I OVERVIEW OF THE MARKET
The real estate M&A and private equity market in the United Kingdom in 2016 and 2017 has largely been shaped by the country’s decision to leave the European Union on 23 June 2016. Having reached record-breaking highs in 2015, 2016 saw a 30 per cent drop in investment volumes. However, in spite of continuing political uncertainty and notable quiet periods on either side of the EU referendum, investors have continued to recognise opportunities in the real estate market. In particular, overseas investment in the UK property market has hit unprecedented levels, with investors from East Asia in particular coming to the fore.
Recent months and years have seen a high level of activity in the industrial sector, while the retail sector has generally been weaker and more turbulent in comparison. Industrial real estate had its highest share of the market for seven years in 2016, at 12 per cent. Investment in the hotels, leisure and specialist property industries remains healthy, although these sectors have perhaps seen fewer major deals in 2016 and 2017 than in previous years. Large portfolio deals, a crucial driving factor behind the flourishing real estate market in 2015, have dropped in volume and significance since Brexit. However, as investors regain confidence and appetite, this sector is likely to rebound.
In addition to industrial real estate, office real estate is in a strong position after a significant dip following the EU referendum. This is particularly the case in central London because of a growing demand for prime office space, as indicated by the recent headline deals detailed below. We have seen a significant increase in acquisitions by serviced office providers, who are in turn enjoying a surge in demand from smaller occupiers seeking more flexible terms. Weaker employment growth may slow this demand, but this is likely to be offset by increasing public sector demand for office space, particularly in regional areas.
The real estate market has also seen a shift in the identity of its investors. Uncertainty caused many institutional investors and listed companies to withdraw from the market both before and after the EU referendum, with significant sell-offs in London in particular. In contrast, a weak pound and a fall in capital values has encouraged opportunistic overseas investors to flood the UK market, helping to support prices and causing a supply shortage in recent months. The public sector has also made a notable entrance into the market, with local authorities taking advantage of cheap financing to invest in real estate.
Since the initial market shock caused by Brexit, transaction yields have remained surprisingly stable over the majority of 2016 and early 2017. Banks and institutional investors are now turning back to the real estate market for long-term, low-risk investments, as it is a market that tends to have a greater risk cushion than bonds or equities during times of uncertainty. Pricing pressure is therefore returning at the prime end of the market, while the appetite for risk is varied across sectors, with a greater overall risk appetite for industrial investments than for retail.
With regards to financing, a weak pound has pushed up interest rates and created expectations of inflation. Despite the short-term rise in rates, the cost of debt still remains at a historical low and there is plenty of liquidity in the private debt market. UK traditional lenders continue to target opportunities to lend in relation to prime assets, and pricing remains competitive in spite of Brexit.
The market will continue to experience a great deal of uncertainty as the United Kingdom negotiates its way out of the European Union, particularly given that the terms of its exit currently remain unclear. However, recent years would suggest that the UK real estate market is resilient, and can withstand a great deal of political and economic volatility. It remains to be seen whether investors will remain cautious in this market going forward, or whether 2017 will see a revival of confidence and activity in real estate M&A.
II RECENT MARKET ACTIVITY
i M&A transactions
Some of the most significant real estate M&A transactions of the past few years are summarised below.
Land Securities Group and Canary Wharf Group’s disposal of 20 Fenchurch Street
In July 2017, the joint owners of 20 Fenchurch Street – commonly known as the ‘Walkie-Talkie’ – agreed to sell the building to LKK Health Products Group for £1.28 billion, reflecting a net initial yield to the purchaser of 3.4 per cent. Having been valued on 31 March 2017 at £567.5 million, the headline price achieved for Land Securities’ 50 per cent share was £641.3 million.
20 Fenchurch Street was developed by a joint venture between Land Securities and Canary Wharf Group in 2010 and was completed in 2014. The building was fully let just a few months after completion, largely to insurance companies and brokers, including RSA and Liberty Mutual. It also contains 17,000 square feet of retail space and the three-storey Sky Garden, which has spectacular views across London. Completion was expected to take place at the end of August 2017 and is unconditional.
CC Land’s acquisition of London’s ‘Cheesegrater’ (the Leadenhall Building)
In March 2017, the joint owners of the Leadenhall Building – more commonly known as the Cheesegrater – agreed to sell the building to Chinese investors CC Land for £1.15 billion.
