UK real estate insights - PwC UK blogs · 2013. 1. 17. · UK real estate insights Issue 13 ... (a...

UK real estate insightsIssue 13 – July 2009

02 Introduction04 The UK economy10 ‘Hold versus Sell’13 Investment in real estate distressed debt17 Governance and controls in the

perfect storm19 Corporate occupiers – maximising value

from property23 Finance Bill 200926 Accounting for real estate – amendment

to IAS 40 ‘Investment Property’30 Guarantees in play32 Proposed EU Directive on Alternative

Investment Fund Managers35 The state of pay – real estate

executive remuneration36 The day after tomorrow for

asset management39 Withholding tax on dividends40 EventsPrint Quit

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UK real estate insights HomeQuitPrint

IntroductionReasons to be cheerful, part 3

Welcome to the latest edition ofUK real estate insights. In theprevious two editions we havecommented on the changingnature of the real estate crisis asthe situation has moved beyondone of falling values into a marketwith deteriorating real estatefundamentals. In the April issue,we speculated as to whether wemight be reaching the bottom ofthe market, and what the bottommight look like. Since then,divining the future has notbecome any easier – the augursprodding at the entrails arereceiving very mixed messages.

There are increasing signs of buyersfrom overseas returning to the UK,particularly from Germany and theMiddle East and also some home-grownrecovery funds. Generally, they arelooking for properties with long leasesand strong covenant strength tenants,although there are some examples ofbuyers being slightly less demanding(in the words of Mike Prew from Nomura,not insisting on ‘marmalade on theirtoast’). However, for those lookingfor reasons not to be cheerful, there arealso plenty of signs of distress.In June, administrators fromPricewaterhouseCoopers1 wereappointed at Rock Investments, althoughin that instance the very extensive mediacoverage probably had more to do withPaul Kemsley’s role as one of Sir AlanSugar’s interviewers on The Apprenticethan the importance of Rock to the UKeconomy. Other administrations andreceiverships of property companieshave also been hitting the press. Even onthis, there is a debate as to how itshould be interpreted. Is the increasinglyinterventionist activity by the banks asign that the situation is continuing todeteriorate or that they believe that wehave reached the bottom?

The equity raisings by propertycompanies and funds also sends mixedmessages. The debt covenant breachesthat they are remedying are a clearindicator of the continuing fall in values.

There is also clearly an opportunisticelement. Ian Coull of SEGRO, afterspeaking at our annual real estateclient conference on 21 May, hot-footedit back to his office to announce a bidfor Brixton...

The key issue now is the state of theoccupier market and we have included

our latest economic forecasts in thisedition of UK real estate insights. Asmight be expected, the messages hereto are mixed. A number of economicindicators suggest that although thingsare not yet getting better, at least therate of decline is moderating. However,

Continued 21 “PricewaterhouseCoopers” refers to PricewaterhouseCoopers LLP

(a limited liability partnership in the United Kingdom).


Introductionas our UK economic outlook points out,“the extent of the good news should notbe exaggerated and to a significantextent just reflects the normal operationof the stock cycle”. “Destocking made amajor contribution to the very sharp fallin GDP in Q4 2008 and Q1 2009. Whilethe reversal of this stock adjustmentcould lead to quarterly GDP growthbecoming positive again before the endof 2009, there is a risk of a relapse intorecession in early 2010 (allowing also forthe effect of VAT rising back to 17.5%from 1 January 2010).” The prospect ofunemployment continuing to rise is alsoof direct concern to the real estateindustry. Fewer people occupying deskswill add to the issue of grey space inoffices as well as reducing their capacityto spend in the shops.

The current issue of UK economicoutlook includes a detailed assessmentof the potential adverse impact of thedownturn on different age groups, asubject likely to be of particular interestto retailers and their landlords. “We findthat the youngest age group is the mostexposed to rising unemployment, butthat older workers nearing retirement willalso be severely hit as they are not onlyat relatively high risk of losing their jobsin downsizing exercises, but will alsohave seen their prospective pensionsand their housing wealth fall verysignificantly over the past two years.”On the positive side, the report does

come with a less dramatic healthwarning on downside risk than theprevious edition.

So for both the broader economy andthe real estate markets the outlook is stillunclear. However this is at least animprovement on unremitting gloom.Reasons to be cheerful? The jury isstill out.

Finally, as already mentioned above,we held our annual real estate clientconference on 21 May. More details areincluded elsewhere in this edition of UKreal estate insights, but I would like totake the opportunity in particular tothank our experts from the industry forthe lively panel discussion: Ian Coull,Chief Executive, SEGRO; NickJacobson, Managing Director, Head ofEuropean Real Estate & Lodging,Citigroup; Michael Kenney, SeniorDirector, Hypo Real Estate; and AndrewWood, Chief Investment Officer, MGPA.

3


The UK economyAs discussed in the previousedition of UK real estate insightsand at our conference in May, thenature of the real estate crisis ischanging, and we are seeingincreasing signs of tenantdistress. The prospects for the UKeconomy are therefore key.Simultaneously with thepublication of this edition of UKreal estate insights, we are alsopublishing our UK EconomicOutlook. The executive summaryof the report is set out below.

Highlights

• UK GDP is projected in our mainscenario to fall by around 4.25% in2009, but GDP should start to pick uplater this year and into next year, withmodest average growth of around0.5% in 2010 projected in thisscenario.

• Consumer spending growth is alsoexpected to turn negative at -3.5% in2009, due to the severe squeeze onconsumer spending from high debtlevels, tighter credit conditions,falling housing wealth and risingunemployment. We also expect afurther 0.75% decline in consumerspending in 2010 and only a gradualrecovery thereafter as householdsseek to reduce their debt burdens andreturn their savings ratios to morenormal levels.

• Business investment growth isexpected to fall sharply in 2009 as aresult of the continuing credit crunch,while housing investment will alsocontinue to decline. In our mainscenario, house prices may notbottom out until 2010 with only a verygradual recovery thereafter.

• Destocking made a major contributionto the very sharp fall in GDP in Q42008 and Q1 2009. While the reversalof this stock adjustment could lead to

quarterly GDP growth becomingpositive again before the end of 2009,there is a risk of a relapse intorecession in early 2010 (allowing alsofor the effect of VAT rising back to17.5% from 1 January 2010).

• Public spending growth will remainpositive in 2009 and 2010, but willneed to be cut back sharply in themedium term to bring under control abudget deficit that is projected to riseto over 12% of GDP in 2009/10.Significant tax rises are also likely tobe needed from 2011 onwards, overand above what the government hasalready announced.

• Slower global growth has dampenedexports, but imports have fallen evenmore sharply, which should enable netexports to make a positivecontribution to overall GDP growth in2009. The relative weakness of thepound compared to levels typicallyseen in the previous decade will alsotend to support a gradual export-ledrecovery in 2010.

• Risks around growth in our mainscenario are more balanced thanearlier this year, but are still somewhatweighted to the downside. Wetherefore recommend that businessesshould stress test their plans andvaluations against an alternative‘prolonged recession’ scenario in

which GDP falls by around 5% in2009, with negative growth continuinginto 2010. But an upside scenariowhere growth rebounds to abovetrend levels by the end of 2010 canalso not be ruled out.

• Inflation is projected to fall back belowtarget during the second half of 2009as the economy slows and to remainbelow target during 2010, but thereare still considerable uncertaintiesaround this relating to the path ofglobal commodity prices and sterling.

• The bank rate is assumed to be left at0.5% for the rest of 2009 in our mainscenario. There will be a continuingfocus on quantitative easing by theBank of England to ease liquidity andcredit conditions in key financialmarkets.

• This issue includes a detailedassessment of the potential adverseimpact of the downturn on differentage groups. We find that the youngestage group is the most exposed torising unemployment, but that olderworkers nearing retirement will also beseverely hit as they are not only atrelatively high risk of losing their jobsin downsizing exercises, but will alsohave seen their prospective pensionsand their housing wealth fall verysignificantly over the past two years.

Continued 4


The UK economyRecent developments

The UK economy moved into a severerecession during the course of 2008,with the rate of decline accelerating evenfurther in the first quarter of 2009according to the latest official GDPestimates (see Figure 1.1).

More recent business surveys and datareleases point to a significant moderationin the rate of decline in Q2 2009,although official GDP estimates for thatquarter were not available at the time ofwriting. Consumer and businessconfidence has become less negative,purchasing managers surveys now pointto a modest upturn in activity in servicesand less steep declines in manufacturingand construction, and the housingmarket has also shown some tentativesigns of stabilising, albeit at a low level.Several other major economies have alsoshown signs of bottoming out accordingto OECD leading indicators.

However, the extent of the good newsshould not be exaggerated and to asignificant extent just reflects the normaloperation of the stock cycle: the periodof very sharp destocking has run itscourse, which will lead to an automaticrecovery in orders and output levels inthe short term, but the question iswhether this upturn can be sustained inthe face of rising unemployment and stillfragile confidence levels. Credit

conditions have improved to somedegree, but are likely to remain relativelyconstrained for some time to come. Oilprices have started to rise again and thepound has not been as weak in recentmonths as it was earlier in late 2008 andearly 2009.

Governments around the world haveintroduced fiscal stimulus packages tosupport monetary policy easing,although these are pushing budgetdeficits up to worryingly high levels froma longer term perspective, not least inthe UK. The global financial systemremains fragile, with further major shockspossible, despite governmentintervention to support the bankingsystem across the world.

Future prospects

Our main scenario sees UK GDP fallingby around 4.25% in 2009, but withquarter-on-quarter growth edging backinto positive territory by the fourthquarter, due in large part to the stockcycle effects mentioned above. But therecould be a relapse into negative growthin Q1 2010 after VAT rises back to17.5% on 1 January next year.Thereafter, we would expect a gradualrecovery to resume as the effects of pastfiscal and monetary loosening feedthrough, but growth in 2010 is still likely

to remain modest at an average of onlyaround 0.5% for the year as a whole.

As shown in Table 1.1, our main scenariois broadly similar to the latest averageindependent forecast for 2010, but less

optimistic than the Treasury’s Budgetforecast regarding the pace of recoveryin 2010.

Continued 5

Figure 1.1: Quarterly GDP growth % change on the previous quarter

Source: ONS (note that Q2 2008 growth is zero)

1990 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09-2.5

-2.0

-1.5

-1.0

-0.5

0.0

1.5

1.0

0.5

Table 1.1: Summary of UK economic prospects

Source: HM Treasury Budget 2009 and Survey of Independent Forecasts (average values), PwC scenariosrounded to the nearest quarter of a percent. Investment refers to total fixed investment.

CPI (Q4)

Manufacturing output

Investment

Consumer spending

GDP

Indicator (% change onprevious year)

HM Treasury forecasts(April 2009)

2009

-3.75 to -3.25

-3.25 to -2.75

-11.25 to -10.75

-12.75 to -12.25

1

1 to 1.5

0 to 0.5

-3.25 to -2.75

-0.25 to 0.75

1

-3.7

-2.9

-10.5

-10.8

1.0

0.6

-0.4

-3.0

0.7

1.6

-4.25

-3.5

-13

-11

-1.25

0.5

-0.75

-3

-0.25

-1.75

2010 2009 2010 2009 2010

Independent forecasts(June 2009)

PwC Main scenario(July 2009)


The UK economy

Both our main scenario and theprojections of other forecasters aresubject to significant margins ofuncertainty, as indicated by thealternative GDP growth scenarios shownin Figure 1.2. Risks to our main scenario

for growth are more balanced thanearlier in the year, but are still weightedsomewhat to the downside, particularlyin the short-term. We would thereforerecommend that businesses shouldstress test their plans against the

‘prolonged recession’ scenario shown inFigure 1.2, which envisages a 5% fall inGDP in 2009 with output continuing todecline throughout 2010. This is not themost likely scenario, but it certainlycannot be entirely ruled out. At the sametime, the possibility of an earlier andstronger recovery can also not now beignored, given recent relatively morepositive data.

Consumer spending is projected to fallby around 3.5% in 2009 and a further0.75% in 2010 in our main scenario.This reflects the squeeze on householdspending power from credit constraintsand rising unemployment.

