The Real Estate M&A and Private Equity Review: Australia
Overview of the market
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 about 50 REITs listed on the Australian Stock Exchange (ASX). Commonly referred to as A-REITs (and previously listed property trusts, or LPTs), listed REITs represent a total market capitalisation of around A$110 billion and are important players in the broader Australian market.2
There is also a substantial unlisted REIT sector in Australia, with both listed REIT managers and privately owned fund managers 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 have seen more subdued activity in the sector, with the onset of covid-19 leading to the few active takeovers being discontinued, as well as the withdrawal of a number of portfolio sales from the market.
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 2019, total foreign investment in the sector was estimated at over A$12 billion, involving about 60 transactions.3
International private equity firms and Australian-based private equity-style real estate managers have also been active in the Australian market, both as acquirers and sellers, over the earlier part of the past 12-month period.
Recent market activity
i M&A transactions
In the past 12 months, some of the more significant real estate M&A transactions have been in alternative real estate assets. Two of the more significant real estate M&A transactions over the past 12 months were the acquisition of the Aveo Group by Brookfield Asset Management; and the acquisition of Urbanest Australia by a fund managed by Scape Asset Management.
Brookfield Asset Management's acquisition of the Aveo Group
The Aveo Group was an ASX-listed internally managed retirement village owner and operator, with a portfolio of retirement villages primarily located along Australia's Eastern seaboard. It had a market capitalisation of approximately A$1 billion.
Over the course of late 2018 and 2019, Aveo conducted a strategic review and market testing exercise, announcing in August 2019 that it had entered into a binding scheme implementation agreement with Brookfield Asset Management under which Brookfield would acquire all of Aveo's securities. Aveo securityholders were offered a cash consideration valuing Aveo at about A$1.3 billion, with an option to receive unlisted stub equity instead of cash as an alternative (subject to a scale-back to ensure that Brookfield would own at least 70 per cent of Aveo following the schemes).
Scape Core Fund acquisition of Urbanest Australia
Urbanest Australia was an unlisted student accommodation owner and operator with over 14 facilities located in state capitals and more than 6,500 beds. In December 2019, the Scape Core Fund, a specialist student accommodation investment vehicle managed by Scape Asset Management and backed by Allianz, APG and AXA entered into a conditional agreement to acquire the Urbanest portfolio for more than A$2 billion. The acquisition completed in May 2020.
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 corporate real estate transactions.
Recent transactions include the acquisition by funds managed by Blackstone Real Estate of a portfolio of three office towers owned by the Scentre Group for A$1.5 billion in June 2019 and the subsequent disposal of one of those office towers to Hong Kong-listed Link REIT for A$680 million in December 2019.
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 over A$27 billion to a market capitalisation of about A$1 billion. The largest REIT, Goodman Group, is an integrated industrial property manager with assets across Australia, the Americas, Asia and Europe. The next-largest REIT, the retail property focused Scentre Group, has a market capitalisation of over A$11 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 a trust holds passive investments and does not conduct an active business. This means that income and gains derived by a 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 a 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.
The stapled structure has also been used to enable internalisation of management of REITs. Internalisation involves a 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). Over the past few years there has been increased interest in alternative real estate classes including healthcare, care of the elderly, 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.4 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. More recently, REIT IPO activity has been more subdued, with a range of different types of real estate assets being listed in 2019.
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 multidisciplinary 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 Capital, CorVal, Elanor and QIC;
- international private equity and multiple asset class fund managers, including Blackstone Real Estate, Brookfield, ESR, Macquarie Bank, Morgan Stanley Real Estate Investments, KKR and Starwood Capital Group, for whom real estate funds are one of the asset classes that they offer investors; and
- ASX-listed REITs and developers, including Charter Hall, Dexus, Goodman Group, GPT, Lendlease and Mirvac, 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.
Offshore pension funds and Australian superannuation funds are also increasingly active as direct investors in Australian real estate private equity transactions.
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 that 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 trusts, including detailed rules about matters such as a trustee's powers and fiduciary duties owed to investors.
Overlaying this is an extensive investor-protection regulatory regime under the Corporations Act 2001 (Cth) (Corporations Act).5 The majority of this regulation only applies where a REIT is required to be registered as a managed investment scheme. Registration is generally required where REIT interests are issued to retail investors, which 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.6 This requires the trustee to demonstrate the requisite capability to perform its functions as a responsible entity, as well as meeting minimum net tangible assets requirements. There are alternatives, such as engaging professional trustee companies to perform the responsible entity function.7
The Corporations Act provides for the trustee of a 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 to a third-party manager.
Registered REITs are subject to a range of requirements under the Corporations Act, including as to fundraising, 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.8 This can require detailed analysis (and sometimes Takeovers Panel and court action) to determine who is entitled to vote on REIT matters, such as the approval of trust schemes that affect the REIT's trustee.
Deal structures and terms vary depending on a range of factors, including whether a 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.9 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, 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 a 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.10 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:
- 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;
- 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;
- 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
- 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).11
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 rollover 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 the 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), and 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);12 and
- generally limited warranties and indemnities that 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 bidders 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.13 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; however, long positions exceeding 5 per cent require disclosure.
Private sale processes for REITs tend to follow a substantially similar process as that 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 unitholdings 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 the 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. It is also 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 scheme proposals by Blackstone and Oxford Properties for the Investa Office Fund in 2018, 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 the 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 carveouts 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 Takeovers Panel on aspects of the bid that can affect deal timing: for example, in the 360 Capital bid for Australian Industrial REIT, an 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 the security holders.14 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. However, the onset of covid-19 has seen the number of new money financing transactions decrease, which is reflective of more subdued corporate activity and a focus on existing transactions in the past few months.
Funding types and sources
Financing for real estate M&A is broadly divided into the following:
- 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 security is provided or not, 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 an MIT in any stapled structure). A specific tax regime designed for MITs provides certain tax benefits for REITs, with the policy intent of promoting Australia's funds management industry and its collective investment vehicle management expertise. As a result, whether MIT status will be available is usually a key consideration in structuring real estate investment transactions.
To access the MIT regime, a trust needs to satisfy certain ownership criteria and be managed by a holder of an Australian financial services licence. In addition, the trust cannot control the conduct of a trading business.15
The key benefits of accessing the MIT regime are as follows:
- 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 the distribution of any gain on the disposal of assets held by the MIT;16 and
- for Australian-resident investors, investments made by an 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.17 This enables access to the CGT discount and CGT rollover relief for the MIT.
Accordingly, where the investor mix and investment type lends itself to an MIT structure, this is generally the structure that is used.
Tax law changes relevant to stapled structures
The commonwealth government recently reviewed the use of MITs in stapled structures.18 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 an 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 new legislation designed to limit access to the lower MIT withholding tax rates where MITs are used as part of a stapled structure.19 Under the new rules, 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 changes should not materially affect the use of stapled structures to hold and manage traditional classes of real estate assets (office, retail and industrial); however, the 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), could be affected.
Proposed corporate collective investment vehicle regime
Tax law changes are also in the process of being implemented so that funds established as companies and limited partnerships are taxed on a similar basis to trusts.20 These reforms are intended to facilitate use of investment vehicles commonly used overseas in the Australian market, and complement the commencement of the Asia Region Funds Passport. However, differences between the proposed tax treatment of these vehicles under draft legislation released in December 201721 and the current tax treatment of trusts may mean that these vehicles will remain less attractive than trusts. Currently, legislation to implement the proposed corporate collective investment regime is not being actively progressed as the government pursues other regulatory priorities.
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 whether a security holder can access the CGT discount and CGT rollover relief, and ultimately affects the amount of tax a security holder pays on any gain on disposal.
