Funds’ day out

With experts claiming that the property market has peaked, property investment funds are a new avenue for investors to explore, say Simon Hardwick and Elizabeth Small

Property has become an extremely popular asset class in recent years for all types of investors. It has a low correlation to bonds and equities and, in the 21st century, has been the UK’s most consistent and best-performing asset class.

However, prime yields have dropped below the five-year swap rate, absolute returns are falling and property experts have called the top of the market. As a result UK investment property is viewed with some caution and investors are seeking alternatives.

Property development funds could be one solution in this ‘hot’ environment for experienced investors to find an adequate return on their capital without assuming an unacceptable degree of risk. Lawyers are increasingly likely to find themselves working alongside clients to help achieve this goal.

Despite the lure of substantial profits, the high risks associated with development projects have kept this activity off limits for most investors other than sophisticated specialists or foolhardy amateurs. The landscape has, however, begun to change and some smart fund managers now offer both institutional and sophisticated private investors potential exposure to the development market. This is being achieved through funds that offer a spread of projects, access to development expertise and superior returns in a risk-managed environment.

The icing on the cake for individual investors is that, under current legislation, substantial tax breaks are available on their investments, including a possible exemption from inheritance tax. Indeed, following Gordon Brown’s attack on trusts in the Finance Act 2006, this is one of the few remaining avenues for individual estate planning. Lawyers involved in advising investors on these schemes, as well as those involved generally in estate planning, need to be aware of the associated benefits and risks.

Tax benefits
When property is purchased for development, rather than as an investment, tax relief is available on both capital gains tax (CGT) and inheritance tax (IHT). Maximum business asset taper relief (BATR) is, of course, available on the sale of qualifying property held for at least two years, but is not usually available on investment property (held for revenue purposes) or on the sale of property held by a property development business (which is seen as the sale of trading stock). In these circumstances, individuals will be subject to income tax on trading profits rather than CGT.

One way that individuals may be eligible for BATR and yet still carry on a trade of property development is to ‘warehouse’ the development properties in a company. Shares in a trading company qualify for BATR if the investor is also an employee or director of that company; holds 5 per cent or more of the voting interests in the company; or if the company is not listed on the main market.

The use of these special-purpose vehicles by private investors is well established and real estate funds have developed structures with this in mind. However, the new angle offered by property development funds combines the benefits of BATR together with the potential for 100 per cent IHT relief.

Investment in assets qualifying for business property relief (BPR) on IHT would, on the death of the investor, qualify for 100 per cent relief from IHT if the asset had been held for two years prior to death. Standard investment in property or in traditional real estate funds will not qualify for BPR because equities, real property and high income-earning investments are excluded assets.

However, BPR on IHT should be available if the donor invests in an unlisted company or unincorporated business that is carrying on a real property development business with the intention of obtaining a gain.

As an asset must be owned for at least two years to be shielded from IHT, investments in project type work, such as property development and construction, which takes at least this amount of time, would seem a natural alliance. However, to continue to benefit from IHT relief proceeds must be reinvested when the development is complete. Here, managed funds have an important role to play, as corporate funds backed by dedicated market research functions and experienced fund managers assess the market for reinvestment opportunities where profits can be recycled.

The fund structure
There are many real estate fund managers and even more property investment funds, but those offering the chance to participate in development are less common and quite a recent phenomenon. There is not yet an industry standard for this type of fund, although most can be classified as open-ended or closed-end funds. The objectives of each individual will determine what type of fund will suit their investment criteria and these should be given due consideration when lawyers are providing tax planning advice.

Closed-end funds invite investment from individuals and institutions until the target investment is reached. The fund is then closed and contributions are not realised until the assets are distributed on completion of the development project. Investors will typically be required to commit for a fixed period of at least five years.

However, investors requiring greater flexibility could consider open-ended funds. There are now structures that may benefit from BATR and BPR while remaining open-ended. These allow investors, in theory, to exit from the fund prior to completion of a project. Those advising investors should manage clients’ expectations on the timescales for realising the assets. The structure required for BPR means that the cost-efficient liquidation of assets may take at least two years.

The highs and lows
The common feature of these and other development funds is the participation of an experienced developer, who provides the required development expertise and, crucially, takes on elements of the construction and development risks. The fund and the developer therefore combine forces, not only to share the financial demands and profit of any given project, but also to share the risks that often deter investors from such activity.

There are, however, uncertainties to tackle in order to ascertain the value of the finished product and the likely return. What will the demand be for the new property? Will the project complete on schedule? Will interest rates rise and reduce anticipated profit if finance is in place during construction? The key to the structure of any development fund is how these risks are allocated between the parties and whether the division of profit reflects this. Lawyers advising potential investors need to be aware of these risks.

Funds investing in qualifying property developments could be a convenient opportunity for the wealthy to diversify their investment portfolio while also offering significant estate planning benefits.

It is therefore likely that this type of vehicle will become increasingly popular, especially as returns from other types of real estate investment begin to decline. Lawyers from a variety of practice areas – including private client, property, tax and regulatory/funds – will need to be in a position to understand the benefits and issues associated with real estate development funds.

Simon Hardwick is head of the real estate funds and structures team and Elizabeth Small is a partner at Halliwells