This also takes into account the impactof an expected further fall in averageUK house prices before bottoming out in2010 in our main scenario, althoughthere are considerable uncertaintiesaround any such projections asillustrated in Figure 1.3. As in the 1990s,we would expect the period of relativelysubdued house prices to extend wellbeyond the end of the technicalrecession as measured byGDP and this is reflected in ourprobabilistic house price modelprojections in Figure 1.3.

Business investment1 is also likely toremain weak in 2009, reflecting bothslower expected future demand growthand the influence of tighter creditconditions, even if the latter have started

to ease somewhat in recent months.Housebuilding is also expected toremain subdued in 2009 and 2010, evenif the worst of the decline in activity inthis sector may now have passed.

Net exports are projected to make apositive contribution to GDP growth in2009 and 2010 in our main scenario,although this is more due to weak importsthan strong exports. The boost to exportsfrom the fall in the pound since 2007 isoffset by continued difficult economicconditions in the UK’s key export marketsin Euroland and the US.

Our main scenario for UK GDP growthwould be consistent with inflation (CPI),falling back further during the rest of 2009and probably remaining below target in2010. In this case, it should be possiblefor official short-term interest rates to beheld at levels close to zero during 2009and early 2010, which should eventuallyhelp to revive the economy in conjunctionwith the ongoing quantitative easingprogramme. In the medium term, there isa risk that inflation could pick up again asand when the economy recovers, whichcould eventually cause interest rates torise quite sharply to pre-empt this risk.But this is not likely to be an issue in theshort term.

1 Business investment is the largest component of total fixedinvestment, which also includes housebuilding and governmentinvestment.

Continued 6

Figure 1.2: Alternative GDP growth scenarios Year-on-year % growth

Source: ONS, PricewaterhouseCoopers

2006Q1

2006Q2

2006Q3

2006Q4

2007Q1

2007Q2

2007Q3

2007Q4

2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

2009Q4

2010Q1

2010Q2

2010Q3

2010Q4

-6-5-4-3-2

43210-1

Early recovery

Main scenario

Prolonged recession

Figure 1.3: Fan chart for UK house price projections (plausible range) Average UK house price (£)

Source: PwC analysis based on average of Halifax and Nationwide indices for nominal house prices; the modelestimates 5% chance of house prices being below bottom line and 95% chance they are below top line in chart;50% line shows the median projection

350000

0

50000

100000

150000

200000

250000

300000

2006 07 08 09 10 11 12 13 14 15 16 17 18 19 20

95%

5%

25%50%75%


The UK economy

Longer term outlook for the publicfinances and medium-term policyimplications

Looking further ahead, we would expectthe pace of recovery in the UK economyin 2011 and beyond to be held back bythe need to get the public finances backunder control in the medium term.Public spending will need to be tightlyconstrained in 2011 and beyond as partof a programme of fiscal austerity,probably also including significant taxrises that will be needed to bring downthe budget deficit, which the Treasuryprojects to be around 12% of GDP in2009/10 and 2010/11.

The Treasury has recognised the scale ofthe problem in the Budget and isplanning a programme of fiscal

tightening, building up to just over 6% ofGDP by 2017/18, equivalent to around£90 billion per annum at today’s GDPvalues. But, we believe that the fullextent of the fiscal tightening requiredcould be around 10% of GDP (or around£140–150 billion at today’s values), giventhe need to allow for both the longerterm fiscal costs of an ageing populationand the possibility that medium-termtrend growth may well be somewhatslower than the Treasury projects.

We also highlight the temptation thatfuture governments may face to relax themonetary policy regime (e.g. by raisingthe inflation target), so as to ‘inflateaway’ part of the massive public debtthat is building up. This would be likelyto be self-defeating in the longer termand, to guard against any such

temptation, we would recommend thatall major political parties should commitclearly and unambiguously in theirmanifestos for the next general electionnot to make any such changes to the UKmonetary policy regime.

Which age groups are beingworst affected by the economicdownturn?

In the report we look at a range ofpossible income and wealth effects ofthe downturn on different age groups.Our key conclusions from this analysisare summarised in Table 1.2, whichshows that:

• The youngest age group (18–24) issuffering most from risingunemployment rates and this seemslikely to continue. However, olderworkers (45–64) will tend to find itmore difficult to find a new job if theyare made unemployed.

• Young workers saw slower averageearnings growth than older workers in2008.

• Older generations tend to be netsavers, while younger generationstend to be net borrowers. Therefore,benefitting more from currenthistorically low interest rates (althoughsome of them may also have suffered

more from restrictions on theavailability of credit).

• Workers approaching retirement whorely primarily on defined contributionpensions may have to work for longerbecause the value of their pension hasbeen hit by both falling equity pricesand relatively low annuity rates inrecent years. State pensions, incontrast, have seen strong realincreases recently, but interest incomefor retired savers will have beenreduced to very low levels sincelate 2008.

• Older age groups have on averagebeen impacted more by falling equityand house prices, due to their greaterwealth holdings. Overall, therefore, allage groups will have sufferedsignificantly from the currentdownturn. But the illustrative netbalance calculation shown in the finalrow of Table 1.2 suggests that olderworkers approaching retirement withdefined contribution pensions mayhave been worst hit overall, followedby the youngest workers (aged18–24), who tend to be most likely tolose their jobs in a severe recession.There are no age groups that are fullyimmune from the adverse effects ofthe downturn, but the 25–44 agegroup may be relatively less affected,

Continued 7

Table 1.2: Summary assessment of income and wealth effects of the downturn by age group

Key: X = negative, 0 = zero or non-material, and + = positive impact on income or wealth*Net balance of positive and negative effects – illustrative onlySource: PwC assessment

Unemployment

Average earnings

Interest income/payments

Pensions/equity wealth

Housing wealth

Total net impact*

Age groups

18-24

XXXXX

XXX

+

0

0

-7

XX

XX

++

X

X

-4

XXX

X

+

XXX

XX

-8

0

0

XX

X

XXX

-6

25-44 45-64 65+


The UK economydue both to its somewhat lowerexposure to unemployment increasesthan younger workers and to beingthe age group with the most togain from recent falls in mortgageinterest rates.

To access a video of the highlights of UKEconomic Outlook click here. To accessthe full report click here.

Which industry sectors are mostvulnerable to the economicdownturn? Which will recover first?

Almost all industry sectors are beingaffected to some degree by the currenteconomic downturn. This shows whichsub-sectors are regarded as the mostvulnerable to the effects of the currentrecession. The graphs below show theresults for the sub-sectors considered inthe two excercises.

As outlined in the March editionof UK real estate insights, we havedeveloped a PricewaterhouseCoopersSector Vulnerability Index that combines10 key economic and financial indicatorsfor 15 major industry sectors.

In April we produced an upturn indexthat indicates which sectors are likely tobenefit faster from the eventual recoveryin the UK economy than the average forthe sectors covered by our analysis.

First signs of optimism returningto some parts of FinancialServices

According to the latest CBI/PwCFinancial Services Survey, many parts ofthe UK’s financial services sector expectbusiness volumes to rise in the nextquarter after 21 months of falls, while

Continued 8

Impact of downturn on tenants PwC Sector Vulnerability Index

Source: PricewaterhouseCoopers

Metal products

Financial services

Hotels, restaurants

Engineering

Transport, storage

Post, telecomms

Construction

Textiles

Oil, gas and mining

Business services

Non-food retail

Food manufacture

Chemicals

Food retail

Utilities

Higher index value = greater economic and financial vulnerability

Economy average = 50

70

60

50

40

30

20

10

0

Impact of downturn on tenants PwC up-turn Index


Business services

Engineering

Post, telecomms

Non-food retail

Chemicals

Utilities

Construction

Financial services

Oil, gas and mining

Transport, storage

Hotels, restaurants

Food retail

Metal products

Textiles

Food manaufacture

An overall score above 50 indicates a sector that is likely to benefit faster from the eventual recovery of the UK economy than theaverage for the sectors covered by our analysis

Economy average = 50

80

60

50

40

30

20

10

0

70


The UK economyoptimism about the overall businesssituation has risen for the first time intwo years. But banking remains underpressure.

Although the three months to June sawlevels of business, income andprofitability continue to fall, this was at amuch slower pace than earlier this year.This suggests the industry may now beon a gradual path towards recovery,though differences between the sectorsremain.

Insurance companies are the mostoptimistic about growth in business overthe coming quarter, while banks alsoexpect volumes to rise. Buildingsocieties have experienced extremelytough business conditions since early2008, but are now hopeful that volumes,income and profitability will stabilise inthe next quarter. By contrast, securitiestraders and investment managers expectthe recent improvement in their businessto be short-lived, with volume declinesexpected to resume next quarter.

Although there are some more ‘glimmersof encouragement’ in the survey for thereal estate industry, there is little to becheerful about in this. There is nothing tosuggest a rapid return of liquidity and thenews regarding the financial servicessector as tenants, particularly in London,is gloomy. The sector is expecting furtherreductions in profitability, employment

and expenditure on property. It is alsoworrying for the longer term that overall,financial services firms were slightly lessoptimistic about the competitiveness ofthe UK as a financial centre than inMarch.

Click here to access the full report

Slight optimism also returnsto retail

Following on from the Christmas tradingupdate in January 2009, Andrew Garbutt,Retail Director and Stuart McKee,Corporate Finance Partner atPricewaterhouseCoopers have presenteda webcast looking at the key trends andthemes over the first quarter of 2009 andthe outlook for the remainder of the year.The key messages are:

• Macroeconomic statistics areinconclusive as to where we are in cycle;

• However, other consumer data isstarting to suggest a bottoming outand turnaround – sentiment appearsto be improving – most evident inyounger and higher demographics;

• This is likely driven by falling housingcosts and utility prices, and alsofalling debt servicing costs – puttingmore pounds in the pocket. There isalso evidence the recession mediaintensity has abated;

• In retail sales, there is some evidenceof a ‘declining decline’ – evidencemirrored in the US. The US$:£exchange rate will still have a seriousimpact on gross margin, but it islooking better than predicted andthere are mitigating factors;

• Managing stakeholders – frompension trustees, credit insurers to themore routine players – is as critical asever. It is vital to avoid complacency;

• There are opportunities for retailers –very good property deals, ‘sales inplay’, opportunity for sales to foreignnationals and the growth of theInternet. Some retailers are stillperforming strongly – grocers, valueplayers and young branded fashion inparticular

Click here to access the webcast

For further information regarding macro-economic advice for the real estateindustry, please contact Yael Selfin, whois Head of Macro Consulting, Economicsin our Market & Value Advisory practice.

9


‘Hold versus Sell’As mentioned elsewhere in thisedition, and the previous edition,of UK real estate insights, thenature of the real estate crisis ischanging, as is the attitude of thebanks. As tenants struggle andpressure increases on cash flow,we can expect to see moreproperty companies becomeinsolvent.

PricewaterhouseCoopers is alreadyinvolved in a number of high-profileadministrations of property developmentcompanies such as Castlemore,Oakdene and Rock, as well as otheradministrations where real estate is asignificant component, such as Lehman.A key question that we are often askedis: “Why aren’t you selling more of theproperties that you are holding?”

Our role, as an administrator or receiver,is to achieve the optimum return fromthe assets for the benefit of all creditorsand, in our view, that is more likely to beachieved by holding and working theproperties rather than selling somewherenear the bottom of the sharpest anddeepest property-based recession inrecent memory. When we are instructed,our first task is to make the assets

secure from vandalism or other threat,and then to embark on thorough duediligence from a legal, property, valuationand accounting perspective. Whyaccounting? Well, there may beapplicable and valuable tax losses forexample. We need to completelyunderstand each property.

We also, concurrently, seek publicity forthe assets to see just who, in the market,might be interested in buying theproperties individually or as a portfolio.On average, within the first few weeks ofan appointment, we receive and registerinterest from more than 100 potentialbuyers, and another 50 or so fromagents who say that they representclients. On Lehman, that interest toppedout at more than 350 interested parties.We also make it clear that we are notinterested in a so-called ‘fire-sale’or bargain basement of selling prices,if we decide to bring the properties tothe market.

In the main, our default strategy is hold.Why? There is a very simple answer –if the owning company was still tradingsolvently, would it want to sell its assetsright now? There are some assets ofpoorer quality, low income or decliningvalue, often in Law of Property Act (orLPA) or fixed charge receiverships, whichshould be sold quickly and these are

Continued 10


‘Hold versus Sell’

often to be found in auctions, where themarket can bid against each other toachieve today’s best price.