An investment is generally considered to be held on revenue account where it was made for a profit-making purpose through a 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 a cash consideration and the market value of any securities or other assets received on disposal)22 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)23 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.24
Australian-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.25
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) held 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; and
- more than 50 per cent of the value of the REIT or the company derives from interests in Australian real property.26
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 in working out if any gain on the sale of shares in that company is subject to CGT.
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.27 Transactions are often structured to allow for scrip-for-scrip rollover as it allows a security holder to defer any gain made on a 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 (e.g., by a stapled group).
The acquiring entity must become the 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, if the 80 per cent threshold is not met, target security holders who accept the offer do not receive rollover relief.
Where a 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 (including the making of an irrevocable election to be an attribution MIT) 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).28 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 was abolished from 1 July 2018) generally ranges from 4.5 to 5.95 per cent of improved land value (or purchase consideration, if higher) depending on which state or territory the land is located in.29
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. All Australian states (excluding the territories) have imposed surcharges ranging up to 8 per cent on foreign acquirers of interests in residential real estate (and primary production land in Tasmania).
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 1.1 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, a 0.75 per cent surcharge applies to land in the ACT and a 1.2 per cent surcharge applies to land in Victoria, subject to certain concessions. In Queensland, if the value of a foreign owner's freehold land is greater than A$350,000, there is a 2 per cent surcharge on the value of all of that owner's freehold land above the A$350,000 threshold.
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.30
Nominally, acquisitions of interests in land (including direct investments and investments in land-holding trusts and companies) exceeding A$275 million are notifiable and must be approved by the Commonwealth Treasurer (as advised by the Foreign Investment Review Board (FIRB)).31 However, lower thresholds apply to a range of acquisitions.
An A$60 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.32
A A$15 million threshold applies to acquisitions of agricultural land.33
No monetary threshold applies to:
- most acquisitions of interests in residential land;
- most acquisitions of interests in vacant commercial land; and
- acquisitions of interests in Australian land by foreign government-related investors (including state-owned enterprises, sovereign wealth funds and many state-managed pension funds), such that all such acquisitions must be notified and approved.34
A higher A$1.192 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.35
The legislation provides a 30-day period from the date lodgement fees are paid within which a decision of whether to approve an 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.36 Failure to obtain necessary approvals can lead to divestment as well as criminal sanctions.
In response to the covid-19 pandemic, the Foreign Acquisitions and Takeovers Amendment (Threshold Test) Regulations 2020 (Cth) were introduced to temporarily reduce all monetary thresholds to zero Australian dollars. The measures are expected to remain in place just for the duration of the pandemic, but a date for reversion to the prior monetary thresholds has not yet been set. FIRB has also stated that during the pandemic, it will extend the statutory review period from 30 days to up to six months in order to accommodate the higher volume of applications.
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 47 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 an MIT 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.
Corporate real estate
Recently, real estate-heavy corporations have been increasingly exploring and pursuing strategies for the separation and spin-off or securitisation of their real estate assets.
A variety of separation structures have been used to realise the value inherent in corporate real estate portfolios:
- internally managed ASX-listed REITs (e.g., Shopping Centres Australasia Property Group spun off by Woolworths in 2012, and the Asia Pacific Data Centres Group spun off by NextDC in 2013);
- externally managed ASX-listed REITs, with the manager being the corporation that was spinning off its real estate assets (e.g., the BWP Trust spun off by Wesfarmers in 1998, the Viva Energy REIT listed in 2016);
- property-linked notes (e.g., Westfield Group in 2007 and Wesfarmers in 2013) placed with specific institutions or offered more widely in the wholesale debt capital market;
- private equity real estate fund-led acquisitions of corporate real estate portfolios (e.g., Allied Pinnacle in 2017 and Healthscope in 2019); and
- the establishment of special purpose wholesale funds and co-ownership to hold and lease back corporate real estate (e.g., Telstra and BP in 2019).
The ongoing effects of the covid-19 pandemic, and regulatory responses, including temporary rental relief measures and changes to foreign investment approval thresholds, have clouded the outlook for the Australian real estate sector.
Currently, M&A activity in the real estate sector is constrained by pricing expectation mismatches between sellers and buyers, practical difficulties in conducting on-site due diligence, the availability of acquisition finance and, to a lesser extent, additional foreign investment approval hurdles. These constraints are expected to ease over the coming period.
Generally, listed REITs are not as highly leveraged as they were going into the financial crisis of 2008. Accordingly, it is expected that distressed M&A are likely to be less prevalent in the real estate sector than it was following 2008. Real estate M&A and private equity activity are likely to be driven by corporate real estate activity, as companies resort to using their real estate holdings to raise additional funding, as well as some portfolio rebalancing as fund investors seek liquidity.
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 Australian Stock Exchange, 'ASX Investment Products (Listed Managed Investments, mFunds and ETPs) Investment Product Summary – April 2020' (Report, April 2020) www.asx.com.au/documents/products/ASX_Investment_Products_April_2020.pdf.
3 Sourced from Preqin real estate foreign investment data for the period from 1 January 2019 to 31 December 2019.
5 See Chapters ۵C and ۷ of the Corporations Act.
6 Section 911A, Corporations Act.
7 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.
8 Section 253E, Corporations Act.
9 Section 606, Corporations Act.
10 Section 601FM, Corporations Act.
11 See Chapters 6 and 6A, Corporations Act.
12 The 1 per cent break fee reflects Takeovers Panel guidelines as to the level of break fee that is not likely to be regarded as an unreasonable lock-up device: see Takeovers Panel Guidance Note 7: Lock-up devices.
13 Section 671B and Part 6C.2, Corporations Act.
14 See Takeovers Panel Guidance Note 7: Lock-up devices.
15 For the requirements to be a MIT, see Subdivision 275-A of the Income Tax Assessment Act 1997 (Cth).
16 Subdivision ۱۲-H to Schedule ۱ of the Taxation Administration Act ۱۹۵۳ (Cth).
17 Subdivision ۲۷۵-B of the Income Tax Assessment Act ۱۹۹۷ (Cth).
18 See 'Stapled Structures – Details of Integrity Package', March 2018 at https://treasury.gov.au/publication/p2018-t273732/.
19 See Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Act 2019.
20 Government, 'Budget Paper No. 2 2016-17, Budget Measures,' May 2016.
21 See the exposure draft of Treasury Laws Amendment (Corporate Collective Investment Vehicle) Bill 2017 at https://treasury.gov.au/consultation/c2017-t238960/.
22 Division 112 of the Income Tax Assessment Act 1997 (Cth).
23 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 plants). 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).
24 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 in which the loss is utilised: Division 165 of the Income Tax Assessment Act 1997 (Cth).
25 See Division 115 of the Income Tax Assessment Act 1997 (Cth).
26 Division 855 of the Income Tax Assessment Act 1997 (Cth).
27 Subdivision 124-M of the Income Tax Assessment Act 1997 (Cth).
28 Part IVA of the Income Tax Assessment Act 1936 (Cth).
29 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).
30 Foreign Acquisitions and Takeovers Amendment (Exemptions and Other Measures) Regulation 2017.
31 Section 81, Foreign Acquisitions and Takeovers Act 1975 (Cth); Section 52(5), Foreign Acquisitions and Takeovers Regulation 2015 (Cth). The monetary thresholds are indexed annually. As at the date of publication, the thresholds have been temporarily reduced to A$0.
32 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.
33 At Section 52(4), Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
34 Section 52(1), Foreign Acquisitions and Takeovers Regulation 2015 (Cth).
35 Section 52(5), Foreign Acquisitions and Takeovers Regulation 2015 (Cth). Countries for which the higher threshold applies are Canada, Chile, China, Japan, Mexico, New Zealand, Peru, Singapore, South Korea, the United States and Vietnam. 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.
36 Sections 77, 82, Foreign Acquisitions and Takeovers Regulation 2015 (Cth).