PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 1 Andrew Petersen, Decbert LLP'

On March 17 2004, the UK Treasury announced a consultation exercise on how property investment funds ('PIFs')'

in the UK should be structured to encourage more efficient

investment in commercial and residential real estate.

The consultation paper reveals that

the UK Treasury is contemplating a tax-neutral vehicle which will be well-regulated and appeal to the small investor by boosting liquidity. In order to ascertain the ultimate benefit of PIFs to the UK economy and potential real estate investors and to try to understand what vehicle we should end up with in the UK, this two part article will examine the characteristics of real estate investment trusts ('REITs') currently operating in the US and throughout Europe and compare their appeal to global real estate investors and how respective government's successes (and failures) have formed current vehicles. Part 1 of this article looks at REITs in the US, France and Germany. Port 2, which will be published in the July/August issue of the Journal, will examine REITs in Belgium and Luxembourg and make suggestions as to the kind of vehicle which should be adopted in the UK for a PIF If readers do have comments on the Treasury's consultation process, the Editor, Hugh Pigott via Ann Phillip at ([email protected]) or Andrew Petersen (andrew.petersen@dech ert.com) would be pleased to hear them. In any event all consultation responses by email should be sent by 16 July 2004 to: ([email protected]).

INTRODUCTION liiiQUiD REAL ESTATE?

Even though commercial real estate in the UK has been the top-performing asset class over the past decade, rightly or wrongly, over the same period, direct ownership of such real estate has gained a perception of being illiquid, inaccessible for private investors, tax inefficient for financial institutions and, dare it be said, expensive. As a result, recent years have seen real estate investors across the globe seeking to make iiidirect real estate investment risk-averse and ideally tradable. This has led to a growing market of investors wanting to invest in real estate in a imitised way. To accommodate this need, limited partnerships, limited liability partnerships and offshore unit trusts are just a few of the structures which have developed to allow investors to 'pop in' and 'pop out' of real estate whilst at the same time limiting liability and achieving beneficial tax treatment. Real estate investors in every G7 country, other than the UK, have also had the advantage of REIT-type vehicles - essentially tax transparent collective property investment vehicles formed for the purpose of holding assets which are unitised like shares. This article will examine those vehicles in order to analyse what form the PIF should take and what form should be avoided.

WHY INTRODUCE PIFS? The absence of PIFs in the UK has encouraged a flow of investment offshore. Through the introduction of PIFs, it is hoped to stem this flow and redirect the £25bn or so of UK real estate investment into a properly-regulated onshore investment vehicle, thereby protecting UK tax revenues. A typical REIT offers a number of advantages to both private and institutional investors: 216

it allows accessible indirect investment in real estate - participants can invest in a professionally managed portfolio of real estate that is held in tax-transparent funds that trade shares rather than the underlying assets. This may serve to open up real estate investment to the small investor who otherwise could not have had this investment opportunity; it enables participants to broaden their investment portfolio and diversify risk; it is tax transparent. There is only one level of taxation, namely, at the shareholders' level. The REIT does not pay tax on its profits thereby maximising dividends to shareholders who then pay tax on their dividends and on profits made when they sell their shares. Typically a US REIT will pay back at least 90 per cent of its profits to its shareholders and in many cases even more than that, with some REITs distributing all their profits to their shareholders. REITs can also serve to eliminate some of the tax and other difficulties experienced by institutional investors, such as pension funds and foreign investors, if they invest more directly in real estate; it provides ease of liquidation of assets into cash. One reason for the liquid nature of REIT investments is that the shares of many REITS are primarily traded on major exchanges, making it easier to buy and sell REIT assets/ shares than to buy and sell real estate in private markets; it has an advantage over stocks and bonds in terms of dividends. All REITs are required to pay dividends whereas other companies are not and, as REITs must distribute almost all their taxable income as dividends to shareholders, they instil confidence in the marketplace; it offers low historical volatility. REITs tend to be stable and, therefore, offer an attractive return for investors;

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it has no minimum investment. Additionally, since REITs must be widely held, they are ideal candidates to be public companies.