So, while we are holding the assets,initially, and having completed the duediligence, we sit down as a team, ofteninvolving our lawyers and other advisers,perhaps planners or construction costconsultants, to brainstorm the beststrategy to enhance value over time, orto decide to sell now. Invariably, if theproperty was owned by a property

company with a sound managementteam and viable strategy, we cancontinue the work they were doing(before their corporate insolvency) torealise the optimum value. The optimumis not necessarily the highest value, buttakes into account the time value ofmoney, and the allocation of profits andtax. Sometimes, of course, we amendthe strategy if we think that today’smarket conditions call for a change ofplanning use, for example.

We are definitely interested in workingwith asset managers who have a goodtrack record of enhancing value.We recognise that while we havea wide range of skills in-house atPricewaterhouseCoopers, and we workwith some very talented propertyprofessionals and other consultants,there may be a need for a furtherworking capital injection that theappointing funder does not wish toinject, or there are particular skills,experience or expertise that wouldbenefit the assets for the creditors asa whole.

Sometimes, despite our default ‘hold’position, there are sites that we wish tosell now as it seems strategicallyadvantageous to do so. For example, asAdministrators to Castlemore, the largeMidlands-based commercial andresidential property developer, we havedecided to market a site called “TheBritish” at Talywain in South Wales. Thisis a massive site, of some 1300 acres,which has much work to do to bring it toa profitable fruition.

The British site has the opportunity toextract some 360,000 tonnes of open-cast coal, and the entire planning regimeneeds to be worked up, almost fromscratch, although around 150 acres ofthe site are included in the Local Plan asa general development area and it isestimated that it could accommodate

around 800 dwellings and mixed usedevelopments. In this instance, we thinkthat selling the site to an experiencedopen-cast coal extraction company, whohas significant master-planningexpertise, could produce the best result,as the profit from the coal extractioncould fund the planning process, whichcould last between five and ten years.We will be looking for a cash disposaltoday, with a material overage upside, ora joint venture, where both parties sharein the profits over time.

The British has great potential for profitover time from a range of propertydevelopment and mining activities, so itseems to be just the right kind ofproperty to be marketing at this stage ofthe recessionary cycle. Given the stronginterest already registered in The British,we expect there will be significantcompetition from a range of well-fundedand experienced bidders.

At The British, we believe that sell todayoutweighs hold for the next five to tenyears in optimising realisations for thecreditors.

There is something that funders can do,especially if they favour an early sale.This is what we call ‘stapled debt’, alsoknown as ‘assumable debt’. This simplymeans that the buyer has the

Arial photograph showing part of the Talywain site “The British”

Continued 11


‘Hold versus Sell’opportunity to take over the existingdebt of the failed company in respect ofthe particular asset, or to be able to takeadvantage of new debt, made availableby the secured lender, in order toachieve a better price through debtleverage rather than simply selling to anequity, or cash-rich, player, who themarket knows will expect a bargain.At PricewaterhouseCoopers, we expectto see more of stapled debt deals as therecession continues as lenders may wellprefer to lend on properties that theyalready know well, focusing on theborrower – whom they may also knowwell from other deals, transactions orlending scenarios. Ultimately, whether aplayer can take advantage of these debtopportunities depends as much on theirrelationship with the secured lender andtheir recognised track record in themarket, than their particular appetite forthe property in question, or thepercentage of equity available.

The oldest property adage is, of course,when asked the best three attributes of aparticular property, the answer would be‘location, location, location’. For those ofus working in the realm of distressedproperty assets, when considering theconundrum du jour, of whether to hold orsell, the answer is, more enigmatically,‘timing, timing, timing’.

Barry Gilbertson is a real estate partnerin PricewaterhouseCoopers, formerlyPresident of the Royal Institution ofChartered Surveyors, is a member of theBank of England Property Forum and isVisiting Professor at the University ofNorthumbria in Newcastle.

If The British site might be of interestto you or your clients, contactPalwinderjit Sidhu who maintains ourregister of interested parties on theCastlemore administration andreceivership case.

12


Investment in real estate distressed debtAs discussed elsewhere in thisedition of UK real estate insights,the continuing real estate crisis isentering a new phase of distress.This is creating new opportunitiesfor distressed debt investors.

Typical strategies of distresseddebt investors

Once distressed debt investors identifya real estate backed loan either as asuitable asset in itself or as a means ofsecuring ownership of the underlying realestate asset and/or as an opportunity totake an equity stake in the borrower, theywill most likely implement one of thefollowing strategies:

Outright acquisition of the loan

In this case, distressed debt investorsacquire the loan from the originator ata discount to face value. The level ofdiscount will be the subject ofnegotiation between the two parties andwill be influenced by a number offactors. The acquisition cost may befinanced solely through equity or viadebt financing (less likely in the currentmarket). It is not uncommon in today’s‘buyer’s market’ for potential sellers toconsider providing vendor financing anddeferred payment schemes to investorsas a means of improving price through alower cost of funds.

Through servicing of the loan, investorsmay be able to achieve their targetreturn via:

• seeking to restructure the loan onmore favourable terms to theborrower, with a view to achieving a

refinancing or discounted settlementpayment in excess of their requiredreturn;

• repossession of the collateral (i.e.property asset) via legal or out-of-courtmeans, after which they will managethe asset prior to sale.

Acquisition or conversion of theloan into an equity stake in theborrower

In certain cases, distressed debtinvestors will either seek to acquire an

Continued 13


Investment in real estate distressed debtequity stake in the real estate backedborrower or convert the acquired loaninto an equity holding. The overall aimwould be to influence the managementof the company and collateral assets(for example seek liquidation of thecompany if it is considered that theforecast recovery will achieve theinvestor’s target return).

The type of loans/borrowers spansresidential, small and medium sizedenterprises (SME) and corporateborrowers. The options available,servicing methods, expertise requiredand underlying collateral will differ foreach loan/borrower type.

Acquisition of the security backedby the asset

In this scenario, investors will acquirethe security backed by mortgages oncommercial or residential properties(commercial/residential mortgage-backed securities) at a discount to face value.

Commercial or residential mortgage-backed securities are, in most cases,collateralised by fixed or floating ratemortgages and have multi-classstructures, ranging from AAA to juniorunrated bonds. As with the outrightacquisition, the level of discount isnegotiated between the seller and the

investor. In determining the bestapproach to realise their target rate ofreturn; investors will consider either:

(i) holding the note with the expectationthat property prices or theperformance of the mortgages willimprove and hence the investor willbe able to resell the security at ahigher price and realise its internalrate of return; or

(ii) seeking to influence the servicing ofthe assets, as per the terms of thestructure and in conjunction with theother noteholders. In certain cases,investors might seek to collapse thenote structure and force earlyliquidation of the collateral if they areof the opinion that this helps themachieve their target return earlier.

Market challenges

While financial institutions and lendersare coming under pressure across theUK and Europe as defaults increase andcollateral values fall, in some marketsfew sales of distressed real estatesecured loan portfolios have taken place,predominantly due to:

i) current provisioning levels versus theperceived market value of the loansand underlying collateral;

ii) government intervention, which hascreated uncertainty among sellersand buyers regarding the saleabilityof affected loans and the associatedaccounting and legal issues;

iii) a lack of debt financing and scarcityof investor capital, meaning internalrates of returns (‘IRR’) have risen andpricing has decreased in a marketwhere more sellers are emerging;

iv) certain previously active distresseddebt investors have exited themarket (e.g. Lehman Brothers);

v) lack of specialised servicing capacity,especially in the UK market, due to:

• the more benign credit conditions ofthe last 10 years;

• the deterioration of the currentcredit conditions has challengedthe profitability and operationalstructure of existing servicers thatare finding current collection levelsmuch harder to maintain in arelatively illiquid market for propertysales. This is forcing them to re-examine staff levels and coststructure.

• the difficulties encountered byfinancial institutions that weresignificant players in the UK andEuropean servicing market, hascreated uncertainty over the goingconcern status of some servicingentities.

The factors above should, however, betemporary and as evidenced by recentregional financial crises in Asia, LatinAmerica and more recently in the UnitedStates, financial institutions and lendersare likely to ultimately embrace the loansale solution, as a fundamental solutionto the capital, liquidity, operational andstrategic problems they currently face.

The UK is considered to be the largestemerging market for real estate backeddistressed debt transactions in Europe,although activity to date has centredprimarily on nonconforming loans andmore liquid corporate bonds. Theexpectation is that, like Germany, Italy,Poland and, more recently, Spain, thesale of portfolios of secured defaultedand non-core loan portfolios in the UKwill soon become commonplace. Thiscan be attributed to the followingreasons:

Continued 14


Investment in real estate distressed debt• as financial institutions complete their

mergers or internal restructuring, theywill be focusing more on futurestrategy and looking to exit non-coremarkets or operations;

• the UK Asset Protection Scheme onlycovers approximately 23% for theLloyds Banking Group and 15% forRoyal Bank of Scotland’s1 assets.Taking into account the significant sizeof the Lloyds and RBS balance sheets(in excess of £1trn for Lloyds and£2trn for RBS), significant downsiderisk still exists for the participatingbanks;

• as the levels of distress and capitalpressure points increase, managementwill have to readjust its expectationsregarding the intrinsic value of theassets and hence narrow the currentprice expectation gap;

• investors gradually gain moretransparency regarding the bottom ofthe market and the likely impact thatgovernment initiatives (such as theMortgage Protection Scheme) willhave on their pricing and recoverystrategy, along with therepresentations and warranties thatthey are willing to accept in the saleand purchase agreements;

Tax considerations

When acquiring distressed debt, taxstructuring is mainly driven by investor(purchaser) tax considerations; althoughsellers of distressed debt should bemindful of the potential VAT issues onsale and should seek to ensure that theypreserve their corporate tax losses,where possible. There are a number ofcomplexities that arise that make theconsiderations different from investmentin direct property. Investors’ return onacquiring distressed debt effectivelycomprises two components: interest anddiscount, and the key tax issues thatarise in relation to these are:

(i) taxation of the vehicle used toacquire the distressed debt portfolio;

(ii) withholding taxes;

(iii) VAT; and

(iv) carry planning.

In order to mitigate taxation on the debtcollection profits and the interest, theinvestment vehicle is typically located ina low-tax jurisdiction. However, if thedebt is not a ‘gross paying’ instrumentsuch as a quoted Eurobond, thenwithholding taxes may arise in relation tocross-border interest flows, particularwhere the debt vehicle is resident in ajurisdiction without the benefit ofadequate treaty protection.

The nature of the debt portfolio beingacquired and whether withholding taxesare in point will therefore be key taxdrivers in choosing the jurisdiction of theacquisition vehicle. Suitable offshorelocations without significant treatynetworks include Jersey, Barbados andCayman. Suitable treaty jurisdictionsinclude Luxembourg, the Netherlands,Ireland and Singapore.

Example 1: Typical debt fund structure

Beneficial ownership

Under most tax treaties, reduced interestwithholding tax rates are only available ifthe recipient in the treaty jurisdiction isconsidered the ‘beneficial owner’ of theinterest and not merely a conduit withvery narrow powers. Therefore,investment funds need to takeappropriate care in establishing a debtacquisition vehicle in a treaty jurisdictionto mitigate withholding taxes.

Two court cases that have drawnattention to beneficial ownership fromtax authorities and tax professionalsworldwide are the UK Indofood2 caseand the Canadian Prevost3 case.In Indofood it was proposed that aNetherlands company be interposed toreceive interest and thereby seek tobenefit from the Netherlands–Indonesiantax treaty and reduced Indonesianwithholding tax. Although the UK courtdid not ultimately decide on thebeneficial ownership question, it wasclear that the UK court did not considerthe Netherlands company to be thebeneficial owner of the interest receivedas it was merely a conduit and did nothave any powers in relation to the

1 Lloyds Banking Group and Royal Bank of Scotland presentations.

2 Indofood International Finance Ltd v JP Morgan Chase Bank NA[2006] EWCA.

3 The Queen v Prevost Car Inc, 2009 FCA.

Continued 15

Investors

LuxSecuritisation

Vehicle

DD portfolio

CarryVehicle

GP

Interest income/capital gains

>10% shareholdings

OffshoreFund


Investment in real estate distressed debtinterest received; all the interest had tobe on-paid in short order to the ultimatebeneficiaries who, apart from theproposed interposition of theNetherlands company, would not havebeen entitled to the reduced withholdingtax rates.

