I OVERVIEW OF THE MARKET
The Australian real estate market is highly securitised, with a significant portion of the country’s commercial real estate being held through listed and unlisted real estate investment trusts (REITs).
REITs first appeared in Australia in the early 1970s and have steadily grown in number, size and complexity. Today, there are around 50 REITs listed on the Australian Stock Exchange (ASX). Commonly referred to as ‘A-REITs’ (and previously, ‘listed property trusts’ or ‘LPTs’), listed REITs represent a total market capitalisation of around A$135 billion and are important players in the broader Australian market.2
There is also a substantial unlisted property trust sector in Australia, with a number of listed REITs and privately owned operators also managing unlisted funds that often target larger institutional and sovereign wealth investors from Australia and offshore through syndicate, club and joint venture-style structures.
As a result, larger real estate transactions in Australia tend to reflect a ‘corporatised’ model involving large-scale mergers and acquisitions, takeovers, spinoffs and other securities market transactions (as distinct from the more traditional real estate conveyancing). The past 12 to 24 months has seen significant activity in the sector including hostile and friendly takeover activity, reconstructions and divestment of large portfolios, reflecting a trend towards increasing consolidation in the industry.
Australian REITs have attracted substantial investment from offshore, including significant inflow from Asia and a number of large sovereign wealth funds, with the lower Australian dollar in recent years (reflecting record low interest rates) and relative economic stability being key contributors to the comparative attractiveness of Australian real estate. In 2015, total foreign investment in the sector was estimated at over A$20 billion, involving more than 400 transactions.3
Private equity firms have also been active in the Australian market, with both international and Australia-based real estate private equity firms engaging in significant transactions over the past 24 months.
II RECENT MARKET ACTIVITY
i M&A transactions
The Australian market has seen a number of high-profile REIT M&A transactions in recent years reflecting, in particular, the trend towards consolidation in the sector. Three of the more significant transactions are:
a the separation of the former Westfield Group into two new listed property groups, Scentre Group and Westfield Corporation (currently the two largest listed REITs on the ASX);
b the formation of Vicinity Centres (currently the third-largest listed REIT on the ASX); and
c the proposal by Dexus Property Group to acquire Investa Office Fund (and associated proposals).
Scentre Group is the largest ASX-listed manager of Australian retail assets, with a portfolio focused on investing and operating retail property in Australia and New Zealand and a market capitalisation of more than A$25 billion. Its management platform is internalised within the REIT structure (that is, the trustee and management platform is wholly owned as part of the listed vehicle) and includes capabilities covering property management, leasing, design, development, construction, marketing and funds management.
Westfield Corporation is an internally managed international retail property group with a focus on the US, UK and Europe. It has a market capitalisation of more than A$22 billion.
Each of these REITs was formed out of the restructuring in 2014 of the former Westfield Group. The transaction involved:
a separating the Australian and New Zealand business from the international business of Westfield Group; and
b merging Westfield Group’s Australian and New Zealand business with the separately listed Westfield Retail Trust.
Broadly, the transaction was effected using schemes for the Westfield Group and the Westfield Retail Trust. As those entities comprised both trusts and companies, the schemes involved a combination of trust schemes and company schemes of arrangement. While the processes are technically different in a number of ways (see further Section IV, infra), they each involve preparation of a detailed disclosure document and a vote of security holders.
For existing Westfield Group security holders, the transaction consideration involved receiving securities in the new Scentre Group and Westfield Corporation REITs in exchange for their securities in Westfield Group. For the existing Westfield Retail Trust security holders, the transaction consideration involved receiving a combination of securities in the new Scentre Group REIT and a cash component in exchange for their securities in Westfield Retail Trust. In each case, this reflected an agreed merger ratio.
Implementation of the scheme proposals involved a range of legal mechanics that have evolved in the Australian market, including stapling entities so that their respective securities trade together as a single listed security, destapling other entities, delivering securities to investors through capital distributions and delivering cash consideration through returns of capital.
Vicinity Centres is Australia’s second-largest listed manager of Australian retail assets, with a market capitalisation of more than A$13 billion. Its management platform is internalised within the listed REIT structure.
Vicinity Centres was formed by the merger in June 2015 of two significant listed REITs, Federation Centres and Novion Property Group.
The merger was effected by Novion schemes of arrangement (requiring approvals of Novion security holders) whereby each security in Novion was exchanged for securities in Federation at an agreed merger ratio (effectively valuing the Novion stock at about A$7.8 billion).
The proposal was supported by the boards of both REITs and, as such, an implementation agreement was put in place incorporating customary deal protections and mutual break fees (see further Section IV, infra, on schemes processes and customary implementation terms). Disclosure of key information for Novion security holders in considering how to vote on the schemes was outlined in a detailed scheme booklet, as required by Australian law.
Prior to the merger, Novion (previously known as CFS Retail Property Trust Group) had itself been the subject of significant restructuring through an ‘internalisation’ proposal. This involved the REIT acquiring its trustee and management platform from its original sponsor (Commonwealth Bank of Australia) together with Commonwealth Bank’s property asset management business and commencing the management of a number of wholesale property funds and mandates. The total consideration under these transactions was approximately A$460 million.
As this transaction essentially involved the board of the REIT trustee engaging with its parent group, arrangements were put in place to ensure independent consideration of the transaction from a REIT investor’s perspective.
Investa Office Fund
Investa Office Fund (IOF) is a leading owner of investment-grade office buildings, with investments located in core CBD markets throughout Australia and has a market capitalisation of more than A$2.5 billion.
The trustee and management platform of IOF is externally owned, having been established as part of the Morgan Stanley-owned Investa Property Group.
In 2015 Morgan Stanley commenced processes to exit its position in the Investa Property Group, with two key strands being disposal of its substantial portfolio of Australian office towers and disposal of its funds management platform, spanning both the management of IOF and another large unlisted wholesale REIT, Investa Commercial Property Fund (ICPF).
The sale of Investa Property Group’s portfolio of office towers was completed in 2015. A Chinese sovereign wealth fund, China Investment Corporation, was the successful acquirer with a bid of more than A$2.45 billion.
Processes for the sale of the funds management platform continued through 2015 and the first half of 2016. A committee of the independent directors of the trustee was formed to consider the implications of that sale process from an IOF investor’s perspective.
