residential, which results in investments in BTR assets being caught within tax rules primarily designed to tax other types of residential property investment.
BTR is caught in the middle of tax rules which tax non-residential owners of high end residential property, private rented sector landlords and commercial property owners. In practice this results in increased tax and adviser costs and the need to manage tax risk.
The well-publicised additional cost is the 3% SDLT surcharge for second homes that is added to any claim for multiple dwellings relief. Is it unfair? On the one hand you never pay more than you would for commercial property but on the other hand it is a surcharge aimed at second homers and not BTR investors. Consequently, many have argued for exemptions to apply. The original proposals did suggest an exemption but it was dropped before the rules were enacted, perhaps increasing the sense of unfairness.
Next is VAT, which creates both cost and risk.
Building homes to sell can be carried out on a VAT efficient basis through the availability of zero-rating on both the construction costs and onward sale. The construction rules apply equally to BTR developments but the exempt end-use creates more complexity around the recoverability of VAT on professional and land costs. There are a number of commercially motivated structures used for the development of BTR assets which also may also mitigate VAT. For example, disposing of land at so called “golden brick” stage of construction creates an all-important zero-rated supply.
However, even if development structures are VAT efficient, the operational side will likely create a VAT cost. In the commercial property context, the VAT cost normally sits with the end-consumer. The impact on the rent can be negligible depending on the chain of under-lettings. However, in BTR arrangements, the VAT cost sticks with the landlord because it makes the last supply in the chain as an exempt letting to tenants. This irrecoverable VAT must be factored into decisions about rent setting and acceptable level of returns.
The recent report by BPF, commissioned from Savills, about unlocking the benefits and potential of BTR, recommended zero-rating of residential leases to enable the VAT to be recovered. It recognised that to achieve this we would need Brexit to happen to free the UK from the European rules which would prevent such a change. Of course, the Government would also need to be motivated to accept a reduction of VAT moving to the Exchequer as a result of the change and this would be linked to underlying housing policy. However, such a change would equally benefit private landlords, who HMRC seem set on restricting to avoid fuelling a buy-to-let uptick. Therefore, whilst this is a valid and beneficial recommendation, the chance of such a change being implemented in the short to medium term would seem remote.
As the BTR sector evolves, it also creates issues around interpretation, which lead to tax risk. Determining whether residential units are dwellings for VAT purposes requires analysis of the nature of the dwelling, but also of restrictions in planning and related documents. What about ancillary facilities, gyms, common areas etc – are they part of the dwellings? There is limited guidance which is already feeling out of date in the context of BTR. Guidance confirms that construction of a residents’-only gym in a single residential block should benefit from zero-rating, but what about a residents’-only gym in a separate building, for use by a number of residential blocks? What about services? When does the letting stop being an exempt letting of a dwellings and start to become a hotel or “similar establishment”. Can services be offered separately to rent? These are considerations that will no doubt create debate as the institutional BTR market matures.
When we stop considering indirect tax cost, we have to consider the direct tax impact on residential holding structures. If the BTR asset is, or is planned to be, held within a non-resident holding structure, you have to consider the impact of the direct tax rules designed to dis-incentivise non-residents from investing in high-end UK residential property, or paying tax on value generated if they do. There are exemptions in the rules, but they need to be worked through to know what does or does not apply. Letting property should remove a BTR landlord from the Annual Tax on Enveloped Dwellings and associated capital gains tax charge due to falling into one of the exemptions from the rules. However, the non-resident capital gains tax charge on UK residential property has no such exemption and needs more consideration if BTR assets are owned in non-resident structures. Layered on that is a need to consider the new transaction in land rules and the current consultation to bring non-residential companies with UK income from real property into the UK corporation tax regime. Analysing and managing risk then starts to become an expensive part of the investment process.
And then there is council tax. A different type of tax, but a tax all the same. BTR landlords will generally be liable for council tax when the BTR units are empty. In an ideal world, the rules would exempt BTR landlords in relation to unoccupied properties which are being marketed for rent. This would be a positive policy step and easy to implement especially if an industry definition of BTR is created. However, local authorities, who benefit from the tax, may be less inclined to support such change when they need to collect money from every possible pocket at present.
Tax is, and will remain, an important consideration for any BTR investment. Investors will need to be aware of the tax costs to ensure they are factored into developments cost appraisals and operational returns.
The speed of change of tax rules is burdensome at present. In an ideal world, future tax changes would be motivated by housing policy change benefitting the BTR sector and not change motivated to penalise other parts of the sector. HMRC guidance would also keep pace with the evolving sector. However, in reality, this feels unlikely as HMRC resource is simply not there.
A portion of this article can also be seen in Property Week.