21 November 2005
In a year that has seen exceptional levels of activity across the commercial property market in both the UK and Europe, there have been very few topics to contend with. Unit Trusts and Stamp Duty Land Tax (SDLT) are the exception considering the trepidation with which many in the industry anticipate the pronouncements of the Chancellor Gordon Brown in his pre-budget speech in December. What are his plans for the so-called 'seeding relief', whereby properties can be contributed into unit trusts and relief can be claimed from SDLT?
The year of the SDLT
There were many in the property and tax industry who were surprised when the relief was brought in and who are now wondering whether HM Revenue & Customs (HMRC) will carry out its veiled threat to withdraw the relief if it is abused. This could be done through the Chancellor's speech at the time of the pre-budget report in a few weeks time. But what constitutes abuse?
To be fair to HMRC, throughout the debate it has maintained radio silence and has appeared to observe activity from a distance, leading to speculation as to the motive for such an approach. The most that the Treasury seems to have said is that it is keeping taxes under review and that its function is to police the tax system. The question is therefore whether HMRC is preparing to drop a bombshell in the pre-budget report as some fear, or whether it is, in fact, considering the position more rationally. Perhaps hope can be derived from the previous reaction of HMRC to the exploitation of SDLT legislation in other areas, such as SDLT group relief.
In group relief situations where it was felt appropriate to combat avoidance, HMRC's reaction was not to outlaw group relief, but rather to make life progressively harder for those who were seen as misusing the relief, culminating this summer in the so-called Mini GAAR (general anti-avoidance rule). This brings in a wider test, essentially not just asking whether the strict letter of the law has been met, but whether the transaction is effective for bona fide commercial reasons and does it form part of tax avoidance arrangements.
We can only hope that if there is to be a change in the Section 64A seeding relief, it will come through a tightening of the rules rather than through a total exclusion of the exemption. The reason this approach is needed is that, as with group relief, there are still many genuine situations where businesses would otherwise be unduly burdened.
But where next for the property industry if the relief is repealed? Just as holding property has moved from switching the totality of actual properties to property funds, where investors are able to invest in a small part of an overall portfolio of many properties and thereby manage their risks, the move would actually continue into the derivatives market. No SDLT is payable on derivatives, and therefore if this had to be compared with paying 4 per cent on any form of direct or even indirect economic ownership of an actual property, this must have a distorting effect on how money is invested in the future. We can only wait and see, but we can, perhaps, wait in hope.
Property derivatives come of age
If 2005 has been the year of SDLT, it has also been the year when it looks as if property derivatives have come of age. After a decade of false starts we have finally reached the point where transactions are being completed in significant numbers.
The market so far has developed two distinct products - property interest certificates, which are bonds with a property-related return, and swaps, in which one party pays an interest-related amount and the other makes a payment based on a property index. Property index certificates - issued by Barclays and latterly Protego Real Estate Investors - have for many years been the only game in town and have tended to be bought by fund managers looking to make strategic property allocations within their portfolios.
Property swap transactions undertaken to date are mostly three-year swaps based on the total returns of the UK commercial property market as a whole. Ultimately, a wide range of derivatives seem likely to be developed, with shorter-term instruments and sector-specific swaps likely to come next. Many others are possible, assuming buyers and sellers can be found at a suitable price. Swaps and other derivatives can be put to a wider range of uses than property interest certificates.
A survey of market participants' attitudes towards property derivatives conducted in September by Nabarro Nathanson, in conjunction with CB Richard Ellis and GFI Group, revealed that fund managers were most interested in using derivatives to obtain exposure to the property market prior to finding specific assets. Property by its nature is illiquid and it takes time to find the right asset and complete the purchase. Property derivatives can provide fund managers with a property return during that period. They are also keen to use swaps to increase or reduce specific sectoral allocations within their portfolios. For example, if they find themselves overweight in shopping centres and underweight in London offices, they can balance their portfolios through the use of sector-specific derivatives rather than buying and selling their assets.
Banks and private property companies were significantly more interested in derivatives on individual properties than the norm. It may wbe that they are looking at the use of derivatives to assist with loan structures, which are, by their nature, specific to the properties that are being financed. Property derivatives can help banks get more comfortable with property risks, which should enable debt-funded property companies to borrow more. The key to better exploitation of property derivatives in these transactions is to develop products that are as specific as possible.
The survey also revealed the attitude of occupiers to property derivatives. Their responses to the key questions were far more homogeneous than the other groups of respondent. More than 70 per cent expressed an interest in single property derivatives and more than 80 per cent are looking at longer tenor swaps. This seems to reflect a desire to swap out risks on the properties they are occupying over long periods, chiefly the uncertainty of market rent reviews.
So what will 2006 hold for the market? We have seen there is anticipation, appetite and enthusiasm - we now need to see who wants to come to the table.
Simon Rose is a tax partner and James Dakin a banking partner at Nabarro Nathanson