Real opportunities: how private capital can access real estate
Blog Macfarlanes Blog

Real opportunities: how private capital can access commercial real estate

Over recent years the European commercial real estate (CRE) market has been shaped by persistently higher interest rates and elevated construction costs. At the same time, CRE has continued to become increasingly operational. These factors have triggered increases in yields and corresponding drops in valuations. Today, price discovery is still playing out, debt financing remains more expensive than in the very low-interest rate environment to which we had grown accustomed, and consequently sponsors are thinking more creatively about capital stacks. As some of the traditional players in the CRE investment landscape have pulled back, private capital has emerged as an increasingly important source of liquidity.

In this article, we explore the opportunities, and the complexities, emerging for private capital across the CRE sector, the alternative structures increasingly being used to access the CRE market, and some of the tax structuring considerations that can meaningfully affect returns.

Green shoots: accessing the emerging opportunities for private capital

Signs of sector recovery

Despite the challenges of the current macro-economic and political backdrop, a changing regulatory landscape and practical obstacles to development such as difficulties securing planning and access to power, there are genuine green shoots emerging in the CRE market. Transaction volumes are recovering from the lows of 2023, capital sources are diversifying, and regional fundamentals are strengthening. CRE is an increasingly attractive allocation for institutional investors seeking defensive, income-generating assets amid broader market uncertainty.

This growing appetite for CRE is shaped by the revenue stream associated with particular assets: stabilised assets generate predictable, recurring and relatively passive income streams and are increasingly distinguished from a growing class of operational real estate assets (OPRE), where returns are directly linked to the active management and performance of the underlying business. Alternative lenders are particularly active across OPRE such as hotels, student living, buy-to-rent and logistics and data centres, while banks remain predominantly focused on more traditional core asset classes, including prime central city office locations and, for the right assets, retail. With traditional asset classes becoming increasingly operational, and the market more varied, there are opportunities for agile investors who can deploy capital flexibly. If approached correctly, these opportunities have the potential to deliver resilience in the OPRE market. For more on OPRE, read our report: Fully operational: the future of real assets.

Finding the right partner

CRE investment strategies are becoming increasingly distinct and more specialist, and investors and lenders are often teaming up with specialist asset managers or operators in order to leverage off their connections and specialist expertise. However finding the right partner is not always straightforward. It is fundamentally a collaborative process, requiring both sides to invest time in getting to know each other well. Whilst structuring of the relationship, whether that be by management agreements, joint ventures, and/or vertically integrated structures, and associated documentary protections are of course important, the reality is that terminating an arrangement with a manager or operator is rarely a good outcome for anyone and therefore the groundwork in identifying the right partner a key component of a successful CRE investment.

The evolution of the available capital stack

The evolving role of bank lenders

The capital stacks that underpin CRE transactions today look markedly different from those of even recent years. Increased regulatory capital requirements for bank lenders, most recently through the finalisation of Basel III, have contributed to a significant retrenchment of banks from the sector. And this is one of the reasons why alternative lenders, and credit funds in particular, have become more active in the CRE space.

That is not to say that banks are no longer active in CRE lending, rather they are active in a different way. For example, banks are increasingly seeking more indirect CRE exposure by providing back-leverage into credit funds directly. There is more favourable regulatory capital treatment for banks when lending in this way, and it is also highly attractive for fund lenders, who can use that back-leverage to boost their own returns. For more information, read our article: Back leverage a deep dive.

Addressing the funding gap

Capital stacks have had to adapt to address frequent funding gaps. Where transactions have completed or refinancings have been required in recent years, it has not been uncommon to see a gap in available funding. Lower valuations, compared with when assets last changed hands or were financed, have resulted in higher loan-to-value (LTV) ratios, and the proceeds available to borrowers are correspondingly lower. This dynamic creates a genuine opportunity for private credit lenders who are able to offer whole loans at a higher LTV, and who, in the right situations, can often deploy capital secured on prime assets at conservative valuations, meeting their return requirements even at relatively modest leverage levels.

We are also increasingly seeing subordinated instruments, for example mezzanine debt, junior or structurally subordinated holdco financing, or preferred equity investments being used to plug the funding gap. Where used, these instruments often combine a fixed return with an equity-like upside, where the lender has an additional profit participation akin to a promoted interest in the structure. Whilst these instruments have a higher risk profile than that of senior debt, returns are higher and they typically benefit from fixed security over the underlying asset, albeit subordinated to the senior lender's security. A blending of debt and equity characteristics also offers enhanced returns, potentially without direct involvement in the governance of the borrower, and deployed at lower leverage levels than in previous market cycles.

From a tax perspective, the principal advantage of a debt investment over preferred equity distributions is that generally the finance costs are typically deductible for the borrower. That said, care is needed in respect of related-party debt and profit participating elements. For example, where a mezzanine lender has participation rights, whether by way of a profit share or otherwise, they are unlikely to give rise to a tax deduction. Further, in the case of significant participations, a holder could be effectively treated as an equity holder for tax purposes, potentially breaking tax groupings and giving rise to trapped losses.

