I overview of the market

Whilst the issue of the United Kingdom's exit from the European Union has continued to dominate the political landscape, the UK economy has, generally speaking, remained quite resilient. The government had, by the end of 2018, successfully completed its negotiations with the EU for a withdrawal agreement and a political declaration on the future relationship. However, Parliament has since repeatedly declined to give the approval required under UK domestic law, with the result that the UK was unable to leave, as originally intended, on the basis of a negotiated agreement on 29 March 2019. The European Council ultimately agreed to extend the UK's membership of the EU to 31 October 2019 to allow time for the government to find a way to resolve the impasse. The Prime Minister, Theresa May, announced her resignation on 24 May 2019 and is expected to be replaced by July 2019 following a leadership contest. Whether her successor will have better luck in brokering a compromise and finding a way forward remains to be seen.

Although the continuing uncertainty has undoubtedly affected the real estate M&A and private equity markets, it is important to consider Brexit in a global context. The fear has always been whether the UK (and London in particular) will continue to attract inward investment and retain its appeal as a country in which to do business, and where people from around the world want to live and work.

Overseas investors will continue to look for attractive assets and income streams and, Brexit notwithstanding, UK real estate has retained its appeal as an investment safe haven. Indeed, there are a number of factors that have continued to make the UK an attractive, and slightly more affordable, global property hotspot. These include the ongoing weakness of the pound, historically low interest rates, low unemployment, better-than-expected economic data and continuing international economic and political instability. Although total investment volumes were down on 2017, activity remained above long-run averages and the UK is the leading European destination for cross-border investment. The United States and the Asia-Pacific region continue to dominate investment volumes. The effect of investment capital control measures on Chinese investment has been offset by interest from Hong Kong, Malaysia, Singapore, South Korea and the long-awaited return of Japan. Japanese funds have begun to look further afield for healthy rates of return and UK real estate is expected to be a major beneficiary.

The office market has continued to evolve as it adapts to the requirements of occupiers. Technology, media and telecoms have been the dominant customers accounting for nearly a quarter of lettings. Flexibility and connectivity are the main requirements of the new generation of business occupier and this has been seized upon by the serviced office sector, which accounted for nearly 14 per cent of occupier activity in 2018. Operators in the co-working office sector are also competing with traditional investors for assets, for example WeWork's acquisition of the 630,000 square feet Devonshire Square estate. The serviced office space boom has not been confined to London. Cities with a growing tech and media sector, such as Manchester, Glasgow, Birmingham, Milton Keynes, Cambridge and Oxford, have also benefitted. Channel 4's new national headquarters in Leeds and new creative hubs in Glasgow and Bristol should prove catalysts for creative industries in those cities. Consolidation of a fragmented serviced office market seems likely to mean an increase in inter-operator M&A and a range of external players, including property funds and institutional investors, have started to acquire existing operators. In the wider market, significant deals have included Facebook's new 611,000 square feet headquarters at Kings Cross Central, the Chinese Embassy's acquisition of Royal Mint Court to create a new 600,000 square feet campus, the acquisition of the 400,000 square feet office building at 30 Gresham Street by Wing Tai Properties and Manhattan Garment Group and Blackstone's sale of the 329,000 square feet office building at 125 Old Broad Street, EC2 to Singapore's, City Developments.

There has been no let up in a number of high-profile casualties in the retail and restaurant sectors. Major operators, including Debenhams, New Look, Poundworld, Homebase, Mothercare, HMV and Jamie's Italian, have entered into insolvency processes. In particular, the use of company voluntary arrangements by insolvent companies to restructure their debts is facing increasing hostility from landlords, where many have been forced to accept reduced rents and closed outlets. It is estimated that almost 2,500 shops were lost from the UK's high streets in 2018 as consumers continue to do their shopping, drinking and dining at home. Shopping centres and retail parks are having to reinvent themselves as leisure and experience destinations and retailers are busy adjusting their requirement for physical space to reflect the evolution of their online presence. On a more positive note, the prime central London market continues to attract luxury retailers eager to cash in on the spending power of affluent overseas visitors. The industrial sector has also benefitted from the growth in online retail. Demand for large, well-connected and high specification sheds remains strong in the logistics sector and there has been a pick up in speculative development to meet the needs of occupiers. Key transactions included Blackstone and M7 Real Estate's purchase of the Powerhouse portfolio and Legal & General's acquisition of Woodside Industrial Estate.

The real estate investment market has continued to diversify as investors search for returns in alternative sectors. The UK hotel market accounted for 37 per cent of total investment in the UK specialist property sector and overseas buyers accounted for 78 per cent of volume. Total investment volume for 2018 was £7.4 billion, although the majority of this was transacted in the first half of the year. Private equity vehicles, including Starwood Capital, Apollo Global, Oaktree Capital Management and Lonestar, continued to divest their hotel stock. Key deals included Starwood Capital's disposal of the 12-strong Principal Hotel Group to Covivio, Lone Star's sale of the Amaris hotel portfolio and operating platform to LRC Group, Apollo Global Management's disposal of its 20-hotel Holiday Inn and Crowne Plaza portfolio to HNW Dayan Family and Brookfield's acquisition of the SACO Group. Key single asset deals included Grosvenor's sale of the Beaumont Hotel, Cola Holdings acquisition of the Hilton London Kensington and Katara Hospitality's acquisition of Grosvenor House. Other attractive alternative asset classes include the private rented sector, logistics, student accommodation, data centres, retirement villages, energy and infrastructure.

The London residential property market remains subdued. House prices in central London remain the hardest hit with only a few of the outer boroughs offering limited growth as investors have looked further afield for value. The picture in the regions is more positive with Scotland and the north of England enjoying annual growth of around 7 per cent. The West Midlands and Birmingham have also seen healthy house price growth and this will be boosted by Birmingham hosting the 2022 Commonwealth Games and the City's associated redevelopment projects. Plans to introduce an additional 1 per cent Stamp Duty Land Tax (SDLT) surcharge on non-residents acquiring residential property in England and Northern Ireland will increase the burden of an already punitive tax regime. On a more positive note, a lack of supply means that medium to long-term prospects remain good and price reductions in the ' super-prime' market have created buying opportunities.

In financing, the market has remained strong in the face of ongoing political and economic uncertainty. New lending for real estate rose by 12 per cent in 2018 to reach £49.6 billion and there was an increase in new loan origination against outstanding loan books. The appetite for risk has varied across the sectors with a marked increase in the cost of loans secured against retail property. Alternative lenders have continued to be active and non-bank lending has become an established part of the real estate finance sector.

ii RECENT MARKET ACTIVITY

i Transactions

Blackstone Property Partners and Telereal Trillium have agreed to acquire a £1.46 billion commercial real estate portfolio from Network Rail Infrastructure involving 5,200 assets.

Real estate funds managed by The Blackstone Group acquired a European logistics portfolio from Industrial Securities Europe and MCAP Global Finance for £433.57 million.

Bowmark Capital, MML Capital Partners and management acquired The Instant Group, an independent flexible workspace provider.

The Reuben Brothers acquired Burlington Arcade from Thor Equities and Meyer Bergman for £300 million.

KKR and Round Hill Capital acquired a portfolio of four student accommodation developments from Watkin Jones Group for £180 million.

The Blackstone Group acquired M7 Real Estate's Column portfolio for £110 million.

Sekisui House acquired a stake in Urban Splash.

Singapore Press Holdings has acquired a portfolio of purpose-built student accommodation units from Unite for £180 million.

Aprirose acquired a 45-asset Spirit Pub Company portfolio from British Land for £130 million.

Westbrook Partners has acquired a portfolio of light industrial estates and trade counters from IO2 for £140 million.

Employees Provident Fund and Permodalan Nasional Berhad acquired Battersea Power Station Building for £1.6 billion.

Sourced acquired the Regent Plaza residential development in Manchester for £150 million.

Ashby Capital acquired Kensington Arcade and 127 Kensington High Street from Columbia Threadneedle Investments for £200 million.

Tritax Big Box REIT has agreed to acquire an 87 per cent interest in db Symmetry from DV4, a fund managed by Delancey Estates, for £322 million.

Avison Young has agreed to acquire GVA Grimley from Apleona.

Hana Alternative Asset Management has agreed to acquire Sanctuary Buildings from The Blackstone Group for £280 million.

Arlington Advisors and Equitix acquired student accommodation in Leicester and the Stellar Portfolio for £280 million.

UK Commercial Property REIT acquired a portfolio of five distribution warehouses in the Midlands from Clipstone Logistics for £85.4 million.

Stenprop acquired a portfolio of 22 industrial properties from Hansteen Holdings for £67.9 million.

Hana Alternative Asset Management acquired One Poultry for £185 million from Aermont Capital.

Kiwoom Asset Management acquired Cannon Green from Ocubis for £120 million.

Korean institutional investors acquired 125 Shaftesbury Avenue from Almacantar for £270 million.

Ella Valley Capital acquired 55 Gresham Street from Angelo Gordon and Beltane Asset Management for £180 million.

An Asian investor has agreed to acquire a 50 per cent interest in Highcross shopping centre in Leicester from Hammerson for £240 million.

Singapore's City Developments acquired 125 Old Broad Street from Blackstone for £390 million.

Ares Management has agreed to acquire a portfolio of 12 assets from AEW UK South East Office Fund for £140 million.

An Asian family office has agreed to acquire London Executive Offices from Queensgate Investments for £480 million.

Dobbies Garden Centres acquired 31 garden centres from Wyevale; this followed the earlier acquisition of six Wyevale centres.

Global Infrastructure Partners disposed of a 50.01 per cent shareholding in London Gatwick Airport.

Liberty Property Trust acquired a portfolio of warehouses and logistics centres from Leftfield Properties for £110 million.

Norges Bank Real Estate Management acquired 60 Holborn Viaduct for £320 million from Hines.

Deka Immobilien acquired Verde SW1 from Tishman Speyer and PSP Investments for £460 million.

Singapore's City Developments acquired Aldgate House from Hermes Real Estate Investment and Canada Pension Plan Investment Board for £180 million.

Ascendas REIT acquired a portfolio of 12 logistics properties from Oxenwood Catalina for £257 million.

Spelthorne Borough Council acquired a £290 million portfolio from Brockton Capital and Landid Property Holdings.

Pontegadea Immobiliaria acquired the Adelphi Building for £550 million from the Blackstone Group.

JT Real Estate entered into a joint venture to acquire a prime residential scheme at 185 Park Street from Delancey Estates for £400 million.

Capreon acquired two retail parks from Hammerson for £160 million.

Korea Asset Investment Management acquired Gallagher Shopping Park in the West Midlands for £180 million from KKR and Quadrant.

FG Asset Management and The Valesco Group agreed to acquire 20 Old Bailey for £340 million from The Blackstone Group.

Lendlease and London & Continental Railways sold offices at International Quarter London to DWS Group for £240 million.

Korea Investment & Securities acquired 70 Mark Lane for £200 million from Mitsui Fudosan and Stanhope.

Aviva Investors sold 20 Soho Square for £120 million.

CK Asset Holdings acquired 5 Broadgate from GIC and British Land for £1 billion.

M&G Investment Management acquired Charterhouse Estate for £256 million from Anglo American.

M&G Real Estate acquired a 50 per cent stake in Fort Kinnaird for £170 million from the Crown Estate.

Strathclyde Pension Fund acquired a retail parade in Clapham for £130 million from Delancey.

Starwood Capital agreed to sell its Principal Hayley hotel platform to Foncière des Régions for £750 million.

Wing Tai Properties and Manhattan Garments Group acquired 30 Gresham Street for £400 million from Samsung Life.

IPOs

Glenveagh Properties raised €213 million with its firm placing and placing and open offer to fund new developments.

Tritax EuroBox raised £300 million through its placing, offer for subscription and intermediaries offer on the Specialist Fund segment of the main market of the London Stock Exchange.

Yew Grove REIT issued 72.5 million shares on the Alternative Investments market of the London Stock Exchange and on Euronext Dublin.

MENA Land offered shares on the Standard Listing segment of the Official List and to trading on the London Stock Exchange.

Urban Exposure raised £165 million on its AIM listing.

iii REAL ESTATE COMPANIES AND FIRMS

i REITs

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.

Main conditions

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:

  1. it must be resident in the United Kingdom for tax purposes;
  2. 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;
  3. 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
  4. 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.

ii Recent developments

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. That said, the recent introduction of the indirect chargeable gains charge (discussed in more detail below) has possibly soured things a little, by making disposals by non-residents of holdings in UK REITs subject, in principle, to UK tax.

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, Hammerson and Canary Wharf Group. The number of UK REITs has grown significantly in recent years (including externally managed UK REITs) to over 50.

iii Real estate private equity firms

Structure

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:

  1. has a finite life (usually 10 years with a possible two-year extension, although some have investors with rolling annual commitments);
  2. has one general partner with unlimited liability for the liabilities of the partnership;
  3. has a number of limited partners (LPs) whose liability is limited to the amount of their equity investment in the partnership; and
  4. 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.

Footprint

Private equity firms have been major investors in UK real estate in recent years. Investment has been made across a wide range of sectors including hotels, residential schemes, housebuilding, health care, student housing, restaurants, serviced offices, logistics and retail.

Private equity firms have continued to raise large amounts of capital for investment in UK and European real estate and investment activity has been buoyed by the relatively low risk opportunities afforded by real estate in terms of a reliable income stream and capital growth.

IV TRANSACTIONS

i Legal frameworks and deal structures

Legal frameworks

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 on, in each case, a number of factors and considerations (including funding, tax and exit routes (for private equity funds)). Typical structures include:

  1. 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;
  2. limited partnerships: discussed above in relation to private equity firms;
  3. 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;
  4. 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 to, depending on the structure, general common law rules, the legislative provisions of company and partnership law and the provisions of the JV agreement;
  5. 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
  6. REITs.

Deal structures

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 a way to make contractual claims in respect of warranties and post-completion purchase price adjustments.

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 seller'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.

Conditionality

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 and completion, several practical matters should be considered, including whether:

  1. shareholder (or equivalent) approval is required by either party;
  2. EU merger clearance is required;
  3. any warranties given at signing need to be repeated at completion;
  4. rescission is possible between signing and completion;
  5. any deposit paid at signing should be returned to, or forfeited by, the buyer if the transaction does not complete; and
  6. management of the underlying properties is required and, if so, whether the buyer will exercise control.

Rescission

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 by the buyer (e.g., to procure debt finance), it is less likely the buyer will be able to negotiate a rescission right for anything other than material breach of any restrictive conduct provisions.

Buyer protections

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 seller'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.

Warranties

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.

Indemnities

Where a buyer identifies (through due diligence) a particular risk or liability that it is unwilling to assume (e.g., environmental risks, or planning liabilities) 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.

Seller protections

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.

ii 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:

  1. charges by way of legal mortgages over real estate assets;
  2. charges over rents receivable;
  3. potential charges over bank accounts into which rents are paid; and
  4. 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 drawdown 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.

iii Tax considerations

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 (at least, not yet – see below). 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. Otherwise, even if the buyer can recover all of its VAT, the VAT amount will count towards the SDLT calculation and thus create an absolute cost in all cases.

Interest charges on borrowings are, generally speaking, 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.

With effect from April 2017, the UK introduced a new restriction on the deductibility of debt finance for corporation tax purposes, similar to those that have existed for some time in other jurisdictions (such as Germany). The UK regime limits interest deductions to 30 per cent of a group's taxable EBITDA. The intention is more to discourage groups shifting a disproportionate amount of debt into the UK than to attack debt finance as such. Accordingly, groups that are highly geared on a worldwide basis may benefit from making an election that permits the use of a percentage based on the ratio of the group's net interest expense to its global accounting EBITDA. There is also an exemption for third party debt incurred by 'infrastructure' companies that, somewhat generously, extends to companies carrying on a UK property letting business (provided the leases in question are to third parties and do not exceed 50 years duration).

A significant change to the taxation of offshore investors in UK real estate was announced as part of the 2017 Budget. With effect from April 2019, non-resident companies became subject to tax on profits and gains arising from holding or disposing of UK real estate in the same way as UK resident companies. Previously, non-resident investors paid only income tax on rents, and, although disposals of residential property by non-residents have been subject to capital gains tax since 2015, the new tax charge covers all forms of UK property. A more surprising part of this package was that non-residents that dispose of indirect interests in UK property (essentially, shareholdings in 'UK property-rich' companies or collective investment schemes) are now in principle liable to UK tax on any gain, subject to any exemption and the terms of any applicable double taxation treaty. A company will be UK property-rich if more than 75 per cent of its gross asset value is attributable to UK real estate (whether held directly or via subsidiaries). A non-resident will be subject to tax on any gain if it holds a 25 per cent or greater interest in the company, or has done so within the preceding two years and with interests held by connected parties being aggregated. However, investors in collective investment schemes (including UK REITs) do not benefit from this 25 per cent threshold unless the vehicle they invest in is widely held and is marketed as being invested as to no more than 40 per cent (by market value) in UK real estate. The UK has not before attempted to tax non-residents in this way, and this change has received much negative comment. It is also widely seen as a precursor to the introduction of ' indirect' SDLT, similar to the German RETT, although no formal proposals for this have yet been announced.

v OUTLOOK

Although it is impossible to predict the future, the outlook for UK real estate M&A and private equity is more positive than had been feared. Brexit will undoubtedly have a significant effect on the market for some time to come, irrespective of when, how or indeed if the UK leaves the EU. Taking a global view, it can be argued that the UK's position is such that membership of the EU has limited significance and that London will remain a truly global city irrespective of Brexit. Continuing global political and economic uncertainty, including the escalation of the US-China trade war, political instability in Europe, ongoing concerns about the Chinese economy and the threat of confrontation with North Korea, suggest that UK real estate will continue to attract global investment capital. Indeed, to many overseas investors, the tightening of the UK's tax regime for the direct or indirect disposal of UK commercial property by non residents will be of a far greater significance than Brexit. Other concerns for investors include the threat of a Labour government and the proposed introduction of a new beneficial owners register for overseas entities holding UK real estate.

UK real estate is, of course, only one aspect of a multi-faceted global investment market. Competition is strong and the UK must work hard to continue to attract inward investment. Areas of concern include the need for an investor-friendly tax regime, flexible planning laws, an acceptable immigration policy, a fully functioning hub airport and other infrastructure, affordable housing stock and the preservation of London's status as an international centre of legal excellence. Progress on transport infrastructure remains slow. Completion of the Elizabeth line has been further delayed and the expansion of Heathrow Airport has faced legal and political challenges. The government is also still to commit to much needed new transport projects, such as Crossrail 2 and the Northern Powerhouse rail network. The UK's immigration policy post Brexit will be a major factor if the UK is to retain its status as a place to do business. The UK's continued success is dependent on its ability to attract both a skilled and unskilled workforce. The opportunities offered by other leading global cities, the rest of Europe and the world's emerging economies will provide stiff competition for the increasing amounts of global capital available for investment.

Although risks and challenges remain, UK real estate will retain its appeal for overseas investors and maintain its key role in the global investment market. There will be plenty of opportunities in the UK real estate M&A and private equity markets as a wide range of investors continue to look for value and higher rates of return across the full spectrum of real estate assets. Practitioners can help their clients to develop an appropriate strategy to ensure that risks are assessed and monitored and opportunities are taken.


Footnotes

1 Richard Smith is a partner, Ed Milliner is a senior counsel and Graham Rounce is a professional support lawyer at Slaughter and May.