A proposal for IOF emerged from Dexus Property Group (a large ASX-listed REIT with a market capitalisation of more than A$8.5 billion) to acquire all of the securities in IOF via a trust scheme, with consideration offered comprising a combination of cash and Dexus scrip.
As the IOF independent directors were supportive of the Dexus proposal, an implementation agreement was put in place between the parties reflecting their respective commitment to the proposal, key actions required of each party and closing conditions. As the trust scheme required IOF security holder approval, the proposal was conditional on a vote passing by the required majority (75 per cent of members present and entitled to vote in this case).
Immediately prior to the vote, Cromwell Property Securities Limited, as responsible entity for Cromwell Diversified Property Trust, acquired close to 10 per cent of IOF and ultimately the vote fell short of the requisite majority and the Dexus proposal did not proceed. The Investa funds management platform had been acquired by ICPF prior to the IOF vote, effectively positioning the IOF security holder vote as a decision between acquisition by Dexus with an internalised management structure or continuation with an external management platform now owned by ICPF.
Given the different elements in play, the process attracted significant attention in the Australian financial press. It highlighted in particular the challenges that externally owned trustee boards can face in weighing up competing proposals where one of those proposals may involve the corporate owners of the trustee.
ii Private equity transactions
Real estate private equity firms have been active in acquiring and disposing of a range of real estate assets over the past few years. Particularly more recently, significant recent real estate private equity transactions in Australia have been characterised by a material development component. Recent transactions include:
a Blackstone Real Estate’s acquisition of Goldfields House and its repositioning and subsequent sale of the property to the Dalian Wanda Group; and
b acquisition by a consortium led by Mirvac of the Australian Technology Park for redevelopment with an estimated final value of A$1 billion.
Goldfields House was an office building built in the 1960s, with a prime Circular Quay location directly overlooking Sydney Harbour. It had been acquired for A$245 million by the Valad Property Group, an ASX-listed stapled REIT (together with Valad-advised funds and investors) in 2006. Following the 2007–2008 financial crisis, Valad faced ongoing funding constraints.
In its first foray into the Australian market, Blackstone Real Estate built a blocking stake in Valad by purchasing exchangeable securities that Valad had previously issued to Kimco Realty Corporation. Blackstone subsequently proceeded to acquire the ordinary securities in Valad for A$208 million by way of a scheme of arrangement and trust scheme on terms agreed with Valad. The acquisition was completed in late 2011.
Following its acquisition of the Valad management business and its co-investment interests, Blackstone continued Valad’s repositioning of Goldfields House, obtaining planning approvals for two new residential towers and substantial increases in building height. It also raised leasing levels from 68 per cent to 90 per cent and restructured leasing arrangements for the building so that all leases extending past 2017 would have break clauses allowing the landlord to terminate the lease.
At the end of 2014, Blackstone sold Goldfields House to Dalian Wanda Group for A$425 million, capitalising on strong Chinese interest in Australian real estate assets.
Australian Technology Park
The Australian Technology Park is a 14-hectare industrial redevelopment site in inner-city Sydney originally owned by UrbanGrowth NSW, the New South Wales government’s development agency. In 2015, UrbanGrowth conducted a tender process for the acquisition and urban renewal of the Australian Technology Park site.
Mirvac, an ASX-listed property developer and fund manager, led a consortium comprising Mirvac, the AMP Wholesale Office Fund and SunSuper, together with co-tenderer Centuria Group. The consortium and co-tenderer won the tender for the site, paying A$263 million and committing to a development programme for the site with an estimated final value of A$1 billion.
In support of their bid, the consortium agreed a 15-year lease to the Commonwealth Bank of Australia of 93,000 square metres of office space to be developed on the site. Mirvac will be responsible for managing the development and construction of the precinct, and for ongoing management of the precinct once construction is completed.
III REAL ESTATE COMPANIES AND FIRMS
i Publicly traded REITs and REOCs – structure and role in the market
The larger publicly traded REITs in Australia have significant market capitalisations and are typically structured to hold (in a tax-efficient way) both passive real estate investments and active business operations.
The top 20 listed REITs range from a market capitalisation of just over A$25 billion to a market capitalisation of around A$1 billion. As noted above, the two largest REITs, Scentre Group and Westfield Corporation, were formed following the restructuring in 2014 of the Westfield Group. Their respective market capitalisations are about A$25 billion and A$22 billion, while the next largest REIT, Vicinity Centres, has a market capitalisation of about A$13 billion.
A-REITs have historically been structured as unit trusts, with a key benefit of this being the ability to access flow-through tax treatment where the trust holds passive investments (and does not conduct an active business). This means that income and gains derived through the trust are taxed in the hands of investors at their applicable tax rates.
The increasing sophistication of the market, and diversification of key participants, has driven the development of a range of innovative structures. Most notably, almost all of the larger listed REITs in Australia now use a stapled structure where two or more securities (typically units in a trust and shares in a company) are jointly quoted on the ASX (under a single code) and trade together, with each investor owning a corresponding proportion of each entity.
This can allow for ‘flow-through’ tax structuring for passive real estate investments held in the trust, coupled with access to the returns of an operating business conducted by the company. Typically, the operating business activities are complementary to the holding of real estate assets, for example, funds management, asset management, leasing and property development.
The stapled structure has also been used as a mechanism for ‘internalisation’ of the management of listed REITs. Internalisation involves the REIT management being owned and operated within the listed structure (on the operating business side of the stapled entity) as opposed to the REIT being managed by an externally owned entity with fee leakage. Almost all of the larger listed REITs have moved to an internalised structure. Internalisation can also be adopted for unlisted REITs, but is less common.
Larger A-REITs have tended to focus on more traditional real estate classes (retail, office, industrial and residential). Others, such as Lendlease Group, have a multi-disciplinary focus across the full spectrum of the property life cycle and also operate in areas such as infrastructure (which can also be efficiently accommodated through the stapled structure).
