David Ryland
The Securities and Investments Board issued regulations on July 15 enabling authorised unit trusts to invest directly in commercial, industrial, agricultural and residential land and buildings. Previously, direct investment by authorised unit trusts was prohibited, largely because property was perceived as an illiquid asset which was difficult to value. The new vehicles are known as authorised property unit trusts or APUTs.
Norwich Union and Barclays Unicorn have since each applied for authorisation to establish an APUT. This therefore seems an appropriate time to review the regulations.
An APUT may invest in properties and property-related securities in all EC member states and various other countries including the USA, Canada, Japan, Australia, Switzerland and Sweden.
Detailed liquidity and spread of risk requirements are imposed. For example, the fund must reach a value of £5m within an initial offer period of 21 days; no more than 80% of the value of the fund may consist of real estate; no more than 80% of the value of the fund may be invested in property-related securities (for example, shares, debentures in companies, the main activity of which is investing in developing/redeveloping qualifying property); no more than 25% of the fund may be invested in vacant properties or properties in the course of substantial development, redevelopment or refurbishment; no more than 20% of the gross rental income may be attributable to members of one group of companies; the consideration payable for a single property may not exceed 15% of the value of the property of the scheme (although there is no requirement to sell the property until its value exceeds 25%); no more than 10% of the value of the fund may be invested in leasehold property of which the unexpired term is less than 60 years; the borrowing of the fund may not exceed 10% of the value of that part of the scheme which comprises securities (as opposed to property).
There are exemptions from some of these requirements for the first two years of the scheme or, if earlier, the expiration of six months after the property of the scheme reaches a value of £15m.
Tax
The tax treatment of an APUT is particularly favourable. Any authorised unit trust is taxed as a company for income and capital gains tax purposes but is exempted from tax on capital gains. Accordingly, there is no charge to tax on the disposal of a property held as an investment.
Tax on income is charged at a special reduced corporation tax rate of 25%. This effectively means that no additional charge to tax is suffered by individuals or other non-corporate investors who pay tax at 25%, such as life assurance companies.
Three qualifications to the tax transparency should be noted:
(1) Because an authorised unit trust is taxed as a company, payments by it to the unitholders are treated as distributions. As a consequence the authorised unit trust must account for advance corporation tax (ACT) when making a distribution in the amount of one-third of the distribution. The unitholders will be able to claim a credit in respect of the ACT but, despite this, there is an accelerated payment of tax since ACT is payable three months from the date of distribution whereas mainstream corporation tax is payable only nine months after the end of the relevant accounting period. This is therefore a small cash flow disadvantage.
(2) Payments made by an authorised unit trust to a corporate investor are treated as annual payments in the investor’s hands. This effectively means that the corporate investor is required to account for ACT on any subsequent payment made by it to its own shareholders — thereby giving rise to a further cash flow disadvantage.
(3) Subject to the provisions of any relevant double tax treaty and the availability of unilateral relief, there may be a tax mismatch when an APUT invests in properties abroad. This is because a full tax credit may not be received for any foreign tax on a unit trust’s rental income where this exceeds the UK rate of tax. In addition, a UK corporate investor will generally receive a tax credit only for the tax payable on the net amount received by the unit trust after payment of the foreign tax.
Valuation and pricing
The trustee and manager are required jointly to appoint an independent valuer for the purpose of valuing the property of the fund. There must be a full valuation at least once a year with additional “arm chair” valuations at intervals of not less than once a month. It is currently proposed that valuations will be carried out on the basis stated in the Statement of Asset Valuation Practice published by the RICS.
The minimum frequency for pricing the units will be once a month. Forward-pricing will be mandatory and consequently the units will be priced by reference to the value of the property at the next valuation date. The manager will be entitled to operate “a box” (ie deal with units in its own name) but it is considered that the manager’s ability to make box profits will be limited by the requirement for forward-pricing and the inclusion of an additional requirement that the price of the units must reflect the least which could reasonably be expected to be paid by way of dealing charges.
The manager may enter into options, futures and contracts for difference traded on an approved derivatives market and certain off-exchange products when he reasonably regards such a transaction as economically appropriate to the reduction of risk or cost arising by reason of fluctuations in (inter alia) the price of the property of the scheme, interest rates, exchange rates on the receipt or expenditure of money. These transactions can be entered into only for hedging purposes as opposed to speculation, and the exposure of the APUT must be fully covered by cash or other property sufficient to meet any obligation to pay or deliver that could arise.