Prevost concerned another Netherlandscompany, interposed this time to gainaccess to the favourable dividendwithholding tax rates under theNetherlands–Canadian tax treaty. In thiscase the Netherlands company wasconsidered to be the beneficial owner bythe Canadian court as the dividendsreceived were at the free disposal of theNetherlands company. The on-paymentof dividends received by the Netherlandscompany to its shareholders was subjectto a final decision by the Netherlandscompany’s board.

VAT

Careful structuring is also required toprevent irrecoverable VAT on the debtcollection services provided to theinvestment vehicle, especially where theinvestment vehicle is located in the EU.

Carry planning

When considering managementincentives/carry planning, the taxtreatment of capital gains in the UK

(taxed at 18%) is significantly morebeneficial than current income tax rates;therefore, structuring these incentives ina manner that gives rise to a gain shouldbe advantageous, if this can beachieved. The UK anti-avoidanceprovisions need to be consideredcarefully, however, in the context of adebt fund where a significant element ofthe overall return is likely to be derivedfrom interest, as this is generallycategorised as an income rather than acapital profit.

Tax issues on default

Investors in distressed real estate debtneed to be mindful of the issues thatmay arise if they are required to takepossession of the underlying propertieson which the debt is secured, in theevent of a default of the borrower. Theseissues may include (but are not limitedto) transfer taxes, access to capitalallowances and/or depreciation andstructuring issues. Some widely useddistressed debt investment vehicles,such as the Luxembourg securitisationvehicle, are not suitable to hold realestate or real estate companies andadditional structuring may be requiredwhen taking possession of theproperties.

Example 2: Modified debt fundstructure to accommodate default

As mentioned above, this is a complexarea, and the comments on tax are of ageneral nature only. Readers should seekadvice specific to their circumstancesbefore seeking to establish a debt fundor investing in distressed debt.

Graham Martin is a corporatefinance partner and leadsPricewaterhouseCoopers’ distresseddebt team.

Andrew Jenke and Panos Mizios areSenior Managers in thePricewaterhouseCoopers distresseddebt team.

Bas Kundu is a tax partner inPricewaterhouseCoopers’ real estateteam.

Sander Eijkenduijn is a senior taxmanager in PricewaterhouseCoopers’asset management team.

16

Investors

LuxSecuritisation

Vehicle

DD portfolio

CarryVehicle

Interest income/capital gains

>10% shareholdings(i.e. Real Estate SPVs,

Private equity investments)

Loan

Lux Sarl

OffshoreFund


Governance and controls in the perfect stormOver 12 months ago theEconomist Intelligence Unit (EIU)and PricewaterhouseCoopersconducted an online survey ofsenior executives frominstitutional investors andalternative investment providers.Over 220 executives from theAmericas, Asia and Europeparticipated in the survey, whichwas conducted betweenDecember 2007 and January2008.

The EIU also held 30 one-to-oneinterviews with some participants. Theconclusions of the survey were clear asto the need for a growing focus ongovernance. Participants commentedthat investors have tolerated weakgovernance and risk management in thepast few years as returns have beengood and the sector has been evolving.

At that time, given that sector returnswere moderating and it was felt the sectorhad matured, investors were expecting tobe more exacting in future. When askedabout the criteria behind a decision todeselect a provider, the key driver was notperformance, as is the case when makinga selection; rather it is transparency andthe quality of risk management. Returns

have deteriorated further over the yearsince the survey was conducted, andinvestors are becoming increasinglyfocused on governance and riskmanagement. Performance in this area isbecoming a differentiator in themarketplace. We do not expect this tochange in the foreseeable future eitherand those engaged in deliveringgovernance and controls should preparethemselves to deliver against tougherbenchmarks over the medium term.

As you might expect, much of the recentPricewaterhouseCoopers UK Real EstateClient Conference was focused on thecurrent state of the market and the impactthis is having on organisations in thesector. In periods of such uncertainty, theimportance of managing to ensure risksare mitigated wherever possible, becomeseven more relevant. One of theconference sessions looked at the optionsfor corporate governance, controls andreporting to stakeholders in the light ofrecent events and pronouncements.

Listed entities

• Corporate governance for companieslisted on stock exchanges around theworld is generally well established, butthese are being tested by currentchallenges.

Continued 17


Governance and controls in the perfect storm• Audit committees are generally finding

that understanding the mitigation ofkey risks and challenges is moredifficult when times are hard thanwhen everything is on the up. Timecommitments are increasing forcommittee members as their need toassess the current status requires anenhanced level of detail. The ability toaccess such information easily maynot be possible when one is notinvolved in the daily running of thebusiness.

• Communication between executiveand non-executive members needs tobe transparent and to flow easily toavoid response to governancerequests eating up time available torun the business. This point echoesthe survey findings referred to above.

Unlisted entities

• Currently there is no formalgovernance model that applies tounlisted entities. Many organisationshave one or more key committees foroversight, often in the form of aninvestment committee, to whichsignificant decisions are referred. Themore formalised structures in placewill often have a mix of executive andnon-executive members. However,this remains voluntary and in mostcases is driven by the experience of

key individuals from their pastorganisations, or is derived inresponse to investor requests.

• As discussed elsewhere in this editionof UK Real Estate Insights, changes inEuropean legislation are beingproposed in relation to AlternativeInvestment Fund Managers whichcould actually apply to hedge funds,private equity funds, real estate andinfrastructure funds, Real EstateInvestment Trusts, listed investmenttrusts as well as other forms ofcollective investment vehicles. Whilethere is a draft directive at present,should this be adopted it will pushmuch of the current listed companygovernance and controls onto areas ofthe industry that have previously beenfree of such encumbrances.

• For the non-listed entities suchgovernance guidance as the Directiveoffers is helpful. However, there is aconcern that it is very prescriptive andfar-reaching, such that it is unlikely tosuit all. It will result in difficulties inapplication.

In the event that an organisation is listed,the governance challenges right now arearound ensuring that the systems andcontrols in place are able to respond tothe storm. These tend to be tested totheir limits only when the storm is uponyou and so making sure you keep your

eyes on this as well as everything elsecannot be avoided.

Equally, checking back with thoseengaged in oversight of yourorganisation is important; responding toad hoc requests often takes longer thanif they were known about in advance.Communication, along with anticipation,of additional information can be helpful.So for example some audit committeesare now seeking direct contact withexternal property valuers, with thevaluers attendance at audit committeemeetings giving non-executives theopportunity to gain a widerunderstanding of the process involvedand to ask direct questions (see the Apriledition of UK Real Estate Insights,‘Reporting property valuations: do youknow the risk?’ for more information onthis particular issue).

For those involved in a currently unlistedenvironment, adherence to any industryguidance, for example if you are FSAregulated, clearly remains a key driver forretaining the confidence of yourstakeholders. If you are currentlyunregulated then you have choices as toyour approach to governance, but suchchoices may be removed in future. Thismay be driven by the EU Directive, butalso in times of uncertainty, whateverfinancing or investment is available willfocus on the organised, well-managed,proven and well-controlled business

models. A robust controlled environment,which mitigates the risks, enables thoseengaged in managing the day to day tobe confident that the business willcontinue, even with the focus havingshifted to new areas of concern. Thosein such a position are fortunate and willalready have had time to amend theirview of risk and flex controls to adapt.Those that were not so prepared will befinding life very difficult.

Therefore, revisiting your governanceapproach is a recommendation rightnow. Is it still fit for purpose in thecurrent environment? Are youtransparent enough in sharing your areasof concern with those involved ingoverning your organisation? Are yourinvestors clear as to the risk profile youare adopting? All of these are pertinentquestions that anyone running a realestate business should be able toanswer without too much thought.

Whether you are currently thinking aboutstarting a new venture or engaged inrunning an existing business, you ignorerisk mitigation through controls and goodgovernance at your peril; at some point itwill come back and bite you very hard!

Erica Conway presented this session atthe conference and is an AssuranceDirector in our real estate practice inLondon.

18


Corporate occupiers – maximising value from propertyProperty is typically the secondlargest cost to any corporate.It therefore pays to be proactivelythinking about property at alltimes to maximise efficiency andminimise cost.

It also pays to ensure that propertystrategy is aligned to, and supportive of,business strategy. While the benefits ofthis are by nature intangible, propertyflexibility is an important enabler tobusiness success.

In this article we will consider some ofthe actions that businesses in all

industries could and should beconsidering regarding their operationalproperty portfolio in order to minimisecosts and optimise their propertyposition for the future.

It is worth emphasising that theseactions are not just right for the depthsof a credit crunch; they are the staples of

any good practice in portfoliomanagement. That said, with the ‘cash isking’ mentality necessitated by thecurrent environment, it is accepted thatthe urge to act is likely to be greater atthe moment. However, it is also true thatthese suggestions are not onlyappropriate for those businesses thatmay be in distress; they are alsobeneficial to organisations who currentlyfind themselves in good health but stillwish to enhance their businessoperations to consolidate and streamlinetheir position.

Considering the current propertyposition

Unfortunately, all too often property isignored as it is not considered ‘exciting’enough to warrant attention. As a result,occupiers carry on their day-to-daybusiness without thinking about keyquestions such as:

• are we occupying our property asefficiently as possible?

• do we have spare space that we arenot using?

• do we have any opportunities to exitsurplus leaseholds or dispose offreeholds? and,

Continued 19


Corporate occupiers – maximising value from property• overall, could we structure our

property portfolio in a different waythat would enable us to reduce costsand preserve cash?

These questions should be considered atall times of the economic cycle, but inthe current phase of the economic cyclethe focus will no doubt be greater, due tothe desire of all businesses to minimisecosts. Consideration of these questionscould identify opportunities for someimmediate cash savings.

The answer to these questions may alsoinfluence the longer term propertystrategy. It is important that propertystrategy is aligned to support and enablethe overall business strategy. Questionsarise such as:

• How much is the business anticipatinggrowth over the coming years andhow will the business ensure there issufficient property space to supportthis growth?

• How should acquisitions anddisposals be managed in terms of theassociated impact on property needs?

• When will key leases come to an endand will the business be able to renew?

• What is the environmental position ofthe group and are the properties itoccupies consistent with thisposition?

While a number of the suggestions thatfollow are potential ‘quick wins’ thatcan be undertaken in relative isolation ofthe overall property strategy, there areothers that require a longer termunderstanding of the business directionand associated property requirementsprior to being undertaken.

Opportunities and the challengeof implementation

Implementing change of any type in anorganisation is not without its difficulties,and the extent of the difficulty presentedwill vary depending upon how radical achange is desired. The ‘pain’ comesfrom the fact that the status quo is beingchallenged and, as a rule, people do notlike change. The options presented here,although largely being changes toproperty assets, do impact significantlyon people as they are the users of thoseassets; however, the amount of upheavalrequired varies and, perhapsunsurprisingly, the pain correlates withthe size of the benefit.

Figure 1 illustrates the relationshipbetween the reward possible and thedegree of pain required. Each numberrelates to a specific opportunity, andthese are discussed in more detailafterwards.

Opportunity details

1) Review of facilities managementservice levels and costs

It is entirely possible and not uncommonthat organisations are receiving a levelof service from their facilitiesmanagement (FM) provision that is moresophisticated than is really required. Byreviewing items such as frequency of

cleaning in offices, or levels of securityguarding it is possible to realiseimmediate monetary savings.

It is also often advantageous to reviewexisting contract pricing, and benchmarkit against other providers to see if thebusiness is obtaining a competitive pricefrom its supplier.

Continued 20

Lower Degree of ‘pain’ to implement

Potential savings (£)

Higher

Hig

her

Low

er

1

4

2

86

7 3

5

Figure 1



Corporate occupiers – maximising value from property2) Consolidation of property contracts

In addition, it is not unusual to find insome multi-site organisations that theyhave procured property services in avery fragmented way. This can be quitecommon where the organisation ismade up of a number of operatingcompanies that tend to actindependently of each other, but can still

be the case in a single company thatworks across multiple sites.

The problem that arises is that thecompany fails to realise the benefits ofits overall buying power when it is buyingproperty services such as facilitiesmanagement (cleaning, security,catering). By actively addressing this andcombining the parts of the business for

these purposes to optimise buyingpower, it is often possible to deliversignificant savings to the organisation.If this is combined with the activities in1) above, then the potential upside iseven greater.

