Real estate funds represent a well-established way for investing in property without becoming directly involved in the underlying property assets themselves. There are other benefits too. By combining with others, investors can invest on a scale that they may not be able to do so alone. Dividing up their investment allocation into different funds means that investors can diversify their risk across a number of sectors and geographic regions and by choosing the particular lot size for their investment. Also, a fund manager may be an expert in a particular area, allowing an investor to gain exposure to a sector or geography in which it does not have its own in-house expertise.
Structuring the fund
Investors will want a number of issues addressed in the structuring of the fund. No one fund structure will necessarily deal with all of these issues, but the flexibility of many of the available structures (and the ability to combine them) should allow most requirements to be met. The following key factors should be taken into account:
? Regulation: will the fund need approval (or the manager of the fund need authorisation) from a regulatory authority? If so, will this make the operation of the fund unduly expensive or burdensome?
? Taxation: will the fund vehicle itself be subject to tax (tax-opaque) so that any return is taxed before being received into the hands of the investors, or will the fund itself not suffer tax (tax transparent) so that each investor is taxed in accordance with its own tax regime? Tax exempt investors (such as pension funds) in particular will want to invest through a tax transparent structure. Other investors might wish to invest in a tax opaque structure and rely on specific tax reliefs.
? Management: will investors expect involvement in investment decisions? Some fund structures readily allow investors to take part in management, whereas others preclude such involvement.
? Liquidity: do investors want to be able to sell their interest before the end of the fund’s intended life, or are they expecting to remain in the fund for the whole of its term? Open-ended structures, where an investor is able to redeem his investment, pose particular problems in the context of property investment, since the fund may have to sell some of its property holdings to meet any such redemptions. This takes time and the proceeds of sale are unlikely to match precisely the amount of money required.
? Market acceptability: will the structure be readily understood by potential investors or, equally importantly, other key parties such as debt providers? If a manager is not able easily to explain the workings of a fund structure, it is unlikely to appeal to the investor. Offshore fund structures have previously offered a mainstream, tax-efficient alternative to UK onshore structures, but recent media coverage of perceived tax avoidance in offshore tax havens might lead some investors to feel more comfortable with an onshore fund.
Common forms of fund structure for investment in UK property
Company
Companies are well understood by investors and lenders. Provided the company’s shares are offered only to a limited number of investors (and not to the public), the company will not be subject to financial services regulation, although the provisions of the Companies Act 2006 (the 2006 Act) may constitute an administrative burden in their own right.
The main drawback with a company is that it is a separate taxable entity and this will potentially introduce tax leakage. Locating the company in a no- or low-tax jurisdiction may overcome this. A private company’s shares are likely to be illiquid, with an exit available only on liquidation of the company or if the investor finds another buyer. Stamp duty is payable on the purchase of a UK company’s shares.
Limited partnership
Limited partnerships emerged as a favoured fund vehicle for institutional investors in the late 1990s when tax exempt pension companies were no longer able to claim back tax deducted on company dividends. Limited partnerships are tax-transparent for income and capital gains, with the limited partners treated as holding the underlying property directly.
However, a limited partnership is a collective investment scheme for Financial Services and Markets Act 2000 purposes and therefore it is necessary for a person authorised by the Financial Conduct Authority (FCA) to operate the fund. Also, in order for limited partners to avoid being liable for the debts of the partnership, they must not take part in management. A limited partnership interest represents an illiquid investment and SDLT will be payable on the transfer of a partnership interest, based on the market value of the partnership’s underlying property.
Limited liability partnership (LLP)
An LLP is more like a company than a partnership and many of the provisions of the 2006 Act apply. While LLPs are relatively new in the UK (introduced in 2001), they are now widely accepted vehicles and can allow a great deal of flexibility in terms of providing different rights for different classes of investors.
LLPs are tax-transparent for income and capital gains (although not for UK pension fund investors). Investors can participate in management but if they do not, the LLP could constitute a collective investment scheme and require an FCA-authorised operator. SDLT is payable on the transfer of an LLP interest.