The raft of property investment vehicles which have been created over the last decade demonstrates the depth of institutional enthusiasm for a PIF type structure. Hammersons have converted to a SIIC in France, and the medical charity, the Welcome Trust, recently announced that it was planning to transfer its whole portfolio into a holding company in order to attract investment for its research work. Such a holding company could well be converted into a PIF - which could generate more cash for Wellcome and its investors.^ Moreover, Isis Asset Management has recently launched a £240m 'REITstyle' listed property trust for private investors, which, given that it will pay no Corporation Tax or Capital Gains Tax ('CGT'), will have gearing of around 40 per cent and will distribute much of its profits to shareholders. It holds property in the office, retail and industrial sectors and has been billed as the first fund the nearest in structure to a REIT.^ Consequently, when FIFs arrive in the UK, they will be competing in a fierce market and their restrictions and regime will have to be attractive enough for them to become the preferred ownership vehicle for real estate investors - as they have become in the US.

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US REITS The US REFT was created by the US Congress in 1960 for the purpose of making real property an investment option for the small investor. However, it was not until 1986, when as a result of some dramatic changes in the tax laws, there was a significant increase in REIT investment. These changes may be instructive to those involved in the UK PIF initiative. The original REIT rules imposed an 'all or nothing' qualification test. A REIT that failed to comply in any respect with the rules, for example, by 'actively engaging in a trade or business', albeit unwittingly, lost its tax qualification entirely. Today a REFT is taxed (at the rate of 100 per cent) on its income from non-qualified transactions, but will not lose its REFT status entirely with its compliant income still having the benefits of the REFF dividend deduction. Moreover, REITs originally were required to be passive investors, prohibited from operating or managing assets. Management could only be by independent third parties (whose interests were not fully aligned with those of investors). Today, REITs may 'operate' and provide customary services for most types of real property, and so can be internally managed. REITs now may own taxable REFT subsidiaries (although not more than 20 per cent of total asset value can consist of shares of taxable subsidiaries), that may operate service businesses such as hotel management, day-care centres, golf courses, hospitals and nursing homes as tenants of REFT-owned assets. MARKET FREEDOM?

The UK Treasury's consultation paper suggests that it may be appropriate to restrict the market freedom of a PIF, but the success of REITs is an argument for maximum flexibility, allowing the market to refine the product. The REIT regulations do not regulate: - whether REITs are closed or open-ended. The UK Treasury shows a preference for requiring all PIFs to be closed-ended

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as a way of bringing share prices in line with net asset value. The US markets have, without mandating closedend REITs, developed the finite life real estate investment trust ('FREIT') in recognition of the share to net asset value disconnect. The FREIT has a termination date by which it must liquidate all of its assets. This reduces exposure to interest rate risk and induces investors to factor in expected capital distributions in valuing share prices; the amount of gearing or leveraging. For geared REITs, interest on debt is a deductible expense, but principal amortisation is not; this imposes a practical limit on gearing. The National Association of Real Estate Investment Trusts ('NAREIT') estimates the average REFT gearing is between 4 0 - 4 5 per cent.^ In fact, the presence of leverage at the REIT level makes a REIT a very attractive investment for US tax-exempt investors. US tax exempt investors who try to directly invest their funds in leveraged real estate may incur income tax liability notwithstanding their taxexempt status; by contrast, the existence of leverage in a REIT will generally not cause a US tax-exempt investor's income from the REIT to be taxable (unless the REIT is a closely-held entity owned primarily by tax exempts). This may also be an attraction in the UK and should pass the Treasury's tax neutral requirement; whether the REIT distributes or reinvests its gains on sales of assets. Net capital gains on sales of REIT assets are subject to income tax at the REIT level if retained. If distributed to shareholders as a capital gain dividend, the gain is not taxed at the REIT level, and is taxed to the shareholder; individual shareholders can take advantage of the lower long term capital gains tax rates. The ability to retain capital allows for continued maintenance and upgrading of assets when costs of capital rise; the type of property a REFT may invest in. In the US, there are both diversified and properties, and health care or selfstorage facilities.

