I Overview of the markeT2
The Australian real estate market is highly securitised, with a significant majority 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 over 49 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$130 billion and are important players in the broader Australian market.3
There is also a substantial unlisted REIT sector in Australia, with both listed REIT managers and privately owned fund managers also managing unlisted real estate funds targeting Australian and offshore institutional investors and sovereign wealth funds, primarily through syndicate, club and joint venture style structures.
As a result, larger real estate transactions in Australia tend to reflect a ‘securitised’ 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 months has seen continued high levels of activity in the sector, including hostile and friendly takeover activity, reconstructions and divestment of large portfolios. This reflects a maturing of the real estate investment cycle and 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 2017, total foreign investment in the sector was estimated at over A$8.7 billion, involving nearly 300 transactions.4
International private equity firms, and Australian-based private equity-style real estate managers, have also been active in the Australian market, with a number of significant transactions over the past 12 months.
II Recent market activity
i M&A transactions
The past 12 months have been characterised by an increase in high profile REIT M&A activity in the public markets. Two of the more significant, large-scale transactions are:
- the acquisition of Westfield Corporation by Unibail-Rodamco; and
- the proposed acquisition of Investa Office Fund by Blackstone.
Unibail-Rodamco acquisition of Westfield Corporation.
Westfield Corporation was an ASX-listed internally managed international retail property group with a focus on the United States, United Kingdom and Europe. It had a market capitalisation of over A$18 billion.
In December 2017, it was announced that Unibail-Rodamco SE, a Euronext-listed CAC 40 company headquartered in Paris, had entered into an agreement to acquire Westfield Corporation for approximately A$21 billion using a combination of trust schemes and company schemes of arrangement. The transaction was unanimously recommended by the Westfield and Unibail-Rodamco boards. Following securityholder approval, the transaction was completed in June 2018. OneMarket, Westfield Corporation’s start-up retail property technology company, was demerged prior to the takeover with Unibail-Rodamco holding 10 per cent.
Existing holders of stapled securities (comprising shares and units) in Westfield Corporation received cash and Unibail-Rodamco stapled securities in exchange for their securities in Westfield Corporation. As well as being listed on the Euronext Amsterdam (market of reference) and Paris, the Unibail-Rodamco stapled securities are tradable on the ASX as CHESS Depository Interests.
Blackstone acquisition of Investa Office Fund
Investa Office Fund is an externally managed REIT with a portfolio of office properties primarily located in Sydney, Melbourne and Brisbane. It had a market capitalisation of approximately $2.6 billion.
In May 2018, Investa announced that it had received a non-binding proposal from funds advised by Blackstone to acquire all of the securities in Investa for cash consideration totalling approximately A$3 billion, and that the parties had agreed a process for implementation of the proposal.
Blackstone specifically left open whether Investa’s current manager would remain in place after the acquisition, not committing either to remove or to retain the manager.
ii Private equity transactions
International real estate private equity firms, and Australian-based private equity-style real estate managers have been active in acquiring and disposing of a range of real estate assets over the past few years, including, in the past 12 months, through public capital markets and corporate real estate transactions.
Recent transactions include:
- Blackstone’s proposed acquisition of the Investa Office Fund (see Section II.i);
- the acquisition of Allied Pinnacle’s property portfolio by funds managed by Qualitas; and
- the establishment and subsequent restructure and IPO of the Propertylink Group.
Allied Pinnacle property portfolio
Allied Pinnacle is Australia’s third largest flour and grain mill product manufacturer, owned by Pacific Equity Partners, an Australia-based industrial private equity firm.
In December 2017, real estate investment management firm Qualitas purchased Allied Pinnacle’s industrial property portfolio for approximately A$400 million, using the portfolio to seed its Qualitas Food Infrastructure Fund. The portfolio consists of ten properties in Victoria, New South Wales, Queensland, Western Australia and South Australia. The sale and lease-back deal involved Allied Pinnacle maintaining full control of the operation of the sites through eight 30-year and two 15-year, triple-net leases.