3) Consolidate staff into fewerbuildings and dispose of vacatedspace

If times are proving particularly difficultfor a company, they may have had tomake a number of redundancies.Businesses may also have inherited andmaintained employees in differentlocations, for example, through prioracquisitions.

In these instances it may be possible toconsolidate staff into fewer buildings(for example, those that may be lessmarketable), or fewer floors within onebuilding and realise savings from disposalof the vacated areas. Even where it is notpossible to dispose of the space, eitherthrough a surrender or sublease withleasehold premises, or possible sales offreeholds, it could still be possible torealise some smaller savings by‘mothballing’ – in other words, move thepeople out, turn off the lights and stopservicing the vacated space.

4) Business rates

If part of a property is ‘mothballed’, or isotherwise empty or underused, it may bepossible to enter into negotiations withthe local authority to agree discretionaryrelief from business rates.

Such negotiations are case and factspecific, but savings can be substantial.It is relatively easy to determine whetherthere could be worthwhile cash savingsavailable, so is potentially an attractive‘quick win’ in the current environment.

5) Adoption of more flexible workingpractices

For many organisations, the adoption ofhot-desking and hotelling (pre-bookingyour desk) is new territory. In ourexperience, even those industries thatare generally office-based will only havean average occupancy of about 50%(and many far lower than this) where theyallocate fixed desk positions to staff.The reason for this is that, even wherestaff are designated as ‘office-based’,when factors such as sickness, holiday,training and attendance at meetings areincluded the office is never fullyoccupied. Therefore, by bringing inflexible working practices it is possible toincrease the occupancy levels for thedesks and use less space.

Continued 21


Corporate occupiers – maximising value from property6) Review internal property servicefunction

While often a politically sensitive issueinternally for a business to deal with,it is valuable to intermittently reviewthe shape of an internal propertydepartment, and consider what elementscould be outsourced and what capabilityshould really be retained in-house.

In particular, if redundancies are beingexperienced across an organisation it isoften some of the support functions thatexperience the first hits. This presents afirst-class opportunity to review the overallproperty function and, in particular, itsshape, size and operating model.

7) Structuring for tax efficiency andflexibility

When considering how to optimise valuefrom property, it is important not tooverlook tax factors. This is particularly sowhen considering longer term strategy –for example:

• Will a property need to be sold in a fewyears time due to growth in thebusiness?

• If so, what type of purchaser is likely tobe interested and what will they wantto buy?

• What will the tax consequences be forthe selling company?

and so on.

The current environment provides theperfect opportunity for property holdingsto be restructured for flexibility. This isbecause property prices are depressed,so any taxable gain arising on therestructure should be lower than in recentyears (and if the property was acquiredrecently, may even generate a loss).Businesses of course do not want toaccelerate cash tax, but any gain cangenerally be deferred if a tax shelter doesnot otherwise exist.

As an example of restructuring that istopical at the moment, many corporategroups are currently transferring their UKproperties to group non-resident landlordcompanies. Non-resident landlords areefficient for tax purposes, because anyfuture gain on the property arises outsidethe charge to UK tax, and the companycan be sold in due course with(depending upon territory) no stamp dutycost. It is usually also possible to benefitfrom an 8% tax rate arbitrage on netrentals if the property continues to beused by the group in the UK, because anon-resident landlord is subject to incometax at 20%, compared to a standardcorporation tax rate of 28% for a UKcompany. The key issue with thesestructures is that the property needs to bemanaged outside of the UK.

Non-resident landlord structures arenothing new, but are appealing topurchasers due to their tax efficiency, somay make a property easier to sell in duecourse (the option of course remains tosell the underlying asset if parties prefer

for any reason). Tax transparent structuressuch as partnerships or unit trusts canalso be used in a similar way, which maybe yet more attractive to purchasers infuture (particularly funds).

If it is not practical to hold property via agroup non resident landlord, it may beworth considering whether to moveproperties into group property companiesin the UK instead. While some of thehistoric benefits of such ‘Opco/Propco’structures are gone in the current climate,this may still make it easier to sell theproperty in future, due to the ability to sella geared company paying 0.5% stampduty on its value, rather than 4% stampduty land tax on the full value of theproperty.

8) Funding pension deficits

Those who read the last edition of UKReal Estate Insights will have seen anarticle on using property to fund pensiondeficits. The content of that article will notbe reproduced here, but it is worthhighlighting in this context that propertycan be used to reduce pension funddeficits and thus save cash. It is notnecessary for the property to be fullycontributed to the pension fund for this tohappen, so may be commerciallyattractive to many (and particularly thosethat are in industries where substantialworking capital is tied up in propertyholdings).

Conclusion

To conclude, in the current environment,cash is of course king. A businesses’property portfolio presents a number ofopportunities for saving costs and thusenhancing short-term cash flow. This isthe case not only for distressedbusinesses, but also for those who arebearing up well to the current economiccrisis and simply wish to consolidate andimprove their position.

In this article we have noted the fact thatchange, while delivering clear financialbenefits, also demands some pain on thepart of the business. The amount of painvaries considerably, but then so does thereward, and therefore what we start tosee is a clear spread of actions that couldbe considered ‘quick wins’ while othersare longer term opportunities. Decidingwhat is right for each client requires somediscussion, but the fact remains that thereare things that can and should beconsidered now by clients, particularly ifthey are finding the current economicclimate difficult, while also havingopportunities to undertake actions toposition themselves better in the longerterm.

Carole Le Page is a corporate taxdirector in our London practice, with afocus on property tax. Tom Sidaway is adirector in our real estate advisorypractice in London.

22


Finance Bill 2009A number of changes affectingthe real estate industry wereannounced when the Chancellordelivered his 2009 Budget Reporton 22 April 2009. Apart from acouple of exceptions, the targetedmeasures were largely technicalin nature.

More details of the announcements areavailable in the PricewaterhouseCoopersReal Estate Budget Summary issuedon Budget day.

The publication of the draft FinanceBill 2009 on 30 April 2009 providedclarification on some areas ofuncertainty, but also raised someadditional concerns.

Taxation of foreign profits –debt cap

Following the release of the debt capprovisions in the Finance Bill 2009, PwCsubmitted representations to HMRCwhich, among other things, identified thefollowing concerns:

Debits and credits arising on loanrelationships of property investmentpartnerships (or other entities that aretax transparent for income purposes,e.g. certain property unit trusts) arereflected as loan relationship debits andcredits in the tax returns of the corporatepartners in the partnership. For accountspurposes however, the results of apartnership are not always reflected in agroup’s consolidated income statement.Where a group does not consolidate theresults of the partnership, loanrelationship debits relating to thepartnership would be included in the‘tested amount’, but would not beincluded in the ‘available amount’.

Government amendments wereintroduced but it is unclear whetherthese amendments have dealt with theissue fully.

The Public Bill Committee debatedthe debt cap provisions on Tuesday 9June 2009 and during that debate, theFinancial Secretary to the Treasuryaccepted that the current drafting gaverise to a mismatch of tested amountand available amount in certaincircumstances. He stated that theTreasury would continue to look at theseproblems and to consult with interestedparties on the issue. He also confirmedthat, if solutions could be found,

Continued 23


Finance Bill 2009additional rules to deal with this wouldbe announced at the Pre-Budget Reportto take effect 1 January 2010.

Real Estate Investments Trusts(REIT)

The Government tabled a Finance Billamendment on 3 July 2009 which aimsto remove tax penalties for REITs wherethey have breached the finance costratio for reasons outside their control,e.g. financial hardship. While helpful, theamendment appears to be narrow in itsapplication. Furthermore, there may bespecific criteria that need to be met forthe charge to be waived, but details havenot yet been provided. Removing suchpenalties was one of the measuresraised in representations made by theproperty industry. The measure wasraised again when the Royal Institute ofChartered Surveyors (RICS) representedby Rosalind Rowe of PwC and BritishProperty Federation (BPF) representedby Graham Roberts of British Landrecently gave evidence to the House ofLords on changes needed to support theREIT regime in the current credit crisis.

The finance cost ratio was originallydesigned to stop REITs reducing theamount of tax-exempt profits that arerequired to be distributed by generatingexcessive interest deductions. Under theexisting legislation finance costs include

not only interest costs, but all otherrelated costs including for example,swap and debt break costs. Therefore,where a REIT was required to break aninterest swap or buy in debt, the result ofthis penalty was to unfairly compoundthe REIT’s costs of doing so.

Terminal loss relief

In a written Ministerial Statement on 21May 2009, the Financial Secretary to theTreasury announced that an amendmentto Finance Bill 2009 would be tabled,countering an avoidance scheme thathad been disclosed to HMRC.

The scheme used a trade reorganisationto access corporation tax rules onterminal loss relief. These rules providethat losses, arising in a trade in the 12months before cessation, can be carriedback and set off against profits made inthe previous three years.

These are highly targeted provisions andtherefore are unlikely to be applied,except in those cases where this is aclear avoidance motive behind thereorganisation.

Temporary first-year allowances

The Budget introduced a temporary 40%first-year allowance for expenditure bybusinesses on certain plant and

machinery in a 12-month periodbeginning 1 April 2009 for corporationtax purposes, and 6 April 2009 forincome tax purposes.

The relief will apply equally to theacquisition of new, unused andsecond-hand assets.

At the time of the Budget there wasuncertainty as to which of the existingexclusions for first-year allowanceswould apply. Expenditure on assetsprovided for leasing are excluded fromthe enhanced relief. However, asanticipated, this exclusion will not apply

Continued 24


Finance Bill 2009to relevant plant and machinery installedin properties provided for leasing. Thisrelaxation will only apply to plant andmachinery of a type that mightreasonably be expected to be installed ina variety of buildings. Furthermore, theenhanced relief is not available in respectof expenditure on plant and machinerythat qualifies for the reduced special rateof 10%. Consequently, the expenditureaffected by this new rate is likely to belimited to expenditure on certain itemsincluding (but not limited to) sprinklers,fire alarms, demountable partitions,IT/communication, sanitary ware,catering facilities, signage, intruderalarms/CCTV, fixtures & fittings andcarpets.

This is still good news for landlords ofcore real estate assets, but may be lessso for those that lease out specialistbuildings, structures and infrastructureassets. It is important to note that in-house property companies are likely tobe affected in the same way as externalinvestors of real estate/infrastructure.

As expected, assets acquired fromconnected parties will not qualify for thefirst-year allowance.

Offshore funds

The long awaited new definition of an‘Offshore Fund’ was published in theFinance Bill 2009. Intended to beeffective from 1 December 2009 this newdefinition represents a move away fromthe current regulatory basis to a‘characteristics-based’ approach indetermining what constitutes an‘Offshore Fund’.

HMRC has issued draft guidance on thenew definition for further consultationwith the investment managementindustry with a response deadlineof 10 July 2009. The guidance canbe found at the following linkhttp://www.hmrc.gov.uk/collective/new-offshore-funds.pdf and fund promotersshould take steps now to identify thepotential impact for both new andexisting investors and consider makingrepresentations accordingly.

The scope of the new definition is wide-ranging and, as currently drafted, willpotentially catch many real estate fundvehicles that are outside the scope ofthe current UK Offshore Fund rules.Examples of such funds or vehiclesinclude, but are not limited to, thefollowing:

1. Funds where liquidation referable tothe asset values of the underlyingassets is typically the only exit routefor investors;

2. Offshore property holding companiesmay fall within the scope of the newdefinition when applying the proposedcharacteristics.

Welcome exclusions for certain types ofproperty vehicles include, but are notlimited to, single-tier arrangements suchas Jersey Property Unit Trusts (JPUTs),which are investing directly in propertyand vehicles that are equivalent toUK REITs.

It will therefore be necessary to considerwhether existing funds as well as newfunds are impacted by these changes.In particular, current investments in fundsmade prior to 1 December 2009 will begrandfathered whereas investmentsmade in existing funds after that date willbe subject to the new rules.

Tim Jones is a director in our real estatetax team.

25


Accounting for real estate – amendment to IAS 40 ‘Investment Property’In 2008, the InternationalAccounting Standards Board(IASB) issued a number ofamendments to existingInternational Financial ReportingStandards (IFRSs) as part of itsannual improvements project.The annual improvements projectprovides a vehicle for makingnon-urgent but necessaryamendments to IFRSs.