Conversion to REIT status can generate tax liability for capital gains realised when property is contributed to a REIT in exchange for cash or shares in the REIT. The 'UPREIT' and 'DOWNREIT' structures have developed to minimise and/ or defer the tax impact of contributing property to a REIT; assets Ccm be contributed to one or more limited partnerships (controlled by the REIT), in exchange for lirtuted partnership interests that can be traded for REIT shares. Again, the UK could take advjmtage of this. PuBUC VERSUS PRIVATE?

The REIT regulations do not regulate whether a REIT is publicly traded (ie listed on a recognised exchange) or privately traded. NAREIT reports 171 publicly-traded REFTs at 2003 year-end, and estimates that approximately one-third of all REITs are private." Institutional investors favour public REITs for the quantity and quality of initial and ongoing disclosure and reporting required imder the US securities laws tor public companies; more than 50 per cent of REIT shares are owned by institutional investors, about 15 per cent by retail public investors, and about 17 per cent by REIT management.' At year-end 2003, the 171 publicly-traded REITs had a total market capitalisation of about $224bn.S Of the estimated total US

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real property market of $4.6tn, about $180bn (or 4 per cent) is held by public REITs." REIT shares are liquid; about 80 public REITs held investment grade ratings by Moody's, and 70 by Standard & Poor's; daily trading volume in REITs is about 12 million shares.-'^'' As these figures demonstrate, the strength of the US REIT market is the best argument for the UK Treasury to take a mirumalist approach to regulating the PIF, allowing it maximum adaptability which will translate into larger market capitalisations and liquidity.

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FRENCH REITS iNTRODUaiON

France recognises various types of real estate companies. However, two types of real estate companies correspond generally to the notion of REITS: Societes Civiles de Placement Immobilier - (Civil Real Estate Investment Companies) ('SCPIs'), and the Societes Immobilizes d'Investissement Cotees - ('SIICs'). SCPIs invest directly in real estate and their shares may be purchased by the public, although they are not listed on a stock exchange, as the shares are not negotiable securities. SIICs, which were recently created by the French Finance Law for 2003,^^ are hsted companies which invest on a long term basis in real estate assets to be leased either to businesses or as dwellings or in shareholdings in companies having the same purpose.

SCPIs SCPIs are subject to strict regulations as regards the type of investments they may make, the information they give out to the public, their management, and more particularly the system of share transfers. However, various recent reforms-^'^ have reduced certain restrictions on SCPIs and have granted a specific tax regime to SIICs, making those investment vehicles more attractive. As a result, a SCPI: - must have as its exclusive purpose the acquisition and management of a rental real estate portfolio, whether for dwelling or commercial purposes. Subject to strict conditions, an SCPI may undertake maintenance, repair, improvement, rebuilding and expansion works. For example, the cost of extension may not exceed 30 per cent of the market value of the property and 10 per cent of the SCPI's portfolio. Moreover, the cost of any rebuilding work on real estate owned by the SCPI cannot exceed 10 per cent of the total value of the SCPI's real estate portfolio. A SCPI may sell its real estate assets only if four conditions are met: - the sales do not constitute the company's usual activity; - the sales transactions do not have a speculative purpose; - the sales are not made less than six years after the property has been purchased; and - the cumulated value of the real estate being sold does not exceed 15 per cent of the market value of the SCPI's portfolio (assessed at the end of the last tax year); - is managed by a 'societe de gestion' (management company) accredited by the AMF,^"* and supervised by a supervisory board consisting of at least seven shareholders. The SCPI must also appoint a real estate expert who makes a yearly report on the valuation of the company's real estate 218

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portfolio. Each real asset must be separately valued at least once every five years; must have a minimum capital of €760,000 and at least 15 per cent of the capital must be subscribed by the public within one year of opening of subscription; must have shares in nominative form and must have a par value of at least €150. However, the shares can be transferred either over the counter or on the secondary market by the management company. Pursuant to the 2002 reform, a complex system has been put in place in order to protect investors in SCPIs, which basically consists in the management company matching sale and purchase offers as closely as possible; is not subject to corporate tax and is tax transparent. Revenues received by shareholders are subject to the personal (or corporate) income tax in the real estate income category. In case of sales of shares, capital gains are treated as real estate capital gains. In addition, registration taxes (droits d'enregistrement) in the amount of 4.80 per cent on the price on shares in SCPIs are due upon transfer; permits non resident investors to be subject to a 25 per cent withholding tax on dividends distributed by the SIICs, subject to treaty relief or reduction (which generally reduces the withholding rate to 15 per cent for minority investors and to 5 per cent for parent companies).