The Leadenhall Building was developed under a 50-50 joint venture between British Land and Oxford Properties, and was completed in 2014 after a four-year construction period. The tower is the tallest in the City of London. The transaction marks the largest sale of a single building in the United Kingdom since the 2014 sale of HSBC tower in Canary Wharf for £1.18 billion. It is also one of the largest purchases of UK real estate by a Chinese investor to date.
Deka Immobilien’s purchase of Facebook’s London headquarters
In February 2017, German fund Deka Immobilien purchased the freehold of Facebook’s London headquarters (Rathbone Square) from developer Great Portland Estates (GPE) for £435 million. The 420,000 square-feet development contains almost 250,000 square feet of office space, some retail space and 142 apartments, with construction only finishing shortly after completion. The office space is pre-let to Facebook on 15-year leases at an initial annual rent of £17.8 million.
The purchase price was 4 per cent below what the building was valued at in September 2016, giving rise to speculation that GPE was preparing for a property market downturn. However, factoring in the rental value of the entire scheme (which included the 999-year leases of the 142 residential units), GPE’s total receipts from Rathbone Square were expected to exceed £655 million.
GPE announced on completion that the £110 million capital return from the sale would be returned to shareholders by way of a special dividend, which was announced in April 2017 to be 32.15 pence per share.
Digital Realty Trust’s acquisition of eight data centres
In May 2016, Digital Realty Trust Inc, the US-based REIT, announced that it had entered into an agreement to acquire a portfolio of eight data centres (in London, Amsterdam and Frankfurt) from Equinix Inc, another US-based REIT, for approximately US$874.4 million. The transaction completed in July 2016.
The sale by Equinix was a condition of the clearance from the European Commission for Equinix’s acquisition in January 2016 of TelecityGroup plc, the European data centre provider, for US$3.8 billion. The acquisition, which disrupted an existing merger between TelecityGroup and Interxion and secured Equinix’s position as the top data centre provider in Europe, gave rise to substantive antitrust overlaps and resulted in commitments being given to the European Commission to divest the eight data centres.
As part of the transaction, Digital Realty granted Equinix a binding option to acquire its operating business, including its facility in Paris. Digital Realty saw the deal as an opportunity to enhance its global presence and increase the scale of its European data centre operations.
London & Regional’s acquisition of the Atlas Hotels Group
In April 2016, London & Regional, the UK-based property company, acquired Atlas Hotels Group Limited, the UK-based hotel operator, from Lone Star Funds, the US-based private equity firm, for £575 million.
The transaction included 46 Holiday Inn Express hotels and a Hampton by Hilton and was London & Regional’s first venture into the budget sector. The portfolio comprised 5,575 rooms, 15 per cent of which were located in London.
Greystar Student Living’s purchase of the Nido student accommodation portfolio
In April 2015, Greystar Real Estate Partners (through its subsidiary Greystar Student Living) acquired three student accommodation properties from Nido London, a UK-based student accommodation company, managed by Round Hill Capital, for £600 million.
The portfolio comprised 2,375 beds, spread across three London locations. Greystar saw scope for significant value given the recent growth in the student accommodation industry.
A number of REIT and commercial real estate companies have also listed on the London Stock Exchange in recent years. Some examples are detailed below:
a LXI REIT plc (a REIT investing in commercial real estate in the United Kingdom let or pre-let on long, inflation-linked leases): market capitalisation on admission – £138.15 million; size of the offer – £135.4 million.
b Schroder European Real Estate Investment Trust plc (a REIT investing in commercial real estate in Europe – listed 9 December 2015): market capitalisation on admission – £107.5 million; size of the offer – £107.5 million.
c AEW UK REIT plc (a REIT investing predominantly in a portfolio of smaller commercial properties in the United Kingdom – listed 12 May 2015): market capitalisation on admission – £100.5 million; size of the offer – £98.5 million.
ii Private equity transactions
Private equity is also active in the real estate market in the United Kingdom and in recent years, private equity firms have raised significant funds with relative ease. Some of the major private equity real estate M&A transactions over the past few years are summarised below.
China Investment Corporation’s acquisition of Logicor
In June 2017, China Investment Corporation (CIC), the Chinese sovereign wealth fund, entered into an agreement to purchase Logicor from Blackstone Group LP, the US-based private equity firm, for €12.25 billion. Headquartered in London, Logicor is a Europe-wide logistics business founded by Blackstone’s real estate division in 2012 to manage its European operations. Logicor’s portfolio of logistics assets totals 147 million square feet in 17 countries, with over 70 per cent in the United Kingdom, Germany, France and southern Europe.
Lone Star’s acquisition of MRH (GB) Limited
In January 2016, Lone Star Funds, the US-based private firm, acquired MRH (GB) Limited, a UK owner and operator of petrol filling stations, from Equistone Partners Europe Limited, the UK-based private equity firm, and Susan Tobell and Graham Peacock (private individuals) for £1 billion.
The acquisition included 450 petrol stations (mostly branded BP and Esso) and was particularly attractive to Lone Star given MRH had reported revenues of £1.79 billion for the year ended September 2014.
Brookfield’s acquisition of Center Parcs UK
In September 2015, Brookfield Property Partners (a subsidiary of Brookfield Asset Management) acquired Center Parcs UK from Blackstone Capital Partners V (a fund managed by the Blackstone Group) for £2.4 billion.
The assets included Center Parcs’ five UK holiday parks (which employ around 7,500 people). The transaction was attractive to Brookfield given the target’s steady cash flow generation and average occupancy rates of approximately 97 per cent.
Lone Star’s purchase of a Jurys Inn hotel portfolio
In March 2015, Lone Star Funds acquired a chain of 31 Jurys Inn hotels from a group of investors, including the Oman Investment Fund, Mount Kellett Capital Management, Ulster Bank, Westmont Hospitality Group and Avestus Capital Partners, for £680 million.
The assets included 7,000 rooms across 31 cities (21 provincial UK hotels, four London hotels, five hotels in Ireland and one in Prague). Lone Star saw the potential for future growth of the business and seized the opportunity to further capitalise in the hotel sector.
iii Private equity takeovers
In addition to the above private equity M&A transactions, there have also been a number of recent takeovers and mandatory offers by private equity firms in the United Kingdom.
a Brookfield and Qatar Investment Authority (2015) made a mandatory offer, through their joint vehicle Stork Holdco, to acquire a 30.63 per cent stake in Canary Wharf Group plc (CWGP) at an offer price of £6.45 per share, valuing the transaction at £1.26 billion.
b Lone Star Funds (2015) made a voluntary recommended offer to acquire the shares in Quintain Estates & Development plc, the UK-based real estate company, at an offer price of £1.41 per share, valuing the transaction at around £745 million.
III REAL ESTATE COMPANIES AND FIRMS
The UK REIT regime came into force in January 2007. It exempts from corporation tax the income and capital gains of a UK REIT’s property rental business. The income and capital gains of any other business, including acquiring or developing property for sale, is taxed at the main corporation tax rate. While not all property companies are REITs by any means, the largest corporate real estate groups are structured as REITs to benefit from these tax advantages. As a result, M&A involving UK REITs will have specific considerations that will need to be taken into account.
A UK REIT can consist of either a single company or a group of companies. The basic conditions that must be met by the company, or parent company of a group, are as follows:
a it must be resident in the United Kingdom for tax purposes;
b it can have only one class of ordinary shares, which must be admitted to trading on a recognised stock exchange, and either listed or actually traded on such an exchange;
c it must not be a ‘close company’ (a company that is controlled by five or fewer shareholders), although close companies that are controlled by certain ‘institutional investors’, such as pension funds, charities, certain collective investment schemes and other REITs, are allowed; and
d the property rental business must constitute at least 75 per cent of the total profits and assets of the company or the group.
There are also diversification rules requiring the business to hold at least three properties, each representing no more than 40 per cent of the total value of the portfolio.
To ensure that the property income generated by the property rental business is ultimately taxed, at least 90 per cent of the income profits of the business must be distributed annually by way of dividends. A UK REIT is subject to a tax charge to the extent that it falls short of this.
A leverage requirement is also imposed such that the gross income of the UK property rental business must cover the external financing costs of the entire property rental business by a ratio of at least 1.25:1. Again, a tax charge is imposed on the UK REIT to the extent of any excess financing cost.
Takeover of a UK REIT
If a UK REIT, whether a single company or a group, becomes part of another REIT, it will remain within the UK REIT regime as long as the conditions continue to be met. A takeover may well cause the company (or parent company of a group REIT) to become a ‘close company’ unless the terms of the acquisition are such that at least 35 per cent of the ordinary shares remain in public hands. However, UK and foreign REITs are now recognised as ‘institutional investors’, which should deal with that point in most cases. In a cross-border context, the impact of the leverage requirement – in that it looks at gross income of the UK property rental business only but takes into account the external financing costs of the worldwide property rental business – will need to be considered.
The introduction of UK REITs in 2007 coincided with the beginning of a major downturn in the commercial real estate market. UK REITs were conceived during a UK property boom and consequently faced challenges during the financial crisis.
However, as property prices have recovered, there has been a renewed interest in UK REITs as a tax-efficient investment structure, especially following the abolition of a 2 per cent entry charge on seeding assets in 2012. The UK REIT regime is an improvement to the tax environment for UK real estate companies and has consequently had a positive impact on the UK-listed real estate sector.
The UK REIT sector now includes some of the United Kingdom’s largest real estate companies, such as Land Securities, Derwent London, British Land, SEGRO, Great Portland Estates and Hammerson, and the number of UK REITs has grown significantly in recent years (including externally managed UK REITs) to well over 40.
ii Real estate private equity firms
In the United Kingdom, real estate private equity firms can be structured in a number of ways. As a result of regulatory and tax issues, which affect the operation of a fund and its investors, the most common structure in the United Kingdom is an English (or Scottish) limited partnership. These vehicles have no legal status in their own right; they exist only to allow the partners to act collectively. Each partnership:
a has a finite life (usually 10 years with a possible two-year extension, although some have investors with rolling annual commitments);
b has one general partner with unlimited liability for the liabilities of the partnership;
c has a number of limited partners (LPs) whose liability is limited to the amount of their equity investment in the partnership; and
d is managed by an investment manager on behalf of all the partners.
The investment manager is a separate entity (owned collectively by the private equity fund managers). It is structured as a partnership (often an offshore limited partnership). The manager receives a fee from each fund it manages.
The general partner is a company owned by the investment manager and, in compliance with the Limited Partnerships Act 1907, must have unlimited liability for the liabilities of the private equity fund. However, the individual partners cap their liability by investing through a limited company. Individual partners of the private equity fund manager are required to invest their own money directly in the fund (usually between 1 per cent and 5 per cent of the fund).
External investors are LPs. Their total liability is limited to the amount of capital they have invested. LPs themselves may be structured as corporations, funds or partnerships.
Private equity firms raised large amounts of capital (reports suggest around €23.3 billion) for European real estate between 2013 and 2016. This filtered through to the United Kingdom, with investors attracted by a relatively benevolent tax environment and the lack of legal restrictions imposed on overseas investors holding commercial real estate assets. Investment by firms in real estate in central London alone almost doubled between 2007 and 2013, with investment increasing from £350 million to £636 million.
As highlighted by the deals outlined above, private equity firms have recently purchased large portions of commercial real estate for the diversification that the assets afford, the protection they offer against inflation and the dual benefits of equity-type performance potential coupled with a bond-type risk profile (due to the steady income from rental receipts and capital growth).
Private equity firms have targeted various real estate assets in recent years, including:
a the hotel market, which has seen increased demand from cash-rich investors from Asia, the Middle East and US-based private equity firms;
b healthcare, with investment seen in healthcare services, social care services, pharmaceuticals and medical tech; and
c student accommodation, driven by emerging-market wealth – global investment into UK student housing saw over £4.5 billion invested into 68,000 beds in 2016 alone.
The value of assets and land traded during the first five months of 2015 was £4.2 billion and the bulk of that investment activity shifted from UK owner–operators to UK and overseas-based private equity and global institutions.
i Legal frameworks and deal structures
When investors acquire or dispose of real estate in the United Kingdom, the majority of the deals do not involve the transfer of title to the relevant property from the seller to the buyer. While smaller deals may involve the direct transfer of real estate assets, for a number of reasons (the main driver is often tax, as outlined below), the acquisition or disposal of real estate assets is made through share purchases of corporate vehicles that own the property in question. It is unusual for there to be a direct transfer of real estate.
Various structures are used to acquire and hold real estate. The optimum structure will depend, in each case, on a number of factors and considerations (including funding, tax and exit routes (for private equity funds)). Typical structures include:
a companies limited by shares: body corporates with a legal personality distinct from those of their shareholders and directors; these companies are governed by the Companies Act 2006;
b limited partnerships: discussed above in relation to private equity firms;
c limited liability partnerships (LLPs): bodies corporate with a legal personality distinct from those of their members. Members have limited liability in that they do not need to meet the LLP’s liabilities. They are governed by the Limited Liability Partnerships Act 2000 and the Companies Act 2006;
d joint ventures: there are no laws relating specifically to joint ventures under English law. Their structure will be determined by the nature and size of the enterprise, the identity and location of the parties and their commercial and financial objectives. The relationship between the parties will be subject, depending on the structure, to general common law rules, the legislative provisions of company and partnership law and the provisions of the JV agreement;
e trusts of land: any trust that includes land as part of the trust property will be a trust of land. Trustees have a power to sell the property, but no obligation to do so, unless this is made expressly. They are governed by the Trusts of Land and Appointment of Trustees Act 1996; and
Share acquisitions with cash consideration remain the predominant form of real estate transaction structure. This is likely attributable to the relative simplicity of completing a transaction structured as a share acquisition and, from a valuation perspective, the certainty of receiving cash consideration.
Fixed-price transactions (often in the form of ‘locked boxes’) are the structure of choice for private equity sellers, although they are increasingly used by trade sellers conducting auctions. Earn-outs and deferred consideration are not common features of the UK real estate M&A market.
Post-completion adjustments to the purchase price are also a common feature, particularly where there is a delay between signing and completion (see below). Adjustments are most commonly made to account for variations in working capital and net debt.
The use of escrow structures has also increased in the real estate private equity M&A market as way to make contractual claims in respect of warranties and post-completion purchase price adjustments.
ii Acquisition agreement terms
As noted, typically real estate assets will change hands through the sale of the shares in a corporate vehicle that owns those assets. As with any share deal, the buyer will take on the target’s existing liabilities and commitments and the seller will provide warranties and certain indemnities. The title to the real estate assets will usually be certified by the vendor’s counsel.
The extent of the sales and purchase agreement (SPA) provisions will vary depending on the nature of the transaction, the real estate assets in question and the due diligence undertaken. However, there are a number of aspects to consider.
A number of conditions may need to be satisfied before a real estate transaction can complete (such as obtaining planning permission, third-party consents, or even practical completion of a property development). Any such conditions must be satisfied or waived before the real estate transaction can complete.
Splits between signing and completion
For any split between signing, several practical matters should be considered:
a whether shareholder (or equivalent) approval is required by either of the parties;
b whether EU merger clearance is required;
c whether any warranties given at signing need to be repeated at completion;
d whether rescission is possible between signing and completion;
e whether any deposit paid at signing should be returned to, or forfeited by, the buyer if the transaction does not complete; and
f whether management of the underlying properties is required and, if so, whether the buyer will exercise control.
Where there is a split between signing and completion, this may affect whether the buyer is able to negotiate a rescission right, mentioned above, during that time.
Where a seller is required to obtain shareholder approval for a real estate transaction after signing but before completion, it will be difficult for them to argue that during this period the buyer should face the potential risks and be unable to rescind.
In contrast, where the reason for a split is as a result of the time required for the buyer (e.g., to procure debt finance), it is less likely it will be able to negotiate a rescission right for anything other than material breach of any restrictive conduct provisions.
In UK real estate acquisitions, buyer protections are particularly important as the buyer is not afforded any statutory or common law protection on acquisition; caveat emptor (buyer beware) applies. Where the buyer purchases a target group and is to inherit all related obligations, liabilities and commitments, a robust package of warranties and appropriate indemnities will be required from the seller. These will normally be limited to the corporate vehicle and taxation matters; the buyer will usually be expected to satisfy itself on title to the real estate assets through a normal due diligence exercise or reliance on certificates of title issued by the vendor’s lawyers. Recently we have seen a move towards title insurance as a way for the buyer to deal with title due diligence, sometimes in combination with purchaser due diligence or certificates of title, or both of these. A combination of approaches is not uncommon on portfolio deals with properties of various values or significance.
Although sellers (particularly private equity sellers) will not want to provide a large number of warranties on the sale of real estate assets, they are important to provide the buyer with some contractual protection. An SPA will not generally include long-form property warranties; the buyer’s property enquiries will be answered by the seller in the form of representations.
Buyers are increasingly succeeding in extending the scope of warranty coverage, although sellers often succeed in disclosing all due diligence information against such warranties. Private equity sellers have also conceded business warranties on occasion (however, these tend to be in respect of identified issues that cannot be addressed through further diligence or otherwise reflected in the price).
The repetition of warranties at completion is usually limited to ‘core’ warranties regarding title to the shares or real estate assets and the capacity and authority of the seller to enter into the transaction.
Where a buyer identifies (through due diligence) a particular risk or liability that it is unwilling to assume (e.g., environmental risks, or planning consents or permissions) and that risk is not easily quantifiable, specific indemnities will be sought, shifting the exposure to the seller. Warranty claims are difficult to make in practice, so indemnities are preferable from the buyer’s perspective. Sometimes title insurance to protect against a specific title defect can be obtained.
The limitations on a seller’s liability under an SPA will be dependent on the particulars of each transaction. In practice, however, the parties will agree that certain warranties (i.e., core warranties) will be capped at the overall consideration for the deal. Depending on commercial and competitive pressures, there may be a different cap on liability for other warranty breaches (e.g., 15 to 20 per cent of the overall consideration).
General warranties are likely to have a duration of 18 months to two years, while tax warranties are more likely to have a duration of four to six years. There is also likely to be a de minimis threshold that must be reached before a claim is brought.
As noted, the seller’s exposure under the warranties will be limited by the disclosures made in the disclosure letter (which the buyer will ensure are sufficiently detailed so that a view can be taken on its liabilities).
There is a growing tendency for both sellers and buyers to obtain warranty and indemnity insurance in the UK M&A market. Insurers such as Aon and Willis are increasingly marketing their willingness to offer warranty insurance, although they expect that careful due diligence is carried out in the normal way by the buyer. This trend has been driven by sellers seeking a clean exit – a broader set of warranties can be presented with limited post-completion financial exposure. Similarly, buyers are arranging insurance to supplement or cover gaps in the protection provided by sellers – securing sufficient protection can allow buyers to proceed with a transaction without raising a seller’s exposure and potentially prejudicing the competitiveness of any offer.
iii Financing considerations
Real estate investors are usually backed by a mixture of debt and equity. Lenders will require typical security packages in relation to real estate lending, which will consist of:
a charges by way of legal mortgages over real estate assets;
b charges over rents receivable;
c potential charges over bank accounts into which rents are paid; and
d additional charges over certain contracts (such as leases, insurance policies and development and construction contracts).
Depending on the circumstances, lenders may also seek protection against borrower default through conditions precedent and direct covenants in the facility agreement, property valuations, parent company guarantees and bonds, cash collateral, and by obtaining floating charges from the parent company.
Where development and construction is anticipated, lenders may also require approval of material development documentation as a condition precedent to draw down and may expect to receive collateral warranties or third-party rights from contractors, designers and key sub-contractors. Step-in rights may also be sought to take over a contract in the event of default.
iv Tax considerations
Stamp duty land tax (SDLT) is payable by the buyer of commercial real estate and is a percentage of the purchase price, varying depending on the consideration paid for the property. SDLT is currently payable at 2 per cent on the portion of consideration between £150,001 and £250,000, and 5 per cent on the portion of consideration above £250,000. For investors to avoid paying high tax rates for individual real estate assets, it is better for the shares in the vehicles themselves to change hands. SDLT does not apply to the purchase of shares in companies holding real estate assets. The rate of stamp duty on the transfer of shares in a UK-incorporated company is 0.5 per cent.
If real estate assets are sold and purchased directly, the default position is that the sale or purchase in the United Kingdom is not subject to VAT, though owners can opt to tax the property at the standard rate of 20 per cent. Generally, most sellers opt to tax. Where a property is let to tenants, VAT can be mitigated by ensuring the sale is treated as outside the scope of VAT as a transfer of a business as a going concern, provided the buyer continues letting the business and opts (and notifies HMRC that it has opted) to tax.
Interest charges on borrowings are deductible expenses for tax purposes, so gearing will generally result in tax efficiency. Many real estate investors introduce borrowing to achieve this result. In such circumstances, it is important that any loan arrangement is ‘at arm’s length’. Loans that do not meet that commercial threshold will not qualify as deductible.
Currently all borrowing costs are deductible to reduce taxable profit, but changes have been proposed to limit the amount of deductible interest to 30 per cent of the owner’s EBITDA. This restriction is likely to apply equally to UK and non-UK owners. The enactment of these changes, which were due to take effect from April 2017, was postponed because of the calling of an early general election in June 2017. However, the government has indicated that it will seek to reintroduce them at the earliest opportunity.
The UK real estate M&A market has made significant rebounds since the shock impact of the EU referendum in June 2016. However, the market will continue to be affected by uncertainty in the build up to the United Kingdom’s separation from the EU, particularly as the terms of that separation remain unclear. Financial and political instability have historically reduced M&A activity substantially. Investors will be paying close attention to political developments in relation to migration control, trade protectionism, tax and regulatory change, all of which will impact the real estate market.
It is not yet clear how the surprise outcome of the June 2017 election, in which the Conservatives lost their majority government, will affect the real estate M&A market, but its impact is unlikely to be significant. The UK economy remains relatively strong, with respectable growth projections for 2017. Increasing inflation and a consequential hit to consumer spending are likely to be offset by low unemployment levels and a strong services sector.
Moreover, despite the political developments of the past year, the UK real estate sector remains attractive – the United Kingdom’s well-established legal, tax and planning systems, transparency and lack of corruption means investors continue to see opportunities and consider the United Kingdom a safe jurisdiction in which to operate. As we have seen, short-term political uncertainty can create buying opportunities and can result in a boost in the property market as investors deal at deflated prices. Commercial property is also still seen as a ‘safe haven’ asset. Foreign investors often invest in UK commercial property to escape debt crises or other economic problems at home; leaving the EU is unlikely to change this in the long term. Further, a weakened sterling has attracted more overseas investment into the property market, and this looks set to continue, with international buyers keen to exploit the lower pound in both the residential and commercial property spheres, particularly in London. Although Brexit has undoubtedly increased the risk of UK real estate, political uncertainty is fast becoming a global phenomenon. The Trump administration in the United States and a wave of European national elections in 2017 will make uncertainty a theme throughout the Western world. Brexit no longer appears to be an anomaly.
Consequently, both investment volumes and total returns are expected to see a modest recovery over the course of the coming months and years. Although rental growth is expected to be flat in 2017 and capital growth is likely to continue to see a negative growth trend, the rationale for real estate M&A remains sound in comparison with other asset classes, particularly so long as interest rates remain low. Institutional investors are expected to gradually re-enter the market, and will play an important role in injecting much-needed stock and capital into the market.
Demand for safer assets is likely to increase as investors become more focused on income generation as a means of securing their returns. As political developments lead to continued risk aversion among investors, secure income streams will become highly sought after. Sectors that are shielded from economic volatility – such as public sector services, core infrastructure and build-to-rent – will become significant investor targets. The industrial and logistics sector is also expected to see high levels of investor demand. The future is therefore likely to see a bifurcation in the real estate market between prime and secondary assets.
In summary, the current outlook could be described as cautiously optimistic. While investors remain wary of the unpredictable political and economic climate, they are also seizing opportunities where available. Real estate M&A activity is therefore likely to see a revival, although the lesson to be learned from the events of 2016 is that nothing is certain.
1 Richard Smith is a partner and Chris Smith is an associate at Slaughter and May.
2 Investment volumes in 2016 were £46.5 billion, as compared with heights of £66.3 billion in 2015 (see Lambert Smith Hampton, ‘UK Investment Transactions Bulletin Q4 2016’ (https://www.lsh.co.uk/commercial-property-research/2017/01/volume-rebounds-in-q4-as-overseas-investment-in-the-uk-regions-hits-record-level) and ‘UK Investment Transactions Bulletin Q4 2015’ (https://www.lsh.co.uk/commercial-property-research/2016/02/record-year-for-investment-volume)) (accessed 16 June 2017).
3 Lambert Smith Hampton, ‘UK Investment Transactions Bulletin Q4 2016’ (https://www.lsh.co.uk/commercial-property-research/2017/01/volume-rebounds-in-q4-as-overseas-investment-in-the-uk-regions-hits-record-level) (accessed 16 June 2017).
4 Lambert Smith Hampton, ‘UK Investment Transactions Bulletin Q4 2016’ (https://www.lsh.co.uk/commercial-property-research/2017/01/volume-rebounds-in-q4-as-overseas-investment-in-the-uk-regions-hits-record-level) (accessed 16 June 2017).
5 CBRE, ‘Real Estate Market Outlook: United Kingdom’ (www.cbre.co.uk/portal/pls/portal/!PORTAL.wwpob_page.show?_docname=57013454.PDF) (accessed 19 June 2017)).
6 The mandatory offer was triggered as a result of Stork Holdco’s acquisition in 2014 of Songbird Estates for £4.8 billion. Songbird owned a 69.3 per cent stake in CWGP, which meant Stork Holdco’s acquisition gave rise to the mandatory offer to acquire the remaining shares of CWGP. Following the acquisition, Stork Holdco combined Songbird and CWGP into a single operating entity.
7 Currently 19 per cent, set to drop to 17 per cent from 1 April 2020.
8 This includes the London Stock Exchange, and other exchanges designated as ‘recognised exchanges’ by HMRC.
9 See PwC, ‘Emerging Trends in Real Estate: Europe 2017’ (https://www.pwc.com/gx/en/industries/financial-services/asset-management/emerging-trends-real-estate/europe-2017.html) (accessed 5 September 2017).
10 See Knight Frank research (2014), highlighted in White and Case’s ‘Spotlight on London real estate’ (http://events.whitecase.com/insights/Insight_SpotlightOnLondonRealEstate.pdf) (accessed 28 June 2016).
11 See White & Case, ‘London calling: Investing in commercial real estate’ (2014) (www.whitecase.com/sites/whitecase/files/files/download/publications/print-London-calling-Investing-in-commercial-real-estate.pdf) (accessed 28 June 2016).
12 See BNP Paribas, ‘BNP Paribas Real Estate Guide to Investing in London 2015’ (2014) (https://www.realestate.bnpparibas.co.uk/upload/docs/application/pdf/2015-04/investing_in_london_guide_2015_-_bnp_paribas_real_estate_uk.pdf) (accessed 28 June 2016).
13 Financial Times, ‘Property is one-third of alternative assets’ (13 July 2015).
14 See Savills, ‘Spotlight: UK Student Housing – 2017’ (www.savills.co.uk/research
_articles/205506/216971-0) (accessed 5 September 2017).
15 See Savills, ‘Spotlight: UK Student Housing’ (2015) (http://pdf.euro.savills.co.uk/residential---other/spotlight--uk-student-housing-2015.pdf) (accessed 28 June 2016).
16 See Practical Law, ‘Private mergers and acquisitions in the UK (England and Wales): market analysis overview’ (http://uk.practicallaw.com/6-546-2709?source=relatedcontent) (accessed 29 June 2017).
17 Estates Gazette, ‘Corporate real estate transactions: buyer beware’ (7 March 2015).
19 See Herbert Smith Freehills, ‘A legal guide to investing in the UK for foreign investors’ (2012) (www.herbertsmithfreehills.com/-/media/HS/L050712154578912171416219.pdf) (accessed 27 June 2016).
20 See DLA Piper, ‘Brexit and the UK commercial property market’ (https://www.dlapiper.com/en/uk/insights/publications/2016/06/brexit-and-the-uk-commercial-property-market/) (accessed 28 June 2016).
21 See CoStar, ‘How will 2017 be for UK commercial property?’ (www.costar.co.uk/en/assets/news/2017/January/How-will-2017-be-for-UK-commercial-property/) (accessed on 19 June 2017).
22 See Cushman Wakefield, ‘UK Industrial & Logistics Market Outlook’ (www.cushmanwakefield.co.uk/en-gb/research-and-insight/2017/industrial-and-logistics-report/) (accessed on 19 June 2017).
23 See CoStar, ‘How will 2017 be for UK commercial property?’ (www.costar.co.uk/en/assets/news/2017/January/How-will-2017-be-for-UK-commercial-property/) (accessed on 19 June 2017).