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The Word on the Street: Client & Industry Perspectives on Global Real Estate Markets
When Taxand's global real estate team was asked to leverage their advisory skills and actively engage market participants in obtaining up-to-date input on the state of the industry, the impact of regulation and the ever-changing role of the tax function, the team found the exercise natural and rewarding. After all, keeping up with market trends and constantly searching to better understand the private equity real estate industry and the various influencing macro and micro factors is nothing new for Taxanders. The resulting report represents a summary of the key takeaway points of multiple interviews with Taxand clients, trade representatives and industry influencers.
How do you see sovereign debt concerns affecting yields on existing assets and the pricing of future deals?
The process of pricing future deals has not changed: it is driven by product profile and the availability of financing, which for core-based assets remains competitive, both Taxanders and interviewees agree. Australian residential is one example of a "red hot" product. There are robust discussions about the risk curve for value-added and opportunistic investments. Some see a shift to value-added and opportunistic from core, which depends on the interest / capacity to manage risk and the position in terms of the life cycle of the fund. Interviewees also point to the direct correlation of the sovereign debt crisis and financing costs leading to overall increased pricing on deals.
Another factor to consider is the traditional use of sovereign bonds as a "risk-free" rate from which to price real estate off. That "affects cross-border investors more than domestics one," notes Simon Mallinson, director of European research at Invesco Real Estate. "A cross-border manager with local, on-the-ground teams is able to price the market like domestic buyers and sees through the medium-term sovereign debt issues." While some of the interviewees could not name safe havens,they remarked on spotting real estate bubbles developing in markets like London and New York. "It would be interesting to closely monitor and see what happens when inflation kicks in," they note.
Will recent stock market volatility encourage investors to reduce allocations to real estate equities and potentially increase unlisted real estate allocations?
While many of the interviewees didn't see a significant allocation shift to unlisted real estate and overall found it was too early to confidently say, INREV, the trade association representing the non-listed real estate industry in Europe, reported a noticeable shift. According to a recent survey prepared by the association in conjunction with ANREV (INREV's Asian counterpart), the majority of investors (in Europe and Asia) currently see and "anticipate increasing their allocations to non-listed products such as real estate debt funds, mezzanine debt, separate accounts and joint ventures." The survey reports that this trend is driven by the desire for more control, the anticipated outcome of regulatory initiatives, access to expert management, returns and diversification.
"It's all about income at the moment. Real estate, either listed or unlisted, delivers an attractive cash yield that meets long-term liabilities," says Mallinson. "It depends on the type of investor." Short-term investors might reduce their equity exposure overall, but not the real estate component of it; long-term investors are focused on the return over time and are willing to ride out the volatility. "We are seeing an increase in unlisted real estate allocations, however, this appears to be new capital allocated rather than swapped from real estate equities," he concludes.
A representative of one of the largest real estate fund managers in Europe says: "We are seeing some re-allocation but consider that a short-term trend. Everyone is re-thinking their strategies and taking the volatility of equities under consideration." Another interviewee of similar stature adds, "What we are concerned about is the "denominator effect," which may reduce the absolute allocation to unlisted real estate, penalising the latter for the volatility of listed securities."
Indeed, real estate equities, such as listed REITs, still may be the big winners once inflation and capital markets return to stability. Taxand research shows that listed REITs have outperformed the S&P 500 for the first half of 2011, as well as over a period of 12 months (June 2010 - June 2011). "Transparency, liquidity and alignment of interest with capital players will remain the leading reasons behind the continued interest in listed real estate," according to both INREV and interviewees.
The macroeconomic climate is one of fiscal difficulty for most governments. The same climate has created pools of distressed assets, which slowly are becoming available on the market. Do you see the two being connected, i.e. governments trying to plug their deficits by targeting foreign investors in local distressed assets?
Representative of large European fund managers note seeing some sale-leaseback transactions and disposals of institutional properties, which they attributed to the current macro climate. "At the end of the day, it's about improving the bottom line for most governments, i.e. reducing expenses and increasing income."
Those managers were of the opinion that, once governments realise there is no longer growth outside inflation, they will seek to broaden the tax base. "Prepare for an increased level of scrutiny from the regulatory authorities," most contributors agree, noting that tax authorities are becoming smarter overall and doing a better job of talking to one another.
"[Tax authorities] will most likely focus on enforcing existing policy on transfer pricing and substance," interviewees point out. Tax on management fees in countries where assets are located could be another easy target. One large fund manager wishing to remain nameless adds: "While we are concerned about the transfer pricing of our recurring management fees, the elephant in the room is the allocation of carried interest."
Do you walk away from an asset if the structure gives rise to an effective tax above a certain rate or is it just another expense line?
While tax is not the driver behind an investment decision, it certainly is a significant factor. Industry influencers agree across the board that, while they have not yet walked away from an asset because of a structure that gives rise to an effective tax above a certain rate, they have backed off assets when the after-tax returns are below the targeted IRR.
"When it comes to structures, simple is better," says Demetri Rackos, managing director of tax at LaSalle Investment Management, the Chicago-based real estate investment giant. An industry veteran, Rackos stresses the importance of employing a cost-benefit analysis in evaluating complex structures and the fiduciary duties to the investors. "A simple deal, even if it does not produce the lowest possible effective tax rate, is still acceptable so long as it produces good after-tax returns."
While tax would not drive the decision for investments, it is an important factor. All parties involved (i.e. deal, financing and operations teams) need to understand the value of smart tax planning in this difficult environment.
What is your approach to tax litigation: do you handle each case on its own principled merits or take a portfolio approach and seek to settle cases based on probabilities regardless of merits? Who drives the decisions: a centralised tax function or the individual asset managers? Do you sense a drift in any jurisdictions you are active in that goes against real estate investors and is it particularly focussed on foreign as opposed to local investors? Which jurisdictions do you regard as being especially worrisome in this regard?
The contributors to this piece found this point tough to explain as it is "not always black and white" and usually needs a case-by-case approach. "It's like looking into a dark room with sunglasses and figuring out the shade of grey," one of them quips. Most of the firms are pragmatic and would look at the merit of the case and the impact on the fund or the asset: they would fight against big amounts and likely settle on small ones.
As for who drives the decision, Taxanders received a unanimous answer: "It's a team decision." The leading tax functions work closely with deal leaders and the CFOs of platforms to identify the best solutions for the particular fund. It's a system of collaboration and checks and balances across the industry, Taxanders found. In most cases, neither function has the authority to settle on its own.
The participants, who on a daily basis act as foreign direct investors, felt as if the tax man was coming after them. Although the process appears to be arbitrary, France, Germany, India, Japan, Korea, Mexico, Russia (e.g. VAT recovery) and the US were mentioned by the interviewees as some of the jurisdictions where they are experiencing heightened sensitivity.
Have you been engaged with pension funds seeking an individualised structure in order to be able to access tax benefits particular to pension funds, even if it requires specific structuring for that individual investor? Is there a particular level of equity commitment below which you are not prepared to facilitate the pension fund?
Deciding on when to customise a structure to accommodate pension funds for tax benefits would depend on the situation. The industry leaders that Taxanders spoke with have both seen and designed tailored structures for individual groups. The most often-quoted structures were parallel structures for US investors into Japan and the reverse: REITs for non-US investors into the US and increasing numbers of European parallel structures for European tax-exempt institutions investing cross border.
Germany is one example. "We have been actively involved in these types of solutions for both individual funds and fund of funds structures," says Stefan Rockel, managing director with Universal-Investment, the largest independent investment company in the German-speaking countries. "Furthermore, we currently are involved in industry discussions on adding rules to the German Investment and Investment Tax Act, as the need for regulated, cross-border pension pooling structures has been acknowledged by the German authorities."
Evaluating facilitation of an individual pension fund based on a level of equity commitment appears to be another example of a case-by-case approach. Some of the participants admitted to no stringent threshold requirements, while others quoted
specific limits (not considered if below $20 million and certainly if above $100 million) and numbers of investors.
How do you manage/ model the risk of future tax law changes in such an uncertain environment? Are there particular jurisdictions where you regard the risk as being especially acute? Are there particular proposals that you view as especially favourable or unfavourable?
"Modelling and managing the risk of future tax law changes is the most difficult part of my job," admits La- Salle's Rackos. "It requires continuous engagement with deal teams, tax advisors and lawmakers." Striking a balance between structuring sophisticated structures and keeping them current with the ever-changing tax codes is a delicate job, the interviewees agree.
While risk is material in all jurisdictions, most participants segmented their approach using the maturity of the jurisdiction as a base.
(i) In established jurisdictions, the risk is factored only on the basis of the existing tax laws. For example, Germany and even the US represent markets where participants rarely have seen a large impact of changes. Hence, the risk factor is between 10 and 40 and the structures used usually are fairly straightforward.
(ii) Emerging markets present greater risk. Often, if the proposed tax changes are unclear or offer something under stress, the participants agree they may underwrite more than 50 percent in terms of cost for change. India (i.e. the case of Vodafone) is a prime example of that. Other jurisdictions in this category include China, Mexico, Brazil and Korea (i.e. the evolving treatment of beneficial ownership).
The bottom-line feedback on this point is to not only constantly follow and communicate the impact of the tax law developments, but also to prepare to modify existing structures before the tax law changes take effect.
Do you centralise tax management with a centralised tax function or decentralise it to the teams making the investment decisions? Do you manage group tax risk on management fees, carry, etc. with the same teams that manage the = investmentlevel tax risk or separately? What's the proper balance?
To centralise or not to...that is the question. As a general rule, the internal tax functions appear to have a hybrid reporting line - technically centralised, but operationally decentralised. The tax leaders that Taxanders spoke with are spending the majority of their time providing advice on new deal structures, communicating risk and managing controversy. In these cases, the tax functions involved with operating matters sit with the finance teams but report to the centralised tax lead function. This topdown / bottom-up framework provides agility and efficiency.
In a few cases, Taxanders discovered firms with a decentralised approach to the internal tax team. Some of them actually consider their structure "more centralised" because the tax team is considered a part of the deal team, which ultimately produces the returns. This approach is very results-oriented and focused.
Where does the tax function spend the majority of its time: transactions, transfer pricing, effective tax rate planning, compliance, litigation or risk management? Have there been significant shifts over the last 24 months?
There have been significant shifts over the last 24 months, which reflect the changing times. During the period of 2007 to 2008, the majority of those interviewed agree that they were occupied with heavy transaction volume. Over the last two years, they have seen a shift to risk management, and today they find themselves balancing risk, controversy and on-going tax management. Time allocations among the three tasks depend on the region and economics, Taxanders report.
Do your external advisers work with deal teams directly or do they go through internal tax, finance or legal teams for "translation" purposes?
Taxanders found that firms are using another hybrid approach in selecting when and whom to employ. That decision is driven by the quality of the advisor, the complexity of the product and the need to ask tough questions. The latter two points tend to call for involvement of the internal tax function and, when an external counsel is involved, it's normally one with a well-established relationship with the firm - trusted advisors, one might call them.
How are you managing substance/ beneficial ownership issues in your investment structures and what are your interactions with investors on the subject?
Taxanders discovered that, as a result of the heightened sensitivity of investors and the increased scrutiny of complex structures, firms are managing substance and beneficial ownership issues by involving external counsel to guide them through the specificities of certain jurisdictions, amplifying their focus on jurisdictions with strong platforms and avoiding those with administrative functions only and, overall, shifting to a more conservative policy.
"This always has been a substantial part of prudent administration of investment structures for us, but the focus is even greater today," says Andreas Walter of Universal-Investment. "We are encouraging our asset managers to invest in attracting board members with the most appropriate credentials and experience. We are setting up processes to ensure that all parties involved understand the importance of this issue and have real substantial conversations at the statutory seat of the company, while managing the need for a fast, goal-oriented decision process triggered by the investment advisor."
In conclusion, there are several pieces of advice that private equity real estate firms should consider when dealing with the global property markets and the ever-changing regulatory and tax regimes surrounding them. They are: prepare to pay more for core properties; balance your listed and unlisted real estate products; prepare for an increased level of scrutiny from the regulatory authorities; match your organisational structure and tax approach to the business model and strategy of the firm; and constantly follow and communicate the impact of tax law developments. It also helps to modify existing structures before the tax changes take effect.
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