More recently there has been increasing interest in alternative real estate classes including healthcare, retirement living, student accommodation, childcare and manufactured housing. This was particularly evident from the REIT IPO activity during 2015, where three of the four REIT IPOs in that period fell outside the more traditional asset classes.4
Many of the larger listed REITs have a significant global footprint. For example, Westfield Corporation operates in the US, UK and Europe and Lendlease has operations throughout Australia, Asia, the Americas and Europe.
ii Real estate PE firms – footprint and structure
Real estate private equity firms in Australia comprise a mix of Australian-based specialist managers (including the Goodman Group, Centuria, Altis, Propertylink, Abacus and CorVal) and large international real estate private equity fund managers (including Blackstone Real Estate, Morgan Stanley Real Estate Investments and KKR). Unlike the global private equity houses, Australia’s traditional private equity firms have generally not expanded their activities into real estate investment, although they are increasingly looking at alternative asset classes with a significant real estate component.
A number of the larger listed A-REIT managers and developers (such as Lendlease and Mirvac) also manage funds focusing on real estate private equity using their integrated funds management platforms and development capabilities.
Real estate private equity operations in Australia are characterised by the active management of real estate assets, focusing on repositioning, releasing and differing degrees of development of portfolio properties. Over the past five years, private equity real estate investment activity has gradually shifted from higher-risk opportunistic transactions, such as acquisitions of real estate-backed debt portfolios, securities market transactions and acquisitions of highly leveraged distressed assets, to value-added investments and alternative real estate classes. Investment vehicles vary in size ranging from below A$100 million in real estate assets to over A$10 billion.Real estate private equity firms adopt a variety of approaches to structuring investments, depending on the type of asset, the manager’s position in the market, and the level of oversight which investors wish to exercise. These range from joint ventures (or clubs or syndicates), to the wholesale fund structures more commonly used for investment in other real estate asset classes.
Australian real estate private equity firms typically use externally managed unit trust structures (whether the investment vehicle is a joint venture or a wholesale fund), although single-asset investments can also be structured as direct co-ownerships of the underlying real estate assets. As for A-REITs, unit trust structures provide flow-through tax treatment where passive investments are held. Management of and development activities, where the purpose is to retain the assets within the investment vehicle (rather than, for example, development for sale), generally do not compromise the flow-through tax treatment of such trusts.
Offshore real estate private equity funds typically invest in Australia real estate assets through unit trusts, leveraged corporate structures, or (where suitable) direct ownership of the underlying assets.
i Legal frameworks and deal structures
REITs are primarily constituted in Australia as unit trusts comprising a separate trustee and the trust estate. General trust law principles apply to the establishment and operation of unit trusts, including detailed rules about matters such as the trustees’ powers and fiduciary duties owed to investors.
Overlaying this is an extensive investor-protection regulatory regime under the Corporations Act 2001 (Cth) (the Corporations Act).5 The majority of this regulation only applies where a REIT is required to be registered as a ‘managed investment scheme’. Registration is generally required where REIT interests are issued to retail investors (which will be the case for all listed REITs). A REIT may voluntarily register even in the case where it only has wholesale investors and therefore does not need to register, for example, to signal to investors that the more prescriptive statutory investor protection regime will apply to the management of the fund.
To be registered under the Corporations Act, the trustee of a REIT (known as a ‘responsible entity’ under the Corporations Act) needs to hold an Australian financial services licence covering the operation of the REIT. This requires the trustee to demonstrate the requisite capability to perform its functions as a responsible entity, as well as meeting minimum net tangible assets requirements. There are various options available to prospective fund sponsors such as engaging professional trustee companies to perform the responsible entity function, with the fund sponsor providing critical management support. However, this introduces operational complexity and fee leakage and is typically only considered by new entrants into the market as an interim measure while a licence is being obtained.The Corporations Act provides for the trustee of the REIT to be the single entity responsible to investors in relation to the operation of the REIT (in contrast to separate trustee and manager structures used in other jurisdictions). In practice, trustees will delegate management functions either to a manager under common ownership with the trustee or a third-party manager.
Registered REITs are subject to a range of requirements under the Corporations Act including as to fundraising, takeovers, financial reporting and related-party transactions.
REITs that are listed on the ASX are also subject to the ASX’s listing rules. These include rules for continuous disclosure of materially price-sensitive information, rules promoting good corporate governance, and rules regulating investor dilution and restricting related-party transactions and significant changes in the nature or scale of activities without appropriate investor approvals.
The statutory regime is primarily overseen by the Australian Securities and Investments Commission (ASIC) as the chief corporate regulator in Australia. The Takeovers Panel which acts as the primary forum for resolving disputes about takeover bids may also be involved in regulating control transactions for listed REITs.
Particular features of the Australian legal framework for REITs include the following:
a Governance complexities are often evident where a REIT’s management is owned separately from the REIT’s securities (as is the case for externally managed REITs). Interests can diverge between the shareholders in the trustee and manager and REIT’s investors (for example, where a transaction may result in the corporate trustee losing management control of the REIT and associated fee streams). This can place directors, and executives, in a position of conflicting responsibilities and interests. Practically, this is typically managed through detailed governance protocols, including establishing a committee of independent trustee directors to manage transactions from an investor perspective (with conflicted executive directors abstaining).
b Restrictions apply to security holders voting on resolutions of REITs that are registered as managed investment schemes.6 In particular, the responsible entity and its associates may not vote their securities if they have an interest in the resolution other than as a member of the REIT. This can require detailed analysis (and sometimes Takeovers Panel and court action) to determine who is entitled to vote on REIT matters such as approval of trust schemes (as further described below).
ii Acquisition agreement terms
Deal structures and terms vary depending on a range of factors, including whether the REIT is listed or unlisted, concentration of investor holdings, and whether the objective is to take ownership of the REIT and its underlying assets or to assume control of the management of the REIT. Tax and stamp duty considerations are also relevant.
Broadly, the Corporations Act prohibits a person from acquiring more than 20 per cent of a listed REIT (or increasing an interest above 20 per cent) unless a permitted gateway applies.7 The most common techniques to acquire control of listed REITs within this framework are an off-market takeover bid regulated by the Corporations Act or a trust scheme.
Takeovers regulation under the Corporations Act does not apply to unlisted REITs. Accordingly, a buyer might engage directly with individual investors to acquire their interests on whatever terms the buyer wishes (subject to any transfer restrictions in the REIT constitution or relevant unit holder agreements). Alternatively, a trust scheme may also be used (which may be more efficient where an unlisted scheme has a number of members).
Where the primary objective is to gain control of the REIT’s management, rather than ownership and control of the REIT (and its underlying assets), a further alternative is to seek to replace the trustee of the REIT, which can be effected by a REIT investor vote where REITs are registered as managed investment schemes (or where the REIT’s constitution specifically provides for REIT investors to replace the trustee).
Takeovers and trust schemes
Under an off-market takeover bid, a bidder makes separate but identical offers to all holders of securities in the target to acquire their securities. The process is highly regulated and involves the following elements:
a the bidder prepares a bidder’s statement (containing details of the offer and bidder, its funding intentions and other material information known to the bidder), which must be lodged with ASIC and the ASX;
bthe target prepares a target’s statement (containing the recommendations of the directors of the trustee of the target and other material information known to the target), which must also be lodged with ASIC and the ASX;
cregulator consent is generally required to withdraw an offer, and there are various limitations on offer terms (for example, the offer must be open for a minimum period, maximum acceptance conditions cannot be imposed, conditions within the bidder’s control cannot be imposed and consideration cannot generally be reduced); and
dcompulsory acquisition of non-accepted securities is permitted following a bid if the bidder and its associates gain at least 90 per cent of the bid class securities during the bid period (and have acquired at least 75 per cent of the securities bid for).8
Under a trust scheme, the target trust’s unit holders vote to amend its constitution to enable all of the units in the target trust to be transferred to the bidder. A trust scheme may also be used to implement the stapling of the securities of two entities to trade together (rather than one entity acquiring another). In these circumstances a vote of the security holders of both entities is often required.
Market practice has developed such that the process for implementing trust schemes parallels the scheme of arrangement process under the Corporations Act, which is used for consensual company acquisitions. The trust scheme process involves the following elements:
a a disclosure document is provided to the unit holders who are required to vote on the proposal (including details of the offer and acquirer, information about its funding and intentions, a recommendation of the target trustee’s directors, usually an independent expert’s report, and any other material information known to the target and the acquirer);
bcourt approval of a trust scheme is not mandatory (unlike company schemes of arrangement), although ‘court directions’ to the trustee are sometimes sought to the effect that the responsible entity would be justified in effecting a trust scheme based on an affirmative vote; and
ca trust scheme is binding on all unit holders if approved by the requisite majorities (being 75 per cent by value of votes cast to approve an amendment of the trust’s constitution and a majority of votes by value cast to approve the acquisition of control).
In a stapled trust and company structure, the transaction would require inter-conditional trust schemes and company schemes for each entity making up the stapled entity.
For both schemes and takeovers the consideration may comprise cash or scrip or a combination of the two. As further explored in Section VI.v, infra, tax considerations, including availability of roll-over relief from capital gains tax, will often be a key factor in determining the consideration offered.
Implementation agreements between the target and bidder are common for trust schemes and friendly takeover bids. They will contain typical deal protection mechanisms, including:
a exclusivity arrangements such as no-shop and no-talk provisions (subject, in the case of no-talk provisions, to fiduciary outs, allowing trustee directors to talk to rival bidders if it is in the best interests of the target’s investors), notification and matching rights in favour of the bidder if the target receives a competing offer; and
bbreak fees for the bidder of up to 1 per cent of the bid value (with reverse break fees in favour of the target being more unusual in Australia).9
Whether a target provides due diligence access will generally depend on the acquirer’s indicative bid price.
Bidders can acquire a pre-bid stake of up to 20 per cent. Pre-bid stakes are not used as frequently for trust schemes as the bidder cannot vote their securities in a trust scheme. However, it is generally possible to provide for option or voting agreements up to 20 per cent if structured appropriately. Stakes above 5 per cent must be disclosed to the market, and statutory beneficial ownership tracing rules can reveal smaller stakes. Derivatives such as cash-settled equity swaps are also commonly used to acquire stakes of up to 5 per cent without requiring disclosure to the market or the target.
Private sale processes for REITs tend to follow a substantially similar process as for the sale of a company or business.
A formalised sale process may be run with specified timelines for expressions of interest, selection of preferred bidders, due diligence and binding bids. This is generally the case for transactions involving the sale of a large asset portfolio, with investment banks typically engaged to coordinate the sales process. For smaller portfolios, sellers often conduct their own sale processes (or the trustee may be empowered do so under the relevant trust constitution) with known contacts who may be potential buyers.
The primary sale document is typically a form of unit sale agreement. Key terms typically include conditions precedent (with any required foreign investment approvals for offshore buyers, waivers of pre-emptive rights affecting material assets and confirmation of no material adverse effect being the most common), payment of a deposit (5 to 10 per cent of purchase price is common, although sometimes no deposit is payable), warranties (covering usual matters such as title and capacity, ownership of underlying assets and claims affecting the REIT and assets), restrictions on the operation of the REIT between signing and completion outside the ordinary course (by reference to the ability of unit holders to control the trustee’s actions), and steps to enable the change of trustee following completion.
Change of responsible entity
Under the Corporations Act, the responsible entity of a REIT can be replaced by a resolution of unit holders, being an ordinary resolution of unit holders present and voting for a listed REIT and an extraordinary resolution of all unit holders entitled to vote (whether present or not) for an unlisted REIT.10
This can be a cheaper and speedier approach for an acquirer that wishes to take over control of the management of a REIT (rather than ownership of the REIT’s securities) or could be used in combination with acquiring a material stake in the REIT securities.
The challenge is typically demonstrating to existing investors that the proposed replacement responsible entity offers a more compelling proposition than the incumbent. While such action is possible on relatively low voting thresholds, in practice it is very rare that a responsible entity is forcibly removed in this way.
iii Hostile transactions
Activity in relation to ASX-listed REITs can be hostile. While the majority of transactions are negotiated to a position where both parties are supportive, this is not always possible and it is not uncommon for REITs to become subject to competing bids once they are in seen as being in play.
More recent examples in the Australian market include the bid by 360 Capital Industrial Fund for the Australian Industrial REIT in 2015 and the ongoing activity in relation to the GPT Metropolitan Office Fund.
For a hostile bidder, the preferred mechanic is generally an off-market takeover bid, as the schemes process becomes unwieldy without cooperation of the target board (given, in particular that, the target is responsible for management of the scheme process and for obtaining security holder approvals).