The Improvements included, amongothers, an amendment that revised thescope of IAS 40 ‘Investment Property’ toinclude properties under construction ordevelopment for future use asinvestment properties. This led to acorresponding amendment to the scopeof IAS 16 ‘Property, Plant andEquipment’ to exclude such properties.Previously, IAS 16 applied to allproperties under construction ordevelopment, except those recognisedas inventory in accordance with IAS 2,up to the point when construction ordevelopment was completed, regardlessof the intention for future use as eitherowner-used property or investmentproperty. Therefore, the decision over thefuture use of a property must now bemade at an earlier stage.

Measurement at fair value

The driver for the amendment was theperceived inconsistency between IAS 40and IAS 16. It was noted by the IASBthat investment property beingredeveloped remained in the scope ofIAS 40, whereas investment propertyunder construction or development forthe first time was excluded andaccounted for under IAS 16 untilcompletion of the construction ordevelopment. Additionally, the IASBconcluded that with increasingexperience regarding the use of fair

value as the measurement basis sinceIAS 40 was issued, entities were moreable to reliably measure the fair value ofinvestment property under constructionor development.

As a result, properties underconstruction or development for futureuse as investment properties must nowbe measured in the same way as otherinvestment properties recognised by theentity. If the entity measures itsinvestment property portfolio at fairvalue, investment properties that areunder construction or development mustalso be measured at fair value unless it isnot possible to reliably estimate a fairvalue. In these instances the amendedIAS 40 requires these properties to bemeasured at cost until such time as thefair value becomes reliably measureableor construction or development iscompleted (whichever comes earlier).

Financial statement disclosures

The amendment, which is effective foraccounting periods beginning on or after1 January 2009, will increase thevolatility of the income statement andlead to a number of challenges, not onlyin determining the fair value (if possible),but also in meeting the disclosurerequirements of IAS 40 and IAS 1‘Presentation of Financial Statements’.It should be noted that an entity that

chooses to measure its investmentproperties at cost must also disclose thefair value if it is possible to estimate it.

IAS 40, paragraph 75 (d) states that anentity shall disclose the methods andsignificant assumptions applied indetermining the fair value of theinvestment property, including astatement whether the determination offair value was supported by marketevidence or was more heavily based onother factors (which the entity shalldisclose) because of the nature or theproperty and lack of comparablemarket data.

IAS 1 (R), paragraph 125 states that anentity shall disclose information aboutthe assumptions it makes about thefuture, and other major sources ofestimation uncertainty at the end of areporting period, which have a significantrisk of resulting in a material adjustmentto the carrying amounts of assets andliabilities within the next financial year.

Valuation methodology

Outside of financial reporting, themethodology for valuing developmentproperties is reasonably well establishedin the UK, although it is primarily usedfor appraising development opportunitiesprior to acquisition.

Continued 26


Accounting for real estate – amendment to IAS 40 ‘Investment Property’Asset level transactions involvingdevelopment properties typically fall intothree categories:

i) Acquisition of land or properties thatare not in their highest and best usefor development;

ii) Disposal of completeddevelopments;

iii) Transactions involving developmentsin progress. These are rare at theasset (rather than corporate) leveland usually occur in either distressedcircumstances or during periods ofexceptional capital growth.

The latter category, that is developmentsin progress, is the most challenging froma valuation perspective as there isnormally very little, if any, marketevidence, other than forced sales.

The lack of transactions and also the sitespecific nature of development oftenrules out the use of a market approachfor valuation (e.g. comparable salesmethodology). Instead, the valuation ofdevelopment properties is typicallybased on expected future cash flowsand is effectively an income approach.

To estimate the future cash flows, the firstand perhaps most important step is toidentify the optimal development schemeto maximise the value of the site, forexample type, scale, specification, etc.

The estimation of the end value and thedevelopment costs will then be basedupon this conceptual scheme. It isimportant that the assumptions maderegarding the proposed development arerealistic and achievable, having regard tothe site constraints, planning restrictions,project economics and market demand.Once the construction phase has startedthe cash flows will nearly always bebased upon the actual scheme inprogress, unless it clearly fails to deliveroptimal value.

The methodology used to valuedevelopment properties is known as the‘residual method’, which may besummarised as displayed in Figure 1.

This methodology has traditionally beenapplied using the mathematical formulaabove, which involves a number ofsimplifications and needs to be appliedwith caution. The use of this ‘traditionalapproach’ is likely to be mostappropriate in the feasibility stages of aproject when the future cash flows haveyet to be quantified in detail.

A more robust alternative is to use adiscounted cash flow (DCF)methodology to present value as futurecash flows. The inputs into DCFmethodology will typically be moreexplicit, both in terms of quantificationand timing, than the traditional approachabove. The net present value (NPV)

derived from the DCF calculation willrepresent the current value of thedevelopment. The internal rate of return(IRR) will also be visible and provides ahelpful sense check, that is the impliedreturn commensurate with the risksinvolved, having regard to other potentialinvestment opportunities?

Residual method –key valuation inputs

a) Market value of the completeddevelopment

Where the property is a commercialdevelopment and is intended to beleased to third parties the value of thecompleted development is normallydetermined using the methodologyapplicable to standard investment

properties. However, where the endproduct is intended to be sold to owneroccupiers, for example residential units,a sales comparison approach willusually prove to be a more appropriatemethodology. In either case, themethodology for valuing the completeddevelopment does not in itself pose newchallenges.

The big issue is whether the marketvalue of the completed developmentshould be determined having regard toa) levels of value prevailing at thevaluation date or b) the anticipated futureexit proceeds, as forecast at thevaluation date. Whenever pricing isexhibiting an upward or downward trend,there is likely to be a gap between thesetwo values. At present, valuers in the UK

Continued 27

Development costs to completion eg. constructioncosts, fees, planning costs etc (B)

Market value ofthe completeddevelopment (A)

Value of thedevelopment inprogress (A-(B+C+D)

Notional financing costs to completion (C)

Profit margin for the developer (D)

Figure 1



Accounting for real estate – amendment to IAS 40 ‘Investment Property’typically appear to apply levels of valueprevailing at the valuation date. If thisapproach is followed, the prospects offuture value movements prior tocompletion will need to be addressedthrough the developer’s profitmargin/required return, for exampledeclining values will imply the need for ahigher profit margin to cover the adversemarket risk.

Larger developments may be phasedand for some schemes, for exampleresidential, there may well be partialdisposals prior to completion. Thesecredit balances and any rental incomereceived prior to completion need to bereflected and may be more easilyincorporated into a DCF approach.

b) Development costs to completion,for example construction costs, fees,planning costs, etc

Development costs to completionexclude sunk costs. The developmentcosts may be actual (i.e. contracted) orestimated if the costs are not yet certain.The costs relate to any project costsneeded to complete the development,except for i) finance costs, for exampledebt, arrangement fees, etc; ii) thedeveloper’s margin; and iii) taxes.

On larger projects, development costsmight include, for example, items suchas the acquisition of additional plots ofland, compensation paid to existing

tenants for obtaining possession or off-site planning gain costs.

c) Financing costs to completion

As mentioned above, the traditional(‘static’) residual appraisal simplifies anumber of aspects of the developmentprocess. One of the most obvioussimplifications is the use of notionalrather than actual financing costs. For a‘static’ residual valuation, the traditionalapproach assumes that the outstandingdevelopment costs will be 100% debtfinanced with an interest only loanobtained on ‘market terms’, drawn downuniformly over the development period.The interest charge on the notionalborrowings is then deducted as part ofthe static residual calculation. Notionalinterest costs on the value of thedevelopment in progress (i.e.hypothetical purchase price) are alsoreflected as a purchaser would haveholding costs on the capital expendeduntil the development is complete.

The financing assumptions above areclearly divorced from reality asdevelopment projects are rarely 100%debt financed and the actual profile ofexpenditure will typically be loadedtowards the second half of the project(an ‘S’ curve profile). In the currentmarket, the reduced availability of debtfinance is hard to incorporate into atraditional appraisal.

In practice, the financing ofdevelopments is normally a mix of debtand equity, and in a traditional residualvaluation the return on equity to thedeveloper is partly captured through theartificial assumption of debt finance on100% of the costs and partly through theprofit margin discussed below. Theimplied equity return for the developeris not clear from the traditionalmethodology, although this may beovercome by using a DCF approach.

d) Profit margin for the developer

The profit on development is not realiseduntil an exit occurs, although obviouslywith phased schemes/disposals,

profits/losses may be crystallised duringthe development period. Nonetheless,the development profit should start toaccrue as the development progresses.

Post-acquisition, a typical commercialdevelopment will involve a number ofdefinable steps shown in thediagram above.

As the development passes throughthese steps it will (in a stable market)become progressively de-risked. If ascheme has been partially de-risked thena hypothetical purchaser should bewilling to accept a lower profit margin

Continued 28

Conceptstage schemeoptimisation

Design/permits

Construction Leasing Disposal

Planning risk

Construction risk

Leasing risk

Market risk



Accounting for real estate – amendment to IAS 40 ‘Investment Property’

than envisaged at the outset andconsequently will be willing to bid morefor the property. The rate at which theprofit accrues during the developmentwill be judgemental and specific to anindividual development, reflecting therelative risks in each step.

In a static appraisal, it is usual to deductthe developer’s profit as a lump sum,based upon a percentage of thedevelopment costs. When the risks arehigher, the required profit margin willincrease. With a DCF approach, therequired profit margin may be capturedin the discount rate and anticipatedchanges to the quantum and timing of the inputs should be reflected in thecash flows.

While profit will normally accrue asdevelopment progresses, there remainsa very important overlay, namely, marketrisk, which impacts on leasing and exitproceeds. In a market with weakoccupier demand, the inherent risk (andprofit requirement) will remain high untilthe space has been leased to anoccupier(s), even though the front end ofthe development, that is construction,may be largely complete and de-risked.

Market risk also has a dramatic impacton the future exit proceeds. If the capitalvalue of the completed project isdeclining, the assumed profitmargin/return will be eroded unless thedevelopment costs can be scaled back.Consequently, when values are falling,a hypothetical purchaser is likely torequire a higher profit margin and will

reduce their bid accordingly. In thesecircumstances, an alternative might be topostpone an exit until the marketrecovers. Nevertheless, the ongoingholding costs and uncertainty regardingthe future exit proceeds will still have anadverse impact on the current value ofthe project.

Volatility

The high level of operational gearinginherent in the development process hasa direct impact on the residual methodand small variations to the inputs willresult in a disproportionate change in theend value. This sensitivity will amplifyvalue movements during a real estatecycle and consequently the value ofdevelopments in progress may be highlyvolatile.

Conclusions

The requirement to fair valuedevelopment projects has coincided witha particularly sharp downturn in realestate markets. Reduced occupierdemand, falling rents and yielddecompression have resulted in manydevelopments becoming economicallyunviable.

For developments at the feasibility stage,existing use values might now be higherthan the development value and, where

projects have already commenced, thereis a risk that the costs to date may behigher than the current fair value.

From a valuation perspective, the inherentsensitivity of the residual methodologyneeds to be recognised, as does the levelof estimation involved. Most developmentvaluations will be less robust thanequivalent valuations of income-producinginvestments. It is therefore important toapply secondary valuation approacheswherever possible. This might involverunning traditional ‘static’ and DCFmethodologies side by side or thechecking of valuation outputs againstobservable market prices where available,for example values per acre/hectare forindustrial land or a value per square footof developable area for a city centre officesite. When applying the traditional residualapproach, the valuer needs to be aware ofthe simplifying nature of the methodologyand check that it does not produce anotherwise unsupportable value.

In terms of financial reporting, in additionto measuring the fair value of thedevelopment, entities need to considerthe level of disclosure required. Typically,pricing is not observable in the marketand so developments are likely to requirea relatively high level of disclosure.

Nicholas Croft is a director inPricewaterhouseCoopers’ Valuations practice.

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Guarantees in playTraditionally landlords haveinsisted on tenants providing aguarantor where covenantstrength is weak; both to underpincompliance and to supportvaluation. In the current economicclimate landlords are increasinglylooking to guarantors as tenantsdefault, but it is not plain sailingas it is easy to lose the benefit ofa guarantee or to misunderstandwhat it covers.

My tenant has failed to pay therent, what do I do?