Alternative routes to accessing the CRE market

Understanding the asset: investing into operators and asset managers

Where direct investment into CRE is not viable, investors are increasingly adopting hybrid solutions and investing alongside, or directly into, operators and asset managers themselves. The growing complexity of CRE as an asset class means that access to specialist management teams is increasingly valuable, and a direct investment can provide investors with further upside beyond the returns on the underlying real estate, including a share of promoted interest and management economics.

Valuation methodologies are evolving as the brand, people and data held by operators are accounted for. However, it remains challenging to value sector specialisation and, in turn, to reflect this in debt and equity terms. Finding the right operator is key, and the specialism and track record of asset managers and operators will continue to attract greater scrutiny from investors who are looking beyond the value of bricks and mortar and seeking to understand broader value and overall risk profile. With the right asset management there are opportunities to outperform, however, against a backdrop of increasing costs, operators will need to deliver stress-tested business plans which can withstand economic pressures.

For operators and asset managers, this type of investment can be attractive for a number of reasons, including access to growth capital and, in some cases, facilitating succession planning. The governance arrangements in these structures can, however, be complicated, reflecting the need to balance the interests of the capital provider with the operational autonomy of the management team. Tax structuring also requires careful thought, particularly in relation to how the investment is characterised and how returns flow through the structure.

REITs: accessible but not always appropriate

Real estate investment trusts (REITs), those UK property investment companies which have elected into the regime and own real estate portfolios and generate rental income and capital gains for shareholders, provide investors with a liquid, high-yield income stream and diversified exposure to CRE without the hassle of direct ownership or management. They offer inflation protection, transparency, and tax efficiency within the REIT company or group, as REITs generally do not pay corporation tax. REITs have been available for almost 20 years, but the intentional relaxation of certain eligibility conditions around four years ago has put them firmly on the table as a viable option for private capital structures.

That said, whilst each REIT company or group is exempt from tax on income and gains, the regime is not designed to eliminate all UK tax for all non-residents investing into UK real estate; suitability must be determined on a case-by-case basis. In particular there are obligations to distribute, annually, at least 90% of income profits, and the starting point is that the REIT withholds tax at 20% on those distributions. Shareholders resident in certain jurisdictions can reduce that rate by claiming partial relief under a double tax treaty, most commonly to 15%, although this is usually a reclaim rather than a relief at source. Any gains realised during the life of the investment are usually subject to that withholding tax when distributed.

The REIT regime does provide for a rebasing of assets, without a tax charge, on entry and in certain conditions on exit. This sounds attractive, but for many assets the relevant comparison date for values would be around 2019, which represented something of a high-water mark. Many companies are in fact sitting on latent losses that would be attractive to a purchaser and which that purchaser would not want to see wiped out by the rebasing provisions of the REIT regime. Further, from April 2027 the withholding tax rate that REITs apply to property income distributions will increase from 20% to 22%. While investors benefitting from the 15% treaty rate are expected to continue to do so, the increase narrows the gap between the REIT distribution rate and the corporation tax rate, arguably diminishing one of the principal current benefits of the REIT structure for particular investors.

In summary, whilst the REIT regime remains an established and broadly attractive vehicle for investment into UK commercial real estate, it may not always be the most appropriate solution for the transaction at hand. Investors should therefore approach the REIT structure with a clear understanding of the specific tax profile of the intended investor base, the nature and current valuation of the underlying assets, and the broader commercial objectives of the investment, to ensure that the regime delivers a genuine net benefit.

What next?

From a lending perspective, whilst LTV ratios today are more conservative than they have been historically, income-based covenants are coming under pressure. Inflation has pushed up operating costs significantly, and finance charges remain elevated, creating a squeeze on net income and therefore on debt service and income cover ratios. For borrowers caught in this position, there is both risk and, for well-capitalised investors, opportunity.

The cost of construction is another area creating both challenge and opportunity. Elevated build costs have constrained the viability of new development, which in turn is limiting new supply in a number of sectors. For investors and managers with the expertise and risk appetite to navigate these challenges, the supply-demand imbalance that results can create compelling investment opportunities

If there is one key takeaway, it is that the means by which private capital can access the CRE market continue to evolve, and there is no one-size-fits-all approach. The recent acquisition of 70 St Mary Axe (known as the "Can of Ham") by Hayfin and Capreon, is demonstrative of a combined approach and how critical it is for investors to be agile, to understand the asset, and to appreciate the different stakeholders and their respective positions from the outset. Whether deploying capital through senior or subordinated debt, preferred equity, joint ventures, REIT structures, or direct investment into operators and asset managers, the opportunities for private capital in today's CRE market are real and significant. The challenge, and the reward, lies in navigating the complexity.