Issues and challenges for bidders in these circumstances are common in hostile public markets transactions generally, including:
a gaining access to due diligence – while listed REITs have a general obligation under the ASX Listing Rules to disclose to the market materially price-sensitive information, there are various carve-outs including in relation to confidential incomplete proposals;
brelatively high compulsory acquisition thresholds – generally 90 per cent of acceptances are needed;
cdetermining appropriate bid conditions, particularly the level of required acceptances and when it may be appropriate to waive these to seek to encourage further acceptances;11
dpotential approaches to the Australian Takeovers Panel on aspects of the bid, which can affect deal timing – for example, in the 360 Capital case, an application was made to the Takeovers Panel to have certain statements in the bidder’s statement declared misleading; and
e more generally, hostile processes are often protracted and played out in the media attracting significant scrutiny of the parties involved.
In considering strategies for defending against hostile bidders, REIT trustee directors need to comply with their statutory and fiduciary duties, including in particular the duties that any action be for a proper purpose and in the interests of the REIT’s security holders. ASX Listing Rules prohibit certain issues of securities within three months of a takeover announcement and the Takeovers Panel may declare a range of target actions to frustrate takeover activity as unacceptable. Asset lock-up arrangements (such as call options over key REIT assets) are generally uncommon and may be declared unacceptable by the Takeovers Panel if not disclosed or approved by security holders.12 US-style takeover defence arrangements, such as poison pills, are not available to target boards in Australia.
iv Financing considerations
Financing approaches for Australian real estate transactions are primarily influenced by the type of transaction and proposed borrower.
Types of property finance
Real estate financing transactions are broadly divided into investment finance, development finance and portfolio finance.
Investment finance involves financing the acquisition of land or a completed development or building. The key categories of asset are commercial office buildings (including mixed use or retail space), shopping centres, industrial or manufacturing sites, and hotels and leisure sites. The financing may be of a ‘single asset’ or, more recently, the acquisition of an asset portfolio, which may include multiple office buildings, retail spaces and car parks, including by private equity sponsors. For ‘single’ asset investments, financing is typically bilateral from one lender with first-ranking security. For acquisitions of asset portfolios, financing is typically provided on a first-ranking secured syndicated basis.
Development finance involves financing the construction of a building or development, such as a commercial tower, apartment building or multi-use development. The key categories of asset are commercial office buildings, industrial and residential subdivisions, apartment towers, multi-use developments, retail, and health and aged care facilities. This type of financing is typically secured senior debt provided on a ‘club’ basis, and may have some secured second-ranking mezzanine financing.
Portfolio finance involves financing for a REIT or listed or unlisted real estate fund to be used for general corporate or trust purposes, often including ‘bolt-on’ acquisitions. This type of financing is typically senior debt provided on a syndicated basis, and has more recently also included a mixture of bank debt and capital market financing, and may be secured or unsecured depending on the creditworthiness of the borrower group, the size and nature of the portfolio, and the level of gearing.
The trend for the cost of debt funding for real estate transactions has generally been upwards in recent times. While there is still strong appetite for good credit, this has also been combined with a falling appetite among domestic banks for construction and development financing for large residential developments, largely in response to a perceived oversupply of inner city apartment developments in the capital cities.
The importance of alternative funding sources has increased in light of the more subdued appetite of the domestic banks, and funding from non-bank sources is becoming more prevalent with mezzanine debt and also senior debt.
Senior debt is typically limited-recourse debt provided by one lender or a syndicate of lenders. The senior lenders take first-ranking registered security over the key real estate and other assets of the borrower, and the shareholders or unit holders of the borrower, to secure the senior debt.
The majority of transactions are financed using senior debt provided by at least one of the Australian domestic banks.
As noted above however, while most Australian banks are keen to lend to experienced sponsors and developers, there has more lately been a trend, particularly for development financing, towards tighter lending criteria for the major players. There is also an increasing appetite from offshore investors buying into the Australian real estate market.
As a result, an increasing number of deals are being financed by senior debt from offshore banks, particularly the Asian banks supporting the investment of their customers into the Australian market, and life or specialised investment funds. It is likely that this trend will continue.
Subordinated or mezzanine debt ranks ahead of equity or ‘sponsor/parent’ debt but behind senior debt. The margins and fees on third-party subordinated or mezzanine debt are typically significantly higher than for senior debt, and generally the subordinated or mezzanine debt is required to be drawn down prior to or simultaneously with the senior debt.
The use of subordinated or mezzanine financing has been most commonly used for development financing, particularly where the sponsors or parent are unable to fund the equity necessary to achieve the loan-to-value ratio, debt-to-equity ratio or cost-to-complete test imposed by the senior lenders. A trend is beginning to emerge, however, for mezzanine debt to be used for investment finance, particularly due to a tightening of the loan-to-value ratio requirements of senior debt lenders.
Typically, the key providers of mezzanine debt have been life funds or specialist investment funds, although increasingly offshore global investment funds and private equity sponsors are becoming active as mezzanine lenders.
Debt capital markets (bonds, notes, private placements and other debt securities) have been used as a funding method by REITs to obtain longer tenor and to diversify funding sources. The availability of funding in the US debt capital markets, particularly US private placements, has become a significant source of debt funding for REITs in more recent years. This form of financing does not tend to be used for investment or development financing, but is more prevalent for established funds with an existing portfolio of real estate assets.
Sponsors or parents of the borrower are typically required by senior lenders to inject some equity into the borrower, which may be in the form of actual equity or subordinated debt that is contributed prior to the senior debt and fully subordinated to the senior debt and the subordinated or mezzanine debt (if any).
Security requirements depend on the type of finance sought.
Typically, security is required by senior lenders and subordinated or mezzanine lenders for investment or development finance. The senior lenders will require first-ranking security, and the subordinated or mezzanine lenders will require second-ranking security over the same assets, with an intercreditor arrangement regulating the priority of the securities and rights of the mezzanine lenders to enforce their second-ranking security. See further below on intercreditor arrangements.