Redemption
It is an essential characteristic of any authorised unit trust that investors are able to redeem their units at specified intervals. There has been some considerable concern that the manager may not be able to meet the redemption requirements of its investors because of the illiquidity of property as an investment. It could be argued that there is no difference between an authorised property unit trust and any other unit trust in this respect — for example, there was very little liquidity in the securities market in October 1987. However, as a matter of general principle, it is clearly correct that property is subject to greater illiquidity than equities tradable on a listed market.
The potential difficulties associated with redemption were illustrated by recent events in Australia, where property unit trusts have already been established. Here, a downturn in the property market resulted in a run on units. As a result, dealings in the units were suspended for a period of 180 days so that investors were locked into the investment at the very time when they wished to redeem.
Similar problems arose in Holland, where dealings in Rodamco, the world’s fourth largest property fund, were suspended following a fall in the market.
In an attempt to reduce these difficulties the regulations provide that (inter alia):
(a) the fund may invest up to 35% of its value in government securities;
(b) the fund may hold cash or “near cash” where reasonably necessary to enable the redemption or efficient management of a scheme or to meet liquidity requirements;
(c) the manager may refuse to issue new units that would result in a unitholder acquiring units above a limit expressed in the scheme particulars. This provision is intended to prevent a single unitholder from selling a significant proportion of its units at the same time, resulting in additional liquidity problems. The regulation may be difficult to police since it would be open to a purchaser to apply for units in the name of a nominee;
(d) the trustee must request a suspension of dealings if it appears that there is insufficient cash, “near cash” or transferable securities to meet the likely demand for redemption. The initial period of suspension will be 28 days, but there is provision enabling this period to be extended.
The efficient portfolio-management provisions may also provide some additional flexibility/liquidity.
It will be interesting to see whether these measures are sufficient to address investors’ concerns. Some have argued that unitholders should be required to nominate chosen dates for redemption when investing. Unitholders would be entitled to seek redemption on other dates but this would be dependent upon there being sufficient funds to meet their requirements. The SIB has not been willing to agree this proposal on the grounds that it is not legally open to it to make regulations which fetter a unitholder’s ability to redeem.
Investor reaction
Investor reaction will inevitably be cautious. Tax-exempt pension funds have been able to invest in unauthorised property unit trusts in a tax-efficient form for a number of years, and therefore the new vehicles may not offer them any significant advantages. This will place greater importance on the reaction of the non-institutional investor.
Concerns about redemption will continue, particularly in view of the difficulties recently experienced in Holland and Australia. The liquidity and spread of risk requirements will be perceived by many investors as unduly restrictive.
While the current downturn in the property industry may provide purchasing opportunities for cash-rich funds, generally only secondary properties are available at distressed yields. These may be less likely to generate significant capital growth in the longer term than prime property.
In the current climate, many investment companies may prefer to concentrate on direct investment rather than to allow a third party to use its own funds to acquire properties. Shares in property companies are also now available at substantial discounts to net asset value and this may make investment in authorised property unit trusts less attractive.
There is concern that it may be difficult to adjust the composition of the fund following a disposal of property/securities in order to ensure continued compliance with the spread of risk requirements imposed by the regulations — although the regulations do allow a grace period to enable the ratios to be restored.
The level of investors’ interest in any new trust will be unclear at the time when the trust is established. If investors subscribe beyond anticipated limits, the trust may be left with cash held on deposit until it is able to find suitable properties for investment. This could result in some dilution in the initial performance of the trust.
However, there are some positive factors. APUTs could provide investors with the spread of risk that was not available in the case of PINCs. They could also enable investors to unitise part of their existing portfolio and thereby provide a market for the disposal of properties which may not otherwise be readily capable of being sold in the current climate.
APUTs could potentially be an attractive vehicle for cross-border investment, since they would avoid the need to structure individual acquisitions through special purpose vehicles in different conduit countries in order to maximise the benefits of double tax treaties.
APUTs could also provide the benefit of a good income return with a reasonable rate of capital growth and, as such, offer an alternative to the low yield and high capital growth of equities and the high yield and nil capital growth of savings.
Fund managers are under increasing pressure to demonstrate short-term returns and may have an interest in the establishment of the new vehicle.
The vehicles do, therefore, offer a number of advantages. Many investors will no doubt wish to hold back until the performance of the Norwich Union and Barclays Unicorn APUTs has become clearer, but the establishment of the vehicles arguably represents a creative attempt to facilitate the unitisation/securitisation of property which deserves some success.