Moreover, mirroring a post Barker report aim, recent French legislation^^ offers tax advantages to encourage owners of real property, including SCPIs, to invest in housing projects, whether in older or new constructions, and in particular to lease their property in favour of low income individuals. The main advantages relate to the granting of a tax depreciation of the investment made in a SCPI and tax deduction of any rental revenues received from the SCPI.

SIICs Essentially, SIICs are French corporations with a minimum share capital of €15m listed on a French exchange and whose principal corporate purpose is the purchase or construction of real property to be leased out, or the direct or indirect investment in companies having the same corporate object. SIICs are subject to corporate income tax, but may opt for a tax transparent regime in exchange of their undertaking to distribute dividends. Pursuant to this preferential tax regime two types of profits are tax exempted at the corporate level: profits from rental of properties and capital gains from the sale of such properties as well of from the sales of companies which they own. However, in order to benefit from the special regime, profits from rentals must be distributed in the amount of at least 85 per cent before the end of the financial year following the year in which such profits were made. At least 50 per cent of any capital gains which were tax exempted must be distributed within two financial years of the sale in order for the exemption to continue to apply. SIICs may operate their business outside France, however, the preferential tax regime only applies to French assets in SIICs' portfolios. Shares of SIICs are also eligible for tax-efficient saving schemes such as plans d'epargne en actions or PEA (share savings plans) which makes them attractive to individual investors as well. In order to induce large French property

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companies with older building portfolios (and hence large latent capital gains tax exposure) to opt in to the SIIC regime, recent legislation provided for a one time exit tax of 16 per cent on all capital on gains on real estate portfolios.

GERMAN OEFS Germany has well-established tax-transparent property vehicles in the form of the open-ended real estate funds ('OEFs') and in 2003, the OEF market was worth €14.43bn. From the investor's perspective, OEFs are similar to REITs - paper assets that are backed by properties, tax exempt on the corporate level, and have the possibility to accumulate or disperse assets in small lot sizes. Like US REITS, OEFs also accept contributions from individual private investors and then pool resources to buy real estate that would otherwise be out of the financial reach of those investors. Unit shares can be returned to the fund at any time at the going bid price. Capital investment companies that offer OEFs are regulated by a comprehensive and tight legal framework, regulating such legal aspects as licensing requirements, the organisational structure, the function and purpose of custodians, permitted investments, investment restrictions, valuation, accounting, auditing and publication requirements. The state supervision of the rules codified in the Investment Act is exercised by the federal financial supervisory authority - BaFin. In 2002, the 4th Financial Market Promotion Act facilitated the ability of OEFs to invest internationally outside the European Union and the European Economic Area. Before the Act, it was only possible to invest 20 per cent of the fund's capital outside the Eurozone. Now 100 per cent of the fund's capital may be invested internationally, as long as their unhedged currency exposure does not exceed 30 per cent of the fund's capital. However, with the introduction of the Investment Modernisation Act 2004, the German real estate industry hoped for the introduction of 'true REITs' and the establishment of a laissez faire free market approach which in turn could boost the suffering German real estate economy. Unfortunately, the Investment Modernisation Act fell short of allowing properties and property companies to serve as possible investment vehicles of investment stock corporations and the establishment of 'true REITs', is currently ruled out under German legislation. Notwithstanding this, future amendments to the act should give investors the choice, in the real estate field, of investing in an investment stock corporation or a fund separate from the assets of the company and interest groups are already lobbying to transform Germany into a large REIT market. The introduction of 'true REITs' could avoid the tight regulation concerning OEFs, resulting in an opening up of the real estate market to investors who are ready to take a higher amount of risk than the traditional investors in OEFