Whilst the current state of the property market is deterring new entrants as well as experienced investors, real estate remains an important asset class. Traditional investment routes into property for pension funds have been through shares in listed property companies and OEICs (open ended investment companies) or units in specialist unit trusts. However, there are other ways in which property can be held. The focus of this article is on some of those routes.
Tax considerations play a key role in the choice of ownership vehicles used for property investment. For a pension fund, the ideal position is to receive tax free income and capital gains with no “leakage” as a result of tax charges imposed within the structure. This issue has to be considered in the context of each structure. Conversely, transactional taxes, such as stamp duty land tax (“SDLT”) and VAT, generally apply across the board.
SDLT is charged on most transactions in UK land at rates up to 4%, regardless of the ownership structure that is used. There continue to be legitimate opportunities to mitigate SDLT costs and these can involve the use of structures where, for example, indirect acquisition through a company is used instead of a direct route. Dealings in shares are subject to stamp duty at 0.5% (or not at all if the shares are in a non-UK company). On the face of it, this differential makes it attractive to use corporate special purpose vehicles for property transactions, although other tax and commercial implications can outweigh the SDLT saving.
The VAT treatment of property transactions is particularly complex – transactions can be exempt, zero rated, standard rated or outside the scope of VAT. For commercial properties, the default position is that dealings, including lettings, are exempt from VAT, although freehold sales of new buildings are standard rated. To ensure that VAT incurred on construction and other costs can be recovered, many owners exercise the option to tax which makes supplies subject to VAT at 17.5%. The option to tax tends to be selfperpetuating: if a seller is charging VAT, the buyer will need to opt to ensure that the VAT it pays can be recovered.
The simplest way to invest in property remains direct holding of a property asset. For a pension fund, this would generally involve the use of one or more nominees as the registered owner (in England and Wales a second nominee facilitates onward sales) so that changes of trustee do not involve re-registering the title at the appropriate Land Registry. Rental income and disposal proceeds arise directly in the hands of the owner, so the pension fund can benefit from its tax exemption. For VAT opted properties, the fund will need to register for VAT purposes (if it has not already done so). Investment property requires active management – for example, repairs and maintenance, finding tenants, negotiating rent reviews and lease renewals. Many investors contract out this work, as they would do in the case of a portfolio of equities or other securities, although since real estate is not in itself classed as an investment under the Financial Services and Markets Act 2000, such subcontracting is a practical rather than regulatory requirement. For funds that are considering investing in a segregated property portfolio, Hammonds’ Pension Fund Investment Group has experience of negotiating and drafting bespoke property investment management agreements.
Direct ownership of individual buildings may not be appropriate. For example, it will always be difficult to achieve a prudent spread of risk unless the fund is very large and can hold a mixed portfolio of properties. In this situation, indirect investment in a pooled arrangement can be the solution. As noted above, listed property companies, OEICs and property unit trusts have provided one such indirect route into property investment. Indirect investment provides liquidity (although the deferred redemption terms of some unit trusts have been a sharp reminder of the underlying illiquidity of property as an asset class) and a spread of investments, possibly across a variety of sectors.
Apart from quoted companies, OEICs and unit trusts, what other indirect routes are there into real estate?
A key development in 2006 was the introduction of the UK REIT (real estate investment trust). In one sense, REITs were not a new vehicle: they are listed companies that primarily hold investment property. During 2007 many existing publicly traded property companies adopted REIT status.
One of the key disadvantages, from a tax perspective, of investing through a company is that there are two levels of taxation. Profits are taxed in the company and, when those profits are distributed, they are taxed again in the hands of investors. Listed property company shares typically trade at a discount to net asset value, reflecting the accrued tax charge that would be triggered if the portfolio was liquidated. This can be compared to the treatment of open ended funds (OIECs and unit trusts) where the value of an investor’s interest is more directly linked to underlying asset values, since the price of the shares or units is calculated net of any tax.
REITs eliminate the tax cost within the company: they are exempt from tax on rental income and gains but are still taxable on other profits (but in a falling property market have still found their shares trading at a discount to historic asset values). In addition, when distributing the profits arising from property investments, the normal rules for dividends do not apply. The dividend is taxable as rent in the hands of shareholders and, in order to simplify administration for individuals (and deter avoidance by non-residents), the REIT is required to withhold basic rate tax (20%). Pension funds can arrange to receive REIT dividends gross, avoiding the cashflow cost that would otherwise arise.
The use of other vehicles for property investment typically arises where shared, rather than outright, ownership is involved. This can allow pension funds to acquire a stake in an individual property or smaller portfolio. However, these structures can also arise out of tax and SDLT planning. Commonly encountered structures are unlisted companies and partnerships.
For a pension fund, the key tax consideration will be whether the structure operates tax efficiently. As noted above, companies do not generally achieve this for pension funds. There will be a tax charge within the company on its income and gains, reducing the fund’s return on its investment. Nonresident investors often use offshore companies established in jurisdictions with a favourable tax system, such as the Channel Islands or Isle of Man. Unfortunately, these offer no real benefit to pension funds as rental income (but not gains) arising in the offshore company will still be subject to UK tax in the company.
On the other hand, partnerships can provide tax transparency for investors. There is no tax charge within the partnership – partners are taxed on their individual profit share. For a pension fund this should mean that its share of the partnership’s rental income is received gross and without tax being payable. There is a key exception: income and gains derived from membership of a property investment limited liability partnership (“LLP”) are not tax exempt for pension funds.
There is a long tradition of using limited partnerships for property investment. As Clifford discusses in his article above, a UK limited partnership (“LP”) is currently set up under the Limited Partnerships Act 1907. Its key commercial attraction is the limitation on limited partners’ liability for the debts of the LP to the amount of their capital. To ensure this limitation is maintained, limited partners must not participate in the management of the LP. Management is dealt with by one or more general partners, who have unlimited liability (and so are typically limited companies). Offshore LPs operate in a similar way and may be used to reduce the financial services compliance burden.
LLPs have become more popular as an investment vehicle as they offer advantages over LPs. For example, they have separate legal personality from their members (partners) which can facilitate ownership of assets. Feeder funds can be used for pension fund investors to ensure that the LLP’s tax transparency is not lost – the pension fund is not itself a member of the LLP and receives income and gains through the feeder fund.
Following changes to the tax regime in 2004, a market in property derivatives has gradually developed. They remain specialised instruments and have not developed into mainstream investment tools, unlike derivatives based on shares and other securities. This is due partly to the lack of reliable indices to swap against and partly to a shortage of counterparties. Nevertheless, derivatives can have a role in hedging risks arising from property holdings, for example by linking returns to a wider property index. Alternatively, they may offer a route to create a “synthetic” investment in the property sector.
As we have seen, there are a variety of ways to invest in property, ranging from direct ownership of real estate assets to the traditional routes of quoted shares and openended funds. In between, structures such as companies and partnerships can offer a different route into shared ownership, with derivatives providing a further choice. In short, there is no single solution. Each has its own benefits and suits particular situations. Flexibility and tax efficiency are key – along, of course, with confidence that property is the right investment.