Lenders will usually require:
a security over the real estate assets being acquired or developed and all of the assets of the investor or borrower including real property mortgages (requiring side deeds with the applicable landlord if the land is subject to a lease);
b security over the shares or units in the investor or borrower, which will, inter alia, restrict the parent’s ability to deal with or encumber those shares or units without the consent of the lenders;
c in the case of development finance, a guarantee from the parent company (often to cover cost overruns or any interest shortfall) together with tripartite agreements with the builder and the developer; or
d in the case of investment finance of a commercial or retail tower, a tenant side deed with any cornerstone tenants.
Lenders do not usually have recourse to any other assets of the parent or sponsors.
Portfolio financing is either secured against the assets of the REIT group members or is unsecured, the extent of the security often being determined by the creditworthiness of the borrower group, particularly the gearing of the REIT, and in each case is supported by guarantees from the REIT group members. Typically, the margins and fees for secured group financings are lower than for unsecured group financings, but there is less freedom allowed to the members of the REIT group under the terms of the financing documents.
Where portfolio finance is provided on a secured basis, the lenders will require guarantees and first-ranking security over all of the assets of each REIT group member, including real property mortgages over interests in land to secure the loan. While there is typically more flexibility provided in a portfolio-style financing than investment or development financing, the usual ‘security’-style covenants still exist.
Where portfolio finance is provided on an unsecured basis, lenders will require guarantees from each group member and negative pledges restricting the granting of security over any of their assets. In these circumstances the financing typically involves a combination of bank debt (provided on a syndicated and bilateral basis) and capital markets debt, in each case with the same covenant package (being representations, undertakings and events of default) set out in a common-terms deed from which all of the financiers benefit. Typically, the financing is provided on a ‘corporate’-style basis, which offers more flexibility and a less stringent covenant package.
There is a current trend for REITs and real estate funds to move from secured funding to unsecured to provide the group with greater access to other sources of funding such as debt capital markets, which is typically undertaken on an unsecured basis.
Intercreditor arrangements and mezzanine holding company debt
Typically mezzanine debt has been used by developers to secure supplementary financing, and such debt has been provided directly to the borrower and secured by second-ranking security over the assets subject to the first-ranking security granted to senior lenders.
For some time Australian domestic banks have been reluctant to accept capital structures with multiple tiers of debt, due in some part to the rights being sought and negotiated by mezzanine lenders (including rights to enforce, standstill periods and restrictions on senior refinancing) and the practicalities of enforcement.
In more recent times, however, there have been a number of deals executed involving mezzanine debt at the holding company level. These instruments, which are structurally subordinated to senior debt, have often featured ‘payable in kind’ interest together with an equity stake in the form of a conversion feature (somewhat similar to a convertible bond), such that the mezzanine lender can get the benefits of preferred equity and secured debt.
This arrangement is increasingly accepted by senior lenders, and is in some respects a preferred structure because of the structural subordination of the mezzanine debt.
There are a number of terms that have been imported from the leveraged finance market and are being applied to terms of property financing, including the loosening of general covenants and use of materiality qualifiers.
Recent trends also include the use of a ‘certain funds regime’ for property investment financings, and an ‘equity cure’ for breaches of financial covenants (such as the loan-to-value ratio) across property financings generally.
v Tax considerations
Income tax – characterisation of disposals
The disposal of interests in a real estate-holding entity gives rise to either a taxing event (on revenue account) or a capital gains tax (CGT) event (on capital account). The distinction determines if a security holder can access the CGT discount and CGT roll-over relief, and ultimately affects the security holder’s tax rate.
An investment is generally considered to be held on revenue account where it was made for a profit-making purpose through the sale of an interest, rather than for holding over the medium to long term as a ‘passive’ investment. Where an investment is held on revenue account, the investor is subject to tax on any excess in proceeds received over the cost of acquiring the relevant interest. Investments held on revenue account do not enable the investor access the CGT discount, nor is CGT rollover relief available.
If acquired for the holding over the medium to long term as a ‘passive’ investment, an investment will generally be considered to be held on capital account, and subject to CGT rules, in which case:
a a capital gain would normally arise where capital proceeds received by a security holder exceeds the security holder’s cost base in its investment; and
b a capital loss arises where capital proceeds received by the security holder are less than the security holder’s cost base in its investment.
Capital proceeds comprise cash considerations as well as the market value of any securities or other property received on disposal of the relevant asset.13
The security holder’s cost base in an investment is, broadly, the original amount paid to acquire that investment, plus any incidental costs incurred on the acquisition or disposal of that investment.14 Where the investment being disposed of is units in a trust, distributions paid on those units that have been sheltered from tax by way of non-cash tax deductions (for example, depreciation on buildings and plant) are not taxed when received, but rather reduce the cost base in those units.15
Generally, unit holders who are individuals, trusts or complying superannuation funds can offset capital losses against current or future year capital gains. This is also the case for companies, if specific loss recoupment rules are satisfied.16
Australian-resident individuals, superannuation funds and trusts that have held an investment for more than 12 months are entitled to reduce their CGT gains by a CGT discount. Resident individuals and trusts are entitled to a 50 per cent discount on CGT and complying superannuation entities a 33.3 per cent discount.17
The CGT discount is not available to non-residents. However, non-resident security holders are only subject to CGT on the disposal of units or shares if, broadly:
a the non-resident security holder (together with any associates) did not hold a 10 per cent or more interest in the relevant REIT or the company for a 12-month period that began no earlier than 24 months before that time; or
b no more than 50 per cent of the value of the REIT or the company derives from direct or indirect interests in Australian real property.18
As REITs generally hold direct or indirect interests in Australian real property, only the first test above would be relevant to non-resident security holders. In some circumstances, companies stapled to REITs do not meet the 50 per cent real estate threshold,19 and so both tests could be relevant.
Most REITs are structured as managed investments trusts (MITs) (or seek to include an MIT in any stapled structure). A specific tax regime designed for MITs provides certain tax benefits for REITs, with the policy intent of promoting Australia’s funds management industry and its collective investment vehicle-management expertise. As a result, whether MIT status will be available is usually a key consideration in structuring real estate investment transactions.
To access the MIT regime, a trust needs to satisfy certain ownership criteria and be managed by a holder of an Australian financial services licence.20
The key benefits of accessing the MIT regime are:
a for non-resident investors, lower withholding tax rates can apply to distributions of income by an MIT throughout the life of the investment, and also on any gain on disposal;21 and
b for Australian-resident investors, investments made by an MIT automatically become subject to the CGT rules (and are not taxed on revenue account) when the MIT makes a ‘CGT election’.22 This enables access to the CGT discount and CGT rollover relief.
Accordingly, where the investor mix and investment type lends itself to an MIT structure, this is generally the structure that is used.
Availability of scrip-for-scrip rollover relief from CGT
Scrip-for-scrip rollover relief from CGT may be available where units in a REIT or shares in a company are disposed of in exchange for units or shares.23 Transactions are often structured to allow for scrip-for-scrip rollover as it allows a security holder to defer any gain made on the transaction until the replacement units or shares are eventually sold.
The key requirements that must be satisfied to access scrip-for-scrip rollover relief are as follows:
a Shares must be exchanged for shares, and units for units. In many cases, an offshore acquirer or target will only be a trust or a company. If the target or acquirer is not the same type of entity, or is a stapled group consisting of a trust and a company, this requirement cannot be met, or may be only partially met (by a stapled group).
b The acquiring entity must become owner of 80 per cent or more of the target entity. In some cases, the threshold for a scrip offer to become unconditional is lower. It can be the case that not enough approvals are met to reach the 80 per cent threshold, meaning that security holders accepting the offer do not receive rollover relief.
c Where the transaction is a unit-for-unit transaction, each trust must be a ‘fixed trust’. The law as to what constitutes a fixed trust is unclear, so the Commissioner of Taxation’s discretion to treat trusts as ‘fixed trusts’ is almost always sought. Under recent changes to the MIT rules, trusts that are MITs may be automatically deemed fixed trusts if certain requirements are met.
d The offer must be on substantially the same terms to all security holders in the target entity, so that, for example, significant security holders cannot be treated differently to other security holders.
e For foreign-resident security holders, the replacement interest must also be ‘taxable Australian property’. Where a larger entity acquires a smaller entity, a foreign resident’s interest in the target may be over the 10 per cent threshold (and thus ‘taxable Australian property’ and subject to CGT, but the interest in the larger entity may be below the 10 per cent threshold (and thus, not ‘taxable Australian property’), meaning the rollover does not apply to that security holder).
Income tax – anti-avoidance
Australia has a general anti-avoidance rule, which provides that where a transaction is structured for the sole or dominant purpose of reducing Australian income or withholding tax, the Commissioner of Taxation has the power to assess tax on the basis of a reasonable counter-factual (that is, what the structure or transaction would have been without the tax avoidance purpose).24 Where the anti-avoidance regime is applied, the taxpayer is also generally subject to penalties and interest, in addition to the primary tax that has been avoided. Accordingly, it is important that there be robust commercial reasons for using an investment structure (and any steps within a transaction).
Stamp duty and land tax
Acquisitions of Australian real estate assets attract state and territory stamp duty. Duty in relation to acquisitions of commercial land generally ranges from 4.5 per cent to 5.75 per cent of improved land value (or purchase consideration if higher) depending on the state or territory in which the land is located.25
Duty applies not only to acquisitions of direct interests in land, but also to acquisitions of interests (usually above a certain threshold) in land holding trusts and companies.
State and territory annual land taxes may also be payable, subject to the availability of certain concessions. The top marginal land tax rates range between 1.5 per cent and 3.7 per cent (of the unimproved value of the land) depending on the state or territory in which the land is located.26
Higher duty and land tax rates apply to acquisitions of residential property in certain circumstances. Victoria, New South Wales and Queensland have, or are in the process of imposing, surcharges on foreign acquirers of residential real estate. This may affect the activities of foreign-owned real estate private equity firms engaged in residential development or repositioning, although at this stage the likely impact is hard to assess.
vi Cross border complications and solutions
Foreign investment regulation
Foreign investment in Australian real estate is regulated by the Foreign Acquisitions and Takeovers Act 1975 (Cth). This legislation was substantially rewritten in 2015 and, in a number of respects, its application to foreign investment in Australian land remains unsettled.
Nominally, acquisitions of interests in land (including direct investments and investments in land-holding trusts and corporations) exceeding A$252 million are notifiable and must be approved by the Commonwealth Treasurer (as advised by the Foreign Investment Review Board (FIRB));27 however, lower thresholds apply to a range of acquisitions:
a A threshold of A$55 million applies to certain classes of sensitive land. Because of the way the classes of sensitive land are defined, the lower threshold is likely to apply to most types of land in which foreign investors are likely to invest.28
b A threshold of A$15 million applies to acquisitions of agricultural land.29
c No monetary threshold applies to:
• most acquisitions of interests in residential land;
• most acquisitions of interests in vacant commercial land; and
• acquisitions of interests in Australian land by foreign government-related investors (including state-owned enterprises, sovereign wealth funds and many state-managed pension funds);
such that all such acquisitions must be notified and approved.30
A higher A$1.094 billion threshold applies to certain direct investments by foreign investors from countries with which Australia has a free trade agreement, although in practice, this threshold is rarely available.31
The legislation provides a 30-day period from the date lodgement fees are paid within which a decision whether to approve the acquisition is made; however, particularly for sensitive or complex transactions, this period is often extended. Acquisitions are reviewed on national interest grounds, with the FIRB receiving input in relation to proposed acquisitions from a range of government agencies, including the Australian Taxation Office, and national security agencies before providing its advice to the Treasurer. Approval is required before the acquisition can complete.32
Investment income paid to foreign investors in Australian land-owning vehicles is generally subject to Australian withholding tax (generally 10 per cent for interest, 30 per cent for unfranked dividends and up to 49 per cent for trust income distributions). Lower withholding rates may apply in certain circumstances pursuant to double taxation agreements.
Concessional withholding tax applies to income distributions by trusts that satisfy the conditions for being characterised as an MIT for tax purposes (see Section IV.v, supra, for more detail).
While interest is subject to a maximum 10 per cent withholding tax, thin-capitalisation rules generally apply to disallow tax deductions for the entity paying the interest where leverage exceeds 60 per cent of the value of the underlying assets, which increases the overall effective tax rate. Other transfer pricing rules apply to prevent payment of non-arm’s-length fees to offshore entities.
V Corporate real estate
Separation and spin-off or securitisation of real estate assets by real estate-heavy corporations has, until recently, occurred on a sporadic basis in the Australian market. More typically, balance sheet real estate assets would be realised through sale and lease-back arrangements to already established specialist property funds.
A variety of separation structures have been used to realise the value inherent in corporate real estate portfolios:
a internally-managed ASX-listed REITs (eg, Shopping Centres Australasia Property Group, spun off by Woolworths in 2012 and the Asia Pacific Data Centres Group, spun off by NextDC in 2013);
b externally managed ASX-listed REITs, with the manager being the corporation that was spinning off its real estate assets (eg, the BWP Trust, spun off by Wesfarmers in 1998); and
c property-linked notes (Westfield Group in 2007 and Wesfarmers in 2013) placed with specific institutions or offered more widely in the wholesale debt capital market.
Recently, particularly as the listed property market has gained momentum in Australia, there has been renewed interest in separation and spin-off of real estate assets. A number of separations and spin-offs have been announced for 2016, including the Viva Energy REIT, comprising a portfolio of service station sites leased back to Viva Energy, and the proposed Crown Resorts demerger and spin-off of a hotel property trust.
The recent performance of listed property is increasingly encouraging owners of real estate assets to release additional stock into the public markets, with a number of REIT IPOs scheduled for the upcoming year. Also, the externally managed listed fund structure, which fell out of favour following the financial crisis of 2007–2008, is making a comeback.
It is expected that current uncertainties as to how the new foreign investment regulatory regime applies to real estate transactions are likely to be settled, either through regulatory clarification or development of market practice.
1 Philip Podzebenko and Robert Bileckij are partners at Herbert Smith Freehills. The authors would like to thank Melita Cottrell, who wrote the banking section, and Daniel Sydes of Greenwoods & Herbert Smith Freehills, for the tax section. The authors would also like to thank Timothy Coorey and Bianca Doyle for their assistance with background research. Unless otherwise indicated, data as to ASX capitalisation obtained by compiling data from the ASX website as at June 2016.
2 Australian Stock Exchange, ‘ASX Funds (Listed Managed Investments, Funds and ETPs) Monthly Update – May 2016’ (Report, May 2016), www.asx.com.au/documents/products/ASX_Funds_Monthly_Update_-_May_16.pdf.
3 Based on S&P Capital IQ data on ‘Foreign Investment in Australian Real Estate’ for the period from 1 January 2015 to 31 December 2015.
5 See Chapters 5C and 7 of the Corporations Act.
6 Section 253E of the Corporations Act.
7 Section 606 of the Corporations Act.
8 See Chapters 6 and 6A of the Corporations Act.
9 The 1 per cent break fee reflects Takeovers Panel guidelines as to the level of break fee that is not likely to be regarded as an unreasonable lock-up device; see Takeovers Panel Guidance Note 7: Lock-up devices.
10 Section 601FM of the Corporations Act.
11 Relevant to REITs, as the responsible entity of a listed scheme can be replaced by a 50 per cent majority vote of security holders, this can conceptually allow a bidder to gain a level of control over the REIT at a lower acceptance level (as was the case in the 360 Capital bid for the Australian Industrial REIT).
12 See Takeovers Panel Guidance Note 7: Lock-up devices.
13 Division 112 of the Income Tax Assessment Act 1997 (Cth).
14 An investor’s cost base in a share or unit is determined by applying the rules in Division 110 of the Income Tax Assessment Act 1997 (Cth).
15 See Section 104-70 and 104-71 of the Income Tax Assessment Act 1997 (Cth).
16 These rules require the company to have maintained continuity of ownership from the beginning of the year the loss was made to the end of the year it is used; or to have maintained the same business from the time of any continuity of ownership failure to the end of the income year the loss is utilised: Division 165 of the Income Tax Assessment Act 1997 (Cth).
17 See Division 115 of the Income Tax Assessment Act 1997 (Cth).
18 Division 855 of the Income Tax Assessment Act 1997 (Cth).
19 For example, companies in stapled groups might undertake development activity on land owned by others, and such rights under a development contract are not interests in real estate.
20 For the requirements to be an MIT, see Subdivision 275-A of the Income Tax Assessment Act 1997 (Cth).
21 Subdivision 12-H to Schedule 1 of the Taxation Administration Act 1953 (Cth).
22 Subdivision 275-B of the Income Tax Assessment Act 1997 (Cth).
23 Subdivision 124-M of the Income Tax Assessment Act 1997 (Cth).
24 Part IVA of the Income Tax Assessment Act 1936 (Cth).
25 See generally, Duties Act 1999 (ACT), Duties Act 1997 (NSW), Stamp Duty Act 1978 (NT), Duties Act 2001 (QLD), Stamp Duties Act 1923 (SA), Duties Act 2001 (Tas), Duties Act 2000 (Vic), Duties Act 2008 (WA).
26 See generally, Land Tax Act 2004 (ACT), Land Tax Act 1956 (NSW), Land Tax Act 2010 (QLD), Land Tax Act 1936 (SA), Land Tax Act 2000 (Tas), Land Tax Act 2005 (Vic), Duties Act 2002 (WA), and various related administration and assessment legislation.
27 Section 81 of the Foreign Acquisitions and Takeovers Act 1975 (Cth); section 52(5), Foreign Acquisitions and Takeovers Regulation 2015 (Cth). The monetary are indexed annually. The thresholds set out here apply as at the date of publication.
28 See Section 52(5) and (6) of the Foreign Acquisitions and Takeovers Regulation 2015 (Cth). For example, the lower threshold applies to acquisitions of certain types of interests in land under ‘prescribed airspace’. Most of the land in the commercial centres of Australia’s capital cities is situated under prescribed airspace.
29 Section 52(4) of the Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
30 Section 52(1) of the Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
31 Section 52(5) of the Foreign Acquisitions and Takeovers Regulation 2015 (Cth). Countries for which the higher threshold applies include the United States, New Zealand, Chile, Japan, South Korea and (once the Australia–China Free Trade Agreement comes into force) China. The higher threshold only applies where the investor domiciled in the relevant country acquires the relevant real estate interest directly rather than through an interposed entity. In practice, most investments are conducted through interposed entities.
32 Sections 77 and 82 of the Foreign Acquisitions and Takeovers Regulation 2015 (Cth).