Unauthorised offshore unit trust
Unit trusts established in Jersey (JPUTs) and Guernsey (GPUTs) have been widely used by institutional investors. When SDLT became applicable to transfers of interests in limited partnerships, many limited partnership funds converted to JPUTs and GPUTs as such entities are tax-transparent and the transfer of units in an offshore unit trust is free from SDLT.
Offshore unit trusts can be set up with relatively little regulatory burden, although a locally authorised person will be needed to manage the trust. To ensure that it is not taxed as resident in the UK, the management and control of the unit trust must be carried on outside the UK, which may involve on-going administrative costs.
Real estate investment trust (REIT)
A REIT is not a trust; rather it is a closed-ended public company whose shares are traded on the stock exchange. A REIT is therefore subject to the considerable regulatory burden of a listed company as its shares are traded and available to retail investors. A REIT is intended to give investors a return akin to holding the underlying property directly.
To qualify as a REIT, at least 75% of the company’s income and assets must relate to its property rental business (as opposed to any property trading business) and it must have at least three rental properties, none of which may represent more than 40% of the value of all its properties.
A REIT is exempt from UK corporation tax on the profits and gains of its qualifying property rental business, with UK investors then subject to standard income tax rates on distributions received from the REIT. However, the requirements for maintaining REIT status are complex. For example, there is a requirement for the REIT to distribute at least 90% of its net income. While the ownership rules have been relaxed recently in order to allow “diversely owned” institutions to hold significant stakes in REITs, it remains to be seen whether REITs will become fund vehicles for institutional investors.
Property authorised investment fund (PAIF)
PAIFs are authorised investment funds, structured as open-ended investment companies that carry on a property investment business and elect into the PAIF regime. PAIFs have similar features to REITs. A PAIF must have a diversity of ownership, with no company owning 10% or more of the PAIFs shares, and a PAIF must derive at least 60% of its net income from its property investment business and at least 60% of its total assets by value must be used in that business.
As with REITs, investors face broadly the same tax treatment as if they owned the property direct. Although the relevant legislation was introduced in 2008, the complexity of the qualifying conditions for PAIFs has meant that they have not yet been widely used.
Why this matters
The world financial crisis has made it difficult to raise money for new investment funds, especially in the real estate sector. Investors looking for opportunities to put their money into property are becoming increasingly selective about the projects that they are prepared to support. This makes it particularly important to ensure that the chosen fund structure addresses all of the investor’s commercial requirements.
A number of trends in real estate funds have emerged in recent years. For example, investors are increasingly favouring a “club” style (or joint venture approach) involving fewer participants investing in a more bespoke structure, rather than a widely-held fund. This has meant that investors are tending to get involved in the preparation and negotiation of the fund documentation, rather than simply sign up to a set of documentation presented by the fund manager. In other words, the structure for the fund is more likely to be decided on after careful negotiation between the manager and the investors, with the investors’ particular needs specifically addressed.
Given the uncertainty of the global economy, investors are reluctant to commit their capital to too long an investment period and are seeking greater flexibility so as to be able to realise their investment over shorter timescales. This is leading not only to shorter overall fund periods but also to investors looking more closely at ways in which the fund (or the involvement of the fund manager) might be terminated earlier if necessary.
Reduced fund performance over the past few years has led to investors scrutinising the governance of fund vehicles more closely. With this in mind, investors are looking for both greater transparency in reporting and the ability to influence decision-making. This has resulted in investors favouring internally-managed vehicles (rather than funds managed by an external manager on a discretionary basis) and a requirement from investors that the interests of the managers in the fund are more closely aligned with those of the investors.
With the requirements of investors changing to meet the challenges of the prevailing market conditions, it is important to have a thorough understanding of the different types of fund structure that are available and of their particular features and possibilities.
Real estate funds Paul Lester outlines the issues to take into account when constructing funds and co-investment vehicles to suit the requirements of property investors
Paul Lester is a partner at Cripps Harries Hall LLP