Where a tenant has failed to pay the rentthe first port of call for a landlord isfrequently to instruct a bailiff to enter theproperty and seize goods as security forpayment of the debt. If the property issublet, the landlord can serve notice on

the subtenant requiring it to pay rent tothe landlord direct. Consideration mayalso be given to serving a statutorydemand.

Guarantors and other parties

A landlord may also have rights againstboth a guarantor and a previous tenant

who has provided an authorisedguarantee agreement. For older leases(pre-dating January 1996) the landlordmay also have recourse against previoustenants and guarantors.

The first step for the landlord is to workout what rights it has against whom, ifthey are likely to have the money to paywhat is owed and if they can be easilyfound. The vogue for taking guaranteesfrom offshore parent companies toimprove valuation may come back tohaunt some landlords, as the cost ofenforcing judgments in other jurisdictionscan be out of all proportion to theamount owed.

It is important to remember that alandlord’s right to claim for rent andservice charge from a former tenant orits guarantor will be lost if a noticedetailing the amount claimed is notserved on them within six months of thedue date. Payment pursuant to such anotice will give the payer the right torequire the grant to it of an ‘overriding’lease of the space.

Problems with guarantees

When considering what rights it hasagainst a guarantor or former tenant alandlord should check to see if anything

Continued 30


Guarantees in play

has happened that would either havereleased them or put them into abargaining position. An extension of theterm of a lease or of the area demisedwill have given an automatic release toa guarantor unless a new guarantee wascompleted at the same time. Dependingon the wording of the lease, otherchanges to the lease or concessions to

the tenant might also have had the effectof letting the guarantor off the hook –for example changing the rent paymentpattern from quarterly to monthly orvarying a lease to permit underlettingof part.

Landlords need to remember too thata guarantor is only liable for what it has

signed up to. So, for example, where alease prohibits structural works but alandlord has nevertheless given consentto structural works, the guarantor will notbe liable to reinstate if the tenant fails todo so, unless the guarantor was also aparty to the licence for works andguaranteed the tenants obligations in it.

Disclaimer

Where a tenant goes into liquidation theliquidator will be able to disclaim a leaseif it is an ‘onerous’ contract – and thatwill be the vast majority of leases ofcommercial space. The disclaimer willrelease the current tenant but will notautomatically release a guarantor.However, if the landlord takes‘possession’, the guarantor will beautomatically released from liability forfuture rent and compliance with leaseterms. ‘Possession’, for these purposesis undefined but would certainly covernot only literally moving into thepremises, but also going into thepremises to inspect or carry out works,and is likely to cover putting thepremises on the market or paying therates on them.

A landlord therefore needs to considerits position very carefully followingdisclaimer. There is nothing to stop itsitting back and demanding rentquarterly from a guarantor as it is under

no duty to mitigate. A guarantor in sucha position is likely to want to strike adeal, but great care needs to be takenduring the negotiations to ensure thatthose negotiations themselves don’tconstitute taking ‘possession’.

Moral going forward

1. Do not vary lease terms, give sideletters or agree to anything that is notstrictly in accordance with the leaseterms without first checking that youare not releasing a guarantor.

2. If you are willing to permit somethingoutside what was originallycontemplated by the lease, theguarantor will need to be signed upto it.

3. Remember that a claim for rent andservice charge against a formertenant or its guarantor is lost if noticeis not served within six months of thedue date.

5. Following disclaimer, be careful thatyour actions do not release yourguarantor.

6. On new lettings consider taking a rentdeposit instead of a guarantee – cashis surely king!

Jessica Lloyd is a solicitor in the realestate team of PwC Legal.

31


Proposed EU Directive on Alternative Investment Fund ManagersOn 30 April the European Unionpublished a draft directive onAlternative Investment FundManagers (AIFM). As it stands,the directive will catch managersof hedge funds, private equityfunds, commodity funds andother types of institutional funds,but also, real estate funds, REITs,listed investment trusts and otherforms of collective investmentvehicle that have previously beenoutside the scope of financialservices regulation.This may come as a surprise tomany in the real estate industry,as most of the debate oninternational fund regulation hasfocused on hedge funds andprivate equity funds.

The directive could radically reshape thealternative asset management industry insome EU countries, potentially requiringchanges to managers’ business modelsand significantly increasing theregulatory burdens on the fundsthemselves. The directive also posesserious questions on the accessibility ofthe EU’s markets to non-EU alternative

fund managers and how EU-basedmanagers with funds or connectionsoutside the EU are going to be able tocontinue to operate. As the directive islargely non-sector specific, real estatefunds will be subject to the samerequirements as private equity andhedge funds.

If enacted in its current form, thedirective will impose a comprehensiveregulatory regime on the managers of allcollective investment vehicles that arenot qualifying UCITs, whether open- orclosed-ended and whether or not listed,subject to certain exclusions. This couldsignificantly increase the costs faced byreal estate fund managers in launching,marketing and operating funds.

In an interview for our June 2009PricewaterhouseCoopers publicationAsset Management News, Dan Waters,Sector Leader for Asset Management atthe Financial Services Authority (FSA),commented: “this has beenunderstandably driven by enormouspolitical pressure when we are livingthrough what has been dubbed theGreat Recession. We consider thatchanges in regulation are warranted, butwe are concerned about the rapid paceof this and the lack of consultation withstakeholders, and we are worried aboutthe unintended consequences oflegislation that treats such a wide rangeof asset management businesses in thesame way. Fortunately, the EuropeanParliament elections have intervened andwill give us more time to collectfeedback about the proposals in thedirective. This is a huge priority for us.We need to create the window formeaningful consultation that the EU

Continued 32


Proposed EU Directive on Alternative Investment Fund Managersprocess has not allowed. We are runningtown hall meetings and will devote ourannual conference in September to thisimportant issue. To the extent that theproposed directive diverges from thework that was done by the G20 in thisarea, it needs to be questioned.Furthermore, the underlying analysisneeds to be produced to justify some ofthe proposals.”

AIFM, which are divisions of EU banks orinsurers, authorised pension fundmanagers and sovereign wealth fundsare excluded from the scope of thedirective, potentially putting thoseinstitutions at a relative competitiveadvantage and creating an unlevelplaying field in the EU assetmanagement industry.

The directive will apply to all AIFM withassets under management in excess of€100m (including any leverage employed).On this point too there is a lack of clarityin the current drafting and it is unclear ifthis is net or gross assets, but doesinclude assets “acquired through the useof leverage”. This limit is cumulative thatapplies to the total of all funds managedby the AIFM and is not on a per fundbasis. For AIFM that manage unleveragedfunds, the threshold is €500m, providedinvestors are locked in for at least 5 years.Non-EU AIFM who do not manage ormarket any funds in Europe will beoutside the scope of the directive.

All AIFM that are caught by the directivewill need to be regulated by their ‘homestate’ financial regulator. Theauthorisation process will requiresubmission of detailed information to theregulator about managers andcontrollers, about the funds to bemanaged (strategies and constitution),the countries where the funds are to besold and details of the custodians,valuers and other third parties to whommaterial functions are delegated.

All AIFM that become regulated will needto meet the following requirements(among others):

• Regulatory capital of €125,000 plus anamount equal to 0.02% of fundsunder management;

• Documented internal systems ofmanagement and control complyingwith EU standards (as yet unspecified)relating to liquidity, management ofconflicts of interest, risk management(including appropriate ‘documentedand regularly updated due diligencewhen investing’) and short selling;

• An independent ‘valuator’ appointedfor each fund, who must value assetsin the fund on at least a yearly basis,in accordance with local GAAP or inaccordance with rules set out in thefund’s constitution;

• An independent depositary for eachfund (which must be an EU authorisedcredit institution), whose function willbe to receive investor subscriptions,safekeep financial assets and to verifythe fund has ownership of assets ithas invested in;

• An EU or EU-qualified auditor to auditeach fund.

All AIFM will be required to disclose totheir regulators details (yet to bespecified) of the principal markets andinvestments in which they trade(including, on an aggregated basis,details of their principal exposures andconcentrations) and details of theirleverage through quarterly reporting.The directive contains unusual provisionsspecifying that the Commission (ratherthan a home state regulator) can imposecaps on the amount of leverage an AIFMcan employ in a fund. The home memberstate of an AIFM can impose additionallimits on leverage, in exceptionalcircumstances if required to maintainfinancial system stability.

All AIFM will also be required toproduce detailed information forprospective investors and, to the extentthey use leverage on a systematic basis,detailed information on that usage on aquarterly basis.

Participations in alternatives fundsmanaged by AIFM, which are authorised,may be sold only to professionalinvestors (as defined in MiFID). Initially,such funds may be marketed toprofessional investors in the AIFM’shome member state but may, subject tocomplying with passportingrequirements, be sold to professionalinvestors in other member states.

An AIFM whose fund acquires 30% ormore of the voting rights in other bodiescorporate will be subject to an enhanceddisclosure regime, under which they willneed to disclose to shareholders andother stakeholders in the companyconcerned, very detailed informationregarding their holdings and plans withregard to their investment. For non-listedcompanies that accept such funds asinvestors this will mean disclosure ofcommercially sensitive information thatmay not currently be publicly available.There is a carve-out for small andmedium-sized enterprises (SME), whichmeans that acquisitions of propertyspecial purposes vehicles (SPVs) shouldescape, as the employee and turnoverlimits will not typicallybe breached.1

1 Need to satisfy 2 out of the following tests to be a SME: under250 employees; turnover less than 50M Euro; balance sheet lessthan 43M Euro.

Continued 33


Proposed EU Directive on Alternative Investment Fund Managers

The depositary/custodian obligationsunder the directive are also causingmuch concern. While an EU custodian ispermitted to delegate its functions to anon-EU subcustodian, the directiveprovides that the custodian remains fullyliable for any loss experienced by thefund as a result of the subcustodian’snegligence or fraud, which is asubstantial deviation from currentindustry practice and likely to result insubstantially increased custodial costsfor funds.

The ability of a non-EU AIFM to marketfunds that are domiciled outside the EU(e.g. in Jersey, Guernsey or Cayman) willbe subject to detailed restrictions,including a requirement for the non-EUAIFM to obtain authorisation from an EUmember state, and a requirement thatthe relevant authorities in the fund’sjurisdiction have signed an agreement toshare tax information that complies fullywith the OECD standards with thejurisdiction into which the fund is to bemarketed. This passport will not beavailable for three years, and prior tothis, non-EU domiciled funds may onlybe marketed into those EU states wherethey can currently be sold underdomestic law. In addition, the EUcommission must have determined that:

• the third country in which the non-EUAIFM is established has AIFM-related

prudential regulation and ongoingsupervision that is equivalent to thedirective’s and that it is effectivelyenforced;

• the third country grants EU AIFMequivalent market access to thatgranted by the EU;

• various information requirements aremet by the non-EU AIFM regarding theregulator in the EU state it will marketto; and

• there is a cooperation agreement inplace between that regulator and thethird country regulator.

A substantial number of Jersey PropertyUnit Trusts (JPUTs) created over the pastfew years, which have been marketed inthe EU, will fall within this portion of thedirective. This may drive their sponsorsto consider changing the structure ofthese funds and/or winding down beforethe full impact of the directive comesinto force for non-EU funds (likely tobe 2014).

Possible impact on thereal estate industry

• Currently the real estate fundregulatory regime around Europe isbroadly divided between relativelylightly regulated partnership regimes(e.g. the UK) and more heavily

regulated regimes (e.g. in Germany,Luxemburg and France). Investorshave a choice as to what is mostappropriate for them. The new regimewill result in all AIFM being heavilyregulated with significant increasedcosts;

• The directive could accelerate aconsolidation in the European fundmanagement industry with theburden of regulation making thecost/benefits of managing smallerfunds uneconomic;

• There does not appear to be a levelplaying field with managers owned bysovereign wealth funds, EU-registeredbanks, pension funds and insurancecompanies potentially enjoying acarve-out from the directive, whichcould give them an advantage overother real estate fund managers.

The EU Commission has already saidthat it expects the directive to be thesubject of intense discussion andnegotiation, although there has beenvery little consultation with industry upuntil now, which is unusual for a directivewith such a significant impact. It is to behoped that this discussion includessuggestions for considerablesimplification and clarification, but thiswill require considerable input fromindustry participants.

If political approval on the Commission’sproposals is reached by the end of 2009,the directive could come into force in2011. Given the proposed reach of thedirective, potentially affected businessesneed to assess the potential impact ofthe directive immediately (including onany proposed new fund launches), sothat they can seek to influence the shapeof the final directive and its implementingregulations, and, to the extent necessary,start planning for the changes thedirective will require.

Bas Kundu is a tax partner inPricewaterhouseCoopers’ real estateteam.

Laura Cox is a partner inPricewaterhouseCoopers Legal’sfinancial services team.

34


The State of Pay – Real Estate Executive RemunerationThe companies in this sector haveuntil recently enjoyed a markedrun of success, which has flowedthrough to the level of bonusesand incentives paid to theexecutives who run thesecompanies.

Our recent Report titled “The State ofPay – Real Estate ExecutiveRemuneration” shows that with the verydifferent economic environment, salaryand bonus levels are starting to fallmarkedly.

One school of thought is that one takesthe rough with the smooth and that it is

inevitable that reward follows thesame cycle as the overall propertybusiness cycle.

However, in practice, companies in thesesituations become concerned thatexecutives may get poached bycompetitors, particularly those who havedemonstrated a strong track record. Inaddition, there is a desire by companiesand their shareholders to motivateexecutives to maximise and restore valueover a difficult economic period.

The nature of the challenges in thecurrent environment is different from therecent past and therefore it is likely thatexisting incentive structures will betargeting the wrong performancemeasures or levels of performance fortoday’s company strategy where, forexample, growth may take second placeto free cash flow and debt management.

In difficult economic times incentivesbecome even more important, due to thejustified difficulty of getting shareholdersupport for increasing salary and fixedcosts at a time of falling returns. Thisemphasis will increase when one of thelonger term benefits pension will lose asignificant amount of its future valuefrom April 2011, as tax relief is reduced.

It is therefore our view that in the nearfuture the key reward issues for thesector will be:

• the design of short- and long-termincentive arrangements which strikean appropriate balance between theexpectations of executives, thecompany and its particular strategy,and the prescriptive requirements ofinstitutional shareholders and theirrepresentative bodies all in light of thechallenging market conditions; and

• the requirement for the performanceconditions to support companystrategy rather than follow marketpractice, which is a positivedevelopment from the one-size-fits-allapproach, which has historically beenfar too prevalent.

These incentive arrangements shouldsupport the strategy of the individualcompany and therefore there should befar more variation in types and levelsof performance condition. The challengeof this change should not beunderestimated, as like other sectors,too much incentive design has beenoverly dominated by market practice.

Marcus Peaker is a partner inPricewaterhouseCoopers’ HumanResources Practice specialising inexecutive reward.

35


The Day after Tomorrow for Asset ManagementWhile the unprecedented crisis oflate 2008 revealed clear flaws inthe banking system, the assetmanagement sector was shownto be considerably more robust.Assets under management didshrink, of course, and individualcases of malpractice arose, butthe reputation of many firms didnot suffer unduly. Nevertheless,the consequences of the crisis onthe sector are likely to be felt at aprofound level and for a long time.Changes in regulations, investorpreferences and within theindustry itself will provide a rangeof opportunities and threats thatno asset management firm canafford to ignore.

PricewaterhouseCoopers, in the secondof its ‘day after tomorrow’ perspectiveseries, sets out some of the most criticalissues the asset management sectorfaces today and in the future:

Business models are under stress

Many businesses are still in full survivalmode and will examine ways of furtherreducing costs in the short term tomaintain profitability or contain losses.

But they will also need to evaluateexactly what sustainable costmanagement means for them. Marketvolatility may encourage firms to seeknew fee models that are morepredictable over the long term and nothighly correlated to the market. A keyvariable cost – human resources – willremain a focus and firms must decidewhich sections of their staff contributedirectly to the bottom line. This stressand the need for capital could force

some institutions, especially banks, toreconsider their long-term commitmentto asset management. Successful andopportunistic independent assetmanagers and insurance companiescould benefit from these situations togrow their asset base and enhance theirskill sets.

How will investors react in thepost-crisis environment?

Institutional investors will increase theirdue diligence efforts and asset managerswill need to better articulate risk andreward to investors. Investors will alsowant to see more evidence of enhancedmanagement of risk, in its broadestsense. Allocations to equity investmentsare likely to increase as investors seek torebalance their portfolios after a periodof declining values in their equityallocations. However, the investmentstrategies of alternative products will beexamined, given relatively poorperformance by some. Products thatcontain capital guarantees and otherkinds of embedded ‘insurance’ willremain popular.

Continued 36


The Day after Tomorrow for Asset ManagementFiscal pressure will change theshape of the industry

Asset managers, in common with therest of the financial services sector, willbe significant contributors to tax-raisingefforts and can expect more rigorousenforcement of tax rules, swifter closureof loopholes and a more adversarialenvironment. Asset managers will needto consider how they should positionthemselves while remaining protectedfrom excessive tax burdens. There willbe renewed focus on privacy laws andtax evasion, mainly relating toindividuals.

A new spirit of cooperationbetween the G8 and G20 nationswill have consequences for mostasset managers

There will be a particular focus on theactivities of non-cooperative and lightlyregulated domiciles as the possibility ofcoordinated sanctions now exists. Anyactivity that is viewed as systemicallyimportant to the financial system willattract regulation and oversight. It maybe that unregulated offshore businesswill reduce substantially, at least for aperiod, until the stance of politicians andregulators is clear or until jurisdictionsraise levels of transparency to meet newrequirements.

How will the regulatory maelstromimpact asset managers?

Under political pressure, regulators willtarget investment firms directly,predominantly those in the alternativesspace. Many mainstream financialinstitutions may find that connectionswith ‘light-touch’ financial centres will nolonger be commercially viable. TheEuropean Union has already taken stepsto impose regulation on alternativeinvestment funds and managers, andthis may be replicated elsewhere. Thereis, however, less pressure on regulatedmutual funds, where the regulatoryconstruct has not led to widespreadfailures. However, some mutual fundvehicles – such as the UCITS model inEurope – are steadily broadening therange of permissible instruments, whichcould weaken the model.

Is the ‘new model’ in financialservices under pressure?

Over the last few years, capital has nolonger flowed solely to the largest, full-service institutions, which both deployand manage the assets. A modelevolved whereby the deployment ofassets and the management of themwere often carried out by separateentities. Significant new entities emergedusing this model, particularly in theprivate equity space. But there is a

possibility that asset management nowreturns to the days where funds weresimply awarded mandates to run andhad no deeper involvement in the capitalmarkets. There could be a flight toquality by investors – to asset managersthat are owned or backed by FS groupsthat have financial strength.

Deleveraging in the bankingsystem will affect assetmanagement

Asset management firms are not highlyleveraged at the company level, but they

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The Day after Tomorrow for Asset Management

have a high natural gearing to markets,so in a downturn their earnings tend tobe hit disproportionately. This leavesthem exposed to potential breaches ofcovenant and other cash-flow andbalance-sheet difficulties. The biggestimpact of deleveraging is on thosehedge funds and private equity firms thatdepend on debt to gain access

to transactions and magnify successfulinvestment strategies. Without accessto affordable leverage with reasonablelevels of collateral, their business modelsmay struggle.

Compensation in assetmanagement is likely to take itscue from banking

If management and performance feescontinue to decline, there will be animperative to implement a long-termreview of compensation. Where the assetmanager is owned by a banking parentthat has accepted state financialassistance, the influence of governmentis likely to make itself felt, even at theasset management level. The continuingability of hedge funds with illiquidstrategies to earn performance fees fromunrealised profits will be the subject ofsignificant challenge from investors andconsultants. In private equity, the size ofthe management fee on largecommitments may be challenged.

Overall, the fact that the assetmanagement industry is likely to be lessconstrained by government interferenceor direct regulation on compensation islikely to be a source of competitiveadvantage for the asset managementindustry. Most countries have lower ratesof tax on capital gains, so the moreflexible remuneration regarding sharearrangements that the assetmanagement industry can offer is alsoa competitive advantage.

The reawakening of Asia

Patterns of consumption and saving inboth the West and emerging markets areshifting. The West is starting to consumeless and save more, which impliesslower future economic growth.Meanwhile Asia, less affected by theglobal crisis and less encumbered bylegacy debts, should grow at a fasterrate in the foreseeable future. A one-offrerating of Asian stocks in the short-termcould be complemented by long-termgrowth at a higher trend rate than in theWest. Increased savings rates, togetherwith the need to restore assets inretirement accounts due to thesignificant market losses in Westerneconomies will provide opportunities forasset managers to exploit this growth.

The full report is available on ourdedicated ‘day after tomorrow’ website.Access the page herewww.pwc.com/dayaftertomorrow

Pars Purewal leads our AssetManagement team in the UK.

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Withholding tax on dividends – the European Court of Justice delivered itsfinal judgement in the Aberdeen case (C-303/07)

On 18 June 2009, the ECJ issuedits judgment in the AberdeenProperty Fininvest Alpha Oy(Aberdeen) case. It is the first timethe ECJ has considered thecompatibility with the EC Treaty ofan EU Member State, levyingdividend withholding taxes onlyon dividends paid to non-residentinvestment funds while exemptingdomestic investment funds fromsuch taxes; therefore, the ruling isof considerable significance forthe European investmentmanagement industry.

Aberdeen is a Finnish resident real estatecompany, wholly owned by a real estatefund structured as a Luxembourg SICAV.The case concerns Finnish rules thatsubjected dividends paid by Aberdeen toits Luxembourg SICAV parent towithholding tax.

PwC Finland represented Aberdeen inboth the Finnish courts and then theECJ, assisting them in challenging thecompatibility with the EC Treaty of thelevying of Finnish withholding tax on thedividends it paid. The case was referredto the ECJ to rule whether the impositionof withholding tax by Finland ondividends paid to a non-residentcompany constituted as a LuxembourgSICAV while exempting Finnish residentparent companies and investment fundsfrom such taxes is contrary to Articles 43(freedom of establishment) and 56 (freemovement of capital) of the EC Treaty.

Click here for more details

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EventsPricewaterhouseCoopers UK Real Estate conference 2009

Nearly 300 clients and contacts from the real estate industry attendedthe annual PricewaterhouseCoopers UK Real Estate Client Conferencein May.

The attendees heard a plenarysession presentation in whichPricewaterhouseCoopers presentersSimon Boadle, Richard Kibble, BarryGilbertson and Yael Selfin addressed thedangers and opportunities of the currentcrisis. The presentation looked at thecontinuing capital markets crisis and theunfolding occupier crisis. In the secondplenary session, attendees heard a paneldiscussion in which Ian Coull, ChiefExecutive, SEGRO; Nick Jacobson,Managing Director, Head of EuropeanReal Estate & Lodging, Citigroup;Michael Kenney, Senior Director, HypoReal Estate; and Andrew Wood, ChiefInvestment Officer, MGPA discussed thecurrent state of UK and international realestate markets, and the outlook for theshort and longer term.

The plenary sessions were followed bybreakouts on:

• Structuring inbound investment intothe UK;

• Distress, demise and insolvency;

• Valuations in the current environment;

• Financing sustainable buildings in adownturn;

• Investment in distressed debt;

• Financing in the current market;

• Reporting standards, control andcompliance;

• The next decade: What does it looklike for the UK?

For a copy of the presentations, pleasecontact the PricewaterhouseCoopersreal estate insights team.

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PricewaterhouseCoopers provides industry-focused assurance, tax, and advisory services to build public trust and enhance value for its clients and their stakeholders. More than 155,000 people in 153 countriesacross our network share their thinking, experience and solutions to develop fresh perspectives and practical advice.

This report is produced by experts in their particular field at PricewaterhouseCoopers, to review important issues affecting the financial services industry. It has been prepared for general guidance on matters ofinterest only, and is not intended to provide specific advice on any matter, nor is it intended to be comprehensive. No representation or warranty (express or implied) is given as to the accuracy or completeness of theinformation contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers firms do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyoneelse acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. If specific advice is required, or if you wish to receive further information on any mattersreferred to in this paper, please speak with your usual contact at PricewaterhouseCoopers or those listed in this publication.

© 2009 PricewaterhouseCoopers LLP. All rights reserved. “PricewaterhouseCoopers” refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, thePricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity.

UK real estate insights - PwC UK blogs · 2013. 1. 17. · UK real estate insights Issue 13 ... (a...

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