Propertylink, an unlisted property manager established the Propertylink Australian Industrial Partnership (PAIP) with Goldman Sachs’ Special Situations Group and the Grosvenor Group, to invest in and provide value-add management for industrial and logistics real estate opportunities in early 2014.
Over the following two years, PAIP acquired approximately A$700 million of industrial real estate. Propertylink also used its real estate management platform to establish a series of other real estate joint ventures and wholesale funds focusing on industrial, logistics and office real estate.
In mid-2016, Propertylink was restructured and its management platform stapled to PAIP. The stapled Propertylink Group was then listed on the ASX with an initial market capitalisation exceeding A$500 million and assets under management exceeding A$1.5 billion. Goldman Sachs and Grosvenor were able to sell their entire stakes in PAIP through the IPO.
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 assets and active business operations.
The top 20 ASX-listed REITs range from a market capitalisation of just under A$23 billion to a market capitalisation of about A$1 billion. The largest REIT, Scentre Group, was formed in the restructure in 2014 of the Westfield Group (along with Westfield Corporation which has since been acquired by Unibail-Rodamco). Scentre’s market capitalisation is over A$22 billion, while the next largest REIT, the Goodman Group has a market capitalisation of nearly A$17 billion.
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 by the trust are taxed in the hands of investors at their applicable tax rates (see further Section IV).
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 REITs 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 treatment for passive real estate assets 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 Commonwealth government has recently reviewed use of stapled structures in the infrastructure and real estate sectors, and has proposed tax law changes limiting their use – see further Section IV.v, below.
The stapled structure has also been used to enable ‘internalisation’ of management of REITs. Internalisation involves the REIT’s management platform 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 REITs have tended to focus on more traditional real estate classes (retail, office, industrial and residential). More recently there has been increasing interest in alternative real estate classes including health care, aged care, retirement living, student accommodation, childcare, manufactured housing and data centres. 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.5 In 2016, the largest REIT IPO – Viva Energy REIT – was of a specialised service station portfolio. Convenience Retail REIT, which owns a smaller portfolio of service stations, was the only REIT IPO in 2017, raising A$162 million.
The Australian market is also characterised by a number of large listed integrated property companies whose activities cover development and construction as well as asset ownership and management through a stapled REIT structure. Groups such as the Lendlease Group and Mirvac have a multi-disciplinary focus across the full spectrum of the property life cycle.
Many of the larger listed REITs and property companies have a significant global footprint. For example, the Goodman Group and Lendlease Group have operations in Australia, the Americas, Europe and Asia.
ii Real estate PE firms – footprint and structure
Real estate private equity managers in Australia comprise a mix of:
- Australia-based specialist real estate managers, including Altis, Centuria, CorVal and Folkestone;
- international private equity and multiple asset class fund managers, including Blackstone Real Estate, Macquarie Bank, Morgan Stanley Real Estate Investments and KKR, for whom real estate funds are one of the asset classes which they offer investors; and
- ASX-listed REITs and developers, including Brookfield, Charter Hall, Dexus, Goodman Group, Lendlease, Mirvac and Propertylink, which manage separate private equity real estate funds using their integrated funds management platforms, and in some cases use their development and construction capabilities to generate assets for their funds.
Unlike the global PE firms, Australia’s traditional PE 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.
Real estate private equity operations in Australia are characterised by 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-add investments and alternative real estate classes. Investment vehicles vary in size ranging from sub-A$100 million in real estate assets to over A$10 billion.
Real estate private equity managers adopt a variety of approaches to structuring investments, depending on the type of asset, the manager’s position in the market, the type of investors whose funds are managed and the level of oversight which investors wish to exercise. These range from joint ventures, through clubs or syndicates, to the wholesale funds more commonly used for investment in other real estate asset classes.
Typically, externally managed unit trust structures are used 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 listed REITs, unit trust structures provide flow-through tax treatment where passive assets are held. 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 passive nature of the investments.
Offshore real estate PE firms typically invest into Australia real estate assets through unit trusts, leveraged corporate structures, or (where suitable) direct ownership of underlying assets. Their offshore fund structures reflect those typical of the jurisdiction where such funds are based.
i Legal framework 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 the trusts, including detailed rules about matters such as the trustee’s 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).6 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 is the case for all listed REITs.
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.7 This requires the trustee to demonstrate the requisite capability to perform its functions as responsible entity, as well as meeting minimum net tangible assets requirements. There are alternatives, such as engaging professional trustee companies to perform the responsible entity function.8
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, although they retain legal responsibility, trustees will delegate the performance of 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 fund raising, takeovers and other control transactions, 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 providing for continuous disclosure of materially price sensitive information, rules relating to corporate governance, and rules restricting investor dilution, 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 that can affect transaction execution include the following.
Separate ownership of a REIT’s trustee and manager from REIT securities, as is the case for externally managed REITs, can cause divergences between the interests of shareholders in the trustee and manager and those of the REIT’s security holders (for example, where a transaction would result in the trustee losing management of the REIT and associated fee streams). This can place directors and executives of the trustee in a position of conflicting responsibilities and interests. In practice, this is typically managed through governance protocols including establishing an independent board committee to manage the relevant transaction from a REIT security holder perspective (with conflicted executive directors abstaining).
The trustee of a registered REIT (as 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.9 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 which affect the REIT’s trustee.
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.
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.10 The most common techniques to acquire control of a listed REIT within this framework are an off-market takeover bid regulated by the Corporations Act or a scheme (see Section IV.ii for more information about acquisition terms used in takeover bids and schemes).
As takeovers regulation under the Corporations Act does not apply to unlisted REITs, a buyer might engage directly with individual REIT security holders to acquire their securities on whatever terms are agreed, subject to transfer restrictions in the REIT’s constituent documents (see Section IV.ii, below, for more information about acquisition terms). Trust schemes may also be used in this context, and 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 REIT’s trustee. Under the Corporations Act, the responsible entity of a registered REIT can be replaced by a simple majority resolution of unitholders present and voting for a listed REIT or by a simple majority resolution of all unitholders entitled to vote, whether or not present, for an unlisted REIT.11 Constitutions of unregistered REITs may also provide unitholders with similar rights to remove the trustee by resolution. While relatively low voting thresholds apply, in practice it is rare that a responsible entity is forcibly removed in this way. Typically, the challenge is demonstrating to existing investors that the replacement responsible entity offers a more compelling proposition than the incumbent.
ii Acquisition agreement terms
Takeovers and 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:
- a limitations to offer terms apply (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, consideration cannot generally be reduced) and ASIC consent is generally required to withdraw an offer;
- b 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;
- c the target prepares a target’s statement containing recommendations of the directors of the target’s trustee and other material information known to the target, which must also be lodged with ASIC and the ASX; and
- d compulsory 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).12
Under a trust scheme, the target trust’s unitholders vote to amend its constitution to enable all of the units in the target trust to be transferred to the bidder. 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 scheme process involves:
- a disclosure document is provided to the security 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;
- the trust scheme is binding on all security 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; and
- court approval of the trust scheme is not mandatory (unlike company schemes of arrangement), although ‘court directions’ to the trustee are sometimes sought to the effect that the trustee would be justified in implementing a trust scheme if approved by the requisite unitholder majorities.
Acquisition of a stapled trust and company requires inter-conditional trust schemes and company schemes for each entity comprised in the stapled entity. Schemes may also be used to implement the stapling of the securities of two entities so that they trade together (rather than one entity acquiring another’s securities). In these circumstances a vote of the unitholders in both entities is usually required.
For both schemes and takeovers, the consideration may comprise cash or scrip or a combination of the two. Tax considerations, including availability of roll-over relief from capital gains tax, will often be a key factor in determining the consideration offered (see Section IV.v).
Implementation agreements between the target and bidder are common for friendly takeover bids and schemes. They contain typical deal protection mechanisms, including:
- conditions precedent to implementation and the bidder’s and target trustee’s obligations in relation to implementation of the transaction process;
- 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;
- break 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);13 and
- generally limited warranties and indemnities which effectively cease to operate on implementation of the transaction.
Bidders will often seek due diligence access before entry into an implementation agreement. Whether the 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 schemes as the bidder cannot vote their securities in a scheme. However, it is possible to obtain options or enter into voting agreements for up to 20 per cent of a target if structured appropriately. Stakes of 5 per cent or above must be disclosed to the market, and statutory beneficial ownership tracing rules can reveal smaller stakes.14 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 formal auction 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 large asset portfolios, with investment banks typically engaged to coordinate the sales process. For smaller real estate portfolios sellers may conduct the sale process with the assistance of commercial real estate agents. For sales of unit-holdings in wholesale funds, investors will usually conduct their own sale process, or the trustee may be empowered to do so on the selling unitholders’ behalf under the relevant fund constitution.
The primary sale document is typically a unit sale agreement. Key terms 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 will be 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 unitholders to control the trustee’s actions) and steps to enable the change of trustee following completion.
iii Hostile transactions
Activity in relation to ASX-listed REITs can be hostile. While the majority of transactions are negotiated to a position where the boards of both parties are supportive, this is not always possible. Also, it is not uncommon that REITs become the subject of competing bids once they are in seen to be in play.
More recent examples in the Australian market include the competing bids by 360 Capital Industrial Fund and NEXTDC Limited for the Asia Pacific Data Centres Group in 2017, the bid by Growthpoint for the GPT Metropolitan Office Fund in 2016 and 360 Capital’s bid for the Australian Industrial REIT in 2015.
For a hostile bidder, the preferred method is generally an off-market takeover bid, as the scheme process is 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 to hostile public markets transactions generally, including:
- gaining access to due diligence – while listed REITs have a general obligation under the ASX’s listing rules to disclose to the market materially price-sensitive information, there are various carve-outs including, for example, in relation to confidential incomplete proposals;
- relatively high compulsory acquisition thresholds – generally the bidder will need to acquire at least 90 per cent of the bid-class securities;
- determining appropriate bid conditions (particularly the level of required acceptances and when it may be appropriate to waive these to seek to encourage further acceptances). Relevantly as the responsible entity of a listed REIT can be replaced by a 50 per cent majority vote of unitholders, this can 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 Australian Industrial REIT);
- potential approaches to the Australian Takeovers Panel on aspects of the bid which can affect deal timing – for example, in the 360 Capital bid for Australian Industrial REIT, application was made to the Takeovers Panel to have certain statements in the bidder’s statement declared misleading; and
- more generally, hostile processes are often protracted and played out in the media attracting significant scrutiny for 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 requirement that any action be for a proper purpose and in the interests of the REIT’s security holders. ASX listing rules also prohibit certain issues of securities within three months of a takeover announcement. The Takeovers Panel may declare target actions to frustrate a current or pending bid as unacceptable, and require them to be unwound or suspended until approved by target security holders. 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.15 US-style takeover defence arrangements, such as poison pills, are not available to target directors of listed entities in Australia.
iv Financing considerations
Financing approaches for Australian real estate M&A and private equity transactions are primarily influenced by the type of transaction and the financing arrangements already in place for the target.
The cost of debt funding for real estate transactions has been trending higher in recent times. While appetite for good credits remains, domestic Australian banks have reduced their exposures to certain sectors, such as construction and development financing for large residential developments, largely in response to a perceived oversupply of inner city apartment developments in some Australian state capital cities. The importance of alternate funding sources has increased in light of the more subdued lending appetite of domestic banks, and funding from non-bank sources is becoming more prevalent.
Funding types and sources
Financing for real estate M&A is broadly divided into:
- investment finance, or acquisition finance, which involves financing the acquisition of individual real estate assets, specific portfolios or the acquisition of securities in a target REIT, usually on a senior secured basis; and
- portfolio or ‘corporate’ finance, which involves financing for a REIT to be used for general purposes, often including ‘bolt-on’ acquisitions, typically on a senior debt syndicated basis, but more recently also including a mix of bank and capital markets debt.
Investment finance typically comprises senior debt, which is typically limited recourse debt (with recourse limited to the assets being acquired) provided by one lender or a syndicate of lenders. Senior lenders typically take first-ranking security over key assets to secure the senior debt. Senior lenders will typically require the parent or sponsors of the borrower to contribute equity to the borrower in the form of equity or deeply subordinated debt, which is contributed before senior debt and any external mezzanine debt.
The majority of real estate M&A transactions are financed using senior debt provided by at least one of the Australian domestic banks. There is also increasing appetite from offshore investors buying into the Australian real estate market. As a result, an increasing number of transactions are being financed by senior debt from offshore banks, particularly Asian banks supporting the investment of their customers into the Australian market, and from life funds and specialised investment funds.
Mezzanine or subordinated financing has been most commonly used for development financing, particularly where the sponsors are unable to fund the equity required to achieve the loan to value ratio, debt to equity ratio or cost to complete tests imposed by the senior lenders. However, a trend is emerging for mezzanine debt to be used for investment finance, particularly as loan to value ratio requirements of senior debt lenders tighten. 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.
Australian domestic banks have been reluctant to accept capital structures with multiple tiers of debt, partly because of the intercreditor rights being sought by mezzanine lenders (including rights to enforce, standstill periods and restrictions on senior refinancing) and the practicalities of enforcement. However, more recently, senior lenders have become more willing to accept lenders providing mezzanine debt at the holding entity level. These instruments, which are structurally subordinated to senior debt, often feature ‘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.
Debt capital markets (bonds, notes, private placements, and other debt securities) have been used in portfolio financings 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 larger REITs more recently.
Typically, security is required by senior and mezzanine lenders for investment finance. Senior lenders will require first ranking security, with mezzanine lenders receiving second-ranking security over the same assets. The priority of the securities and rights of the mezzanine lenders to enforce their second-ranking security will be regulated by inter-creditor arrangements. Lenders usually require:
- registered security over the real estate assets being acquired or developed and all of the assets of the borrower, including real property mortgages (requiring side deeds with the applicable landlord if the land is the subject of a lease); and
- security over the units or shares in the borrower, which, among other matters, restricts the parent’s ability to deal with or encumber those units or shares without the lenders’ consent.
Lenders do not usually have recourse to any other assets of the parent.
Portfolio financing is either secured against the assets of the REIT vehicle or unsecured, depending on the creditworthiness of the borrower and gearing of underlying investment vehicles. Whether or not security is provided, it is supported by guarantees and negative pledges from all entities comprising the investment vehicles.
There is a current trend for larger REITs 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. Typically, the margins and fees for secured group financings are lower than for unsecured group financings, but there is less freedom allowed to the entities comprising the investment vehicle under the terms of the financing documents. While there is typically more flexibility provided than in investment financing, there are still the usual ‘security’ style covenants.
Unsecured portfolio financings typically involve a combination of syndicated bank debt 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 of which all of the financiers obtain the benefit. Typically, the financing is provided on a ‘corporate’ style basis which offers more flexibility and a less stringent covenant package.
Recently, terms have been imported into real estate financing from the broader leveraged finance market, including the loosening of general covenants and use of materiality qualifiers.
Recent trends also include the use of a ‘certain funds regime’ for 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
Most REITs are structured as managed investments trusts (MITs) (or seek to include a 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. Also, the trust cannot control the conduct of a trading business.16
The key benefits of accessing the MIT regime are:
- for non-resident investors, lower withholding tax rates can apply to distributions of income by a MIT throughout the life of the investment, and also on any gain on disposal;17 and
- for Australian-resident investors, investments made by a MIT automatically become subject to the capital gains tax (CGT) rules (and are not taxed on revenue account) where the MIT makes a ‘CGT election’.18 This enables access to the CGT discount and CGT rollover relief.
Accordingly, where the investor mix and investment type lends itself to a MIT structure, this is generally the structure that is used.
Proposed tax law changes relevant to stapled structures
The Commonwealth government recently reviewed the use of MITs in stapled structures.19 The government was concerned that some land-rich businesses were being split into a land-holding entity and an operating entity, with the relevant land leased to the operating entity. The land-holding entity would be structured as a MIT, which would entitle investors to access concessional tax treatment. The government concluded that, at least for non-residents, income derived from such arrangements should be subject to the full corporate rate of tax.
The review led to release of draft legislation designed to limit access to the lower MIT withholding tax rates where MITs are used as part of a stapled structure.20 Under the proposed legislation, subject to some exclusions and transitional arrangements, net income derived by MITs from operating entities within a stapled group (for example, rent paid by the operating entity to the MIT) will generally be subject to 30 per cent withholding tax when distributed to non-residents.
The proposed changes should not materially affect use of stapled structures to hold and manage traditional classes of real estate asset (office, retail and industrial); however, use of MITs in stapled structures for certain alternative real estate investment classes, where the real estate is integrated with a trading business (for example, hotels, student accommodation, retirement living and aged care) will likely be affected.
Proposed corporate collective investment vehicle regime
Also, tax law changes are in the process of being implemented so that funds established as companies and limited partnerships are taxed on a similar basis to trusts.21 These reforms, are intended to facilitate use of investment vehicles commonly used overseas in the Australian market, and complement commencement of the Asia Region Funds Passport. However, differences between the proposed tax treatment of these vehicles under draft legislation released in December 201722 and current tax treatment of trusts may mean that these vehicles will remain less attractive than trusts.
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 CGT event (on capital account). The distinction determines if a security holder can access the CGT discount and CGT rollover 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 sale of the interest, rather than for the 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 capital gain would normally arise where capital proceeds (being cash consideration and the market value of any securities or other assets received on disposal)23 received by a security holder exceeds the security holder’s cost base (generally, the original acquisition consideration plus incidental costs, less tax-free capital distributions on units)24 in their investment; and
- a capital loss arises where capital proceeds received by the security holder are less than the security holder’s cost base in their investment.
Generally, unitholders 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.25
Australia-resident individuals, superannuation funds and trusts that have held an investment for more than 12 months, are entitled to reduce their CGT gain 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.26
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:
- the non-resident security holder (together with any associates) did not hold a 10 per cent or greater interest in the relevant REIT or company throughout a 12-month period that began no earlier than 24 months before that time; or
- not more than 50 per cent of the value of the REIT or the company derives from interests in Australian real property.27
As REITs generally hold interests in Australian real property, only the first test above would be relevant to non-resident securityholders. In some circumstances, companies stapled to REITs do not meet the 50 per cent real estate threshold (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), and so both tests can be relevant.
Availability of scrip for scrip rollover relief from CGT
Scrip for scrip rollover relief from CGT may be available where units or shares are disposed in exchange for units or shares.28 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.
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).
The acquiring entity must become owner of 80 per cent or more of the target entity. Often the threshold for a scrip-based takeover bid to become unconditional is lower. In such cases, the 80 per cent threshold is not met, target security holders who accept the offer do not receive rollover relief.
Where the transaction is a unit for unit transaction, each trust must be a ‘fixed trust’. As the law as to what constitutes a fixed trust is unclear, the Commissioner of Taxation’s discretion to treat trusts as ‘fixed trusts’ has almost always been sought. However, under recent changes to the MIT rules, trusts that are MITs may be automatically deemed to be a ‘fixed trust’ if certain requirements are met.
The offer must be on substantially the same terms to all security holders in the target. Significant security holders cannot be treated differently to others.
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 exceed the 10 per cent threshold (and thus be taxable Australian property 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.
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 counterfactual (that is, what the structure or transaction would have been without the tax avoidance purpose).29 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 for transaction steps).
Stamp duty and land tax
Acquisitions of Australian real estate assets may attract state or territory stamp duty. Duty in relation to acquisitions of commercial land (other than in South Australia, where duty on commercial land has been abolished from 1 July 2018) generally ranges from 4.5 per cent to 5.75 per cent of improved land value (or purchase consideration if higher) depending on which state or territory the land is located.30
Duty applies not only to acquisitions of direct interests in land, but also acquisitions of interests (usually above a certain threshold) in land-holding trusts and companies.
Higher duty rates apply to acquisitions of residential property in certain circumstances. Victoria, New South Wales, South Australia and Queensland have imposed surcharges ranging between 3 per cent and 8 per cent on foreign acquirers of interests in residential real estate, and a similar surcharge has been proposed in Western Australia.
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 1.23 per cent and 3.7 per cent (usually of the unimproved value of the land) depending on the state or territory in which the land is located. In addition, for foreign owners a 2 per cent surcharge applies to residential land in New South Wales, and a 1.5 per cent surcharge applies to land in Victoria, subject to certain concessions.
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, following completion of a regulatory review, has been the subject of a number of amendments intended to clarify its operation.31
Nominally, acquisitions of interests in land (including direct investments and investments in land-holding trusts and companies) exceeding A$261 million are notifiable and must be approved by the Commonwealth Treasurer (as advised by the Foreign Investment Review Board (FIRB)).32 However, lower thresholds apply to a range of acquisitions.
A A$57 million threshold applies to certain classes of sensitive land. Since 1 July 2017, the classes of sensitive land have been narrowed so that the lower threshold does not apply to many types of land previously caught by the lower threshold.33
A A$15 million threshold applies to acquisitions of agricultural land.34
No monetary threshold applies to:
- a most acquisitions of interests in residential land;
- b most acquisitions of interests in vacant commercial land; and
- c 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.35
A higher A$1.134 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.36
The legislation provides a 30-day period, from the date lodgement fees are paid, within which a decision whether or not 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 FIRB receiving input in relation to proposed acquisitions from a range of government agencies, including the Australian Taxation Office, the Critical Infrastructure Centre (where applicable) and national security agencies before providing its advice to the Treasurer. Approval is required before the acquisition can complete.37 Failure to obtain necessary approvals can lead to divestment as well as criminal sanction.
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-tax agreements.
Concessional withholding tax applies to income distributions by trusts that satisfy the conditions for being characterised as a ‘Managed Investment Trust’ for tax purposes: see Section IV.v 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 leaseback 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, the Viva Energy REIT listed in 2016);
- 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; and
- d PE real estate fund led acquisitions of corporate real estate portfolios (Allied Pinnacle in 2017).
Continued underperformance by the listed REIT sector during the second half of 2017, reflecting broader market concerns about rising interest rates and bond yields, has slowed release of additional real estate assets into the public markets with only one REIT IPO on the ASX in 2017 and no REIT IPOs scheduled for launch on the ASX as at June 2018.
The listed REIT market is expected to experience increasing consolidation over the coming year, particularly among smaller REITs as they seek scale in an environment of increasing competition for direct investment opportunities, as well as further real estate PE-led M&A activity, led primarily by offshore real estate PE firms.
As the current real estate cycle moves more into late stage, offshore real estate investors and real estate PE firms are expected to focus increasingly on real estate-backed debt.
1 Philip Podzebenko and Robert Bileckij are partners at Herbert Smith Freehills. The authors would like to thank Melita Cottrell, Partner, Herbert Smith Freehills who wrote the banking section, and Daniel Sydes, director, Greenwoods & Herbert Smith Freehills, for the tax section. The authors would also like to thank Timothy Coorey, graduate solicitor, Herbert Smith Freehills and Bianca Doyle, business development adviser, Herbert Smith Freehills for their assistance with background research.
2 Unless otherwise indicated, data as to ASX capitalisation obtained by compiling data from ASX website as at June 2018.
3 Australian Stock Exchange, ‘ASX Funds (Listed Managed Investments, mFunds and ETPs) Monthly Update – April 2018’ (Report, April 2018) www.asx.com.au/documents/products/asx_funds_monthly_update_apr_18.pdf.
4 Based on S&P Capital IQ data on ‘Foreign Investment in Australian Real Estate’ for the period from 1/1/2017–12/31/2017.
5 Property Investment Research, ‘December 2015 Editorial – 2015 in review’ (Monthly Review, December 2015) 1 < https://pir.com.au/reviews/82>.
6 See Chapters 5C and 7 of the Corporations Act.
7 Section 911A, Corporations Act.
8 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.
9 Section 253E, Corporations Act.
10 Section 606, Corporations Act.
11 Section 601FM, Corporations Act.
12 See Chapters 6 and 6A, Corporations Act.
13 The 1 per cent break fee reflects Takeovers Panel guidelines as to the level of break fee which is not likely to be regarded as an unreasonable lock-up device: see Takeovers Panel Guidance Note 7: Lock-up devices.
14 Section 671B and Part 6C.2, Corporations Act.
15 See Takeovers Panel Guidance Note 7: Lock-up devices.
16 For the requirements to be a MIT, see Subdivision 275-A of the Income Tax Assessment Act 1997 (Cth).
17 Subdivision 12-H to Schedule 1 of the Taxation Administration Act 1953 (Cth).
18 Subdivision 275-B of the Income Tax Assessment Act 1997 (Cth).
19 See ‘Stapled Structures – Details of Integrity Package’, March 2018 at https://treasury.gov.au/publication/p2018-t273732/.
20 See the Exposure Draft legislation, Treasury Laws Amendment (Stapled Structures and Other Measures) Bill 2018.
21 Australian government, ‘Budget Paper No. 2 2016-17, Budget Measures,’ May 2016).
22 See the exposure draft of Treasury Laws Amendment (Corporate Collective Investment Vehicle) Bill 2017 at https://treasury.gov.au/consultation/c2017-t238960/.
23 Division 112 of the Income Tax Assessment Act 1997 (Cth).
24 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). Capital distributions paid on units may be sheltered from tax by way of non-cash tax deductions (for example, depreciation on buildings and plant). These are tax-free when received, but reduce the cost base in those units: See Section 104-70 and 104-71 of the Income Tax Assessment Act 1997 (Cth).
25 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).
26 See Division 115 of the Income Tax Assessment Act 1997 (Cth).
27 Division 855 of the Income Tax Assessment Act 1997 (Cth).
28 Subdivision 124-M of the Income Tax Assessment Act 1997 (Cth).
29 Part IVA of the Income Tax Assessment Act 1936 (Cth).
30 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).
31 Foreign Acquisitions and Takeovers Amendment (Exemptions and Other Measures) Regulation 2017.
32 Section 81, 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.
33 See Sections 52(5), (6), Foreign Acquisitions and Takeovers Regulation 2015 (Cth). For example, land under ‘prescribed airspace’, which previously applied to most land in Australia’s capital cities will no longer be subject to the lower threshold.
34 At Section 52(4), Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
35 Section 52(1), Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
36 Section 52(5), Foreign Acquisitions and Takeovers Regulation 2015 (Cth). Countries for which the higher threshold applies are Chile, China, Japan, New Zealand, Singapore, South Korea and the United States. 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.
37 Sections 77, 82, Foreign Acquisitions and Takeovers Regulation 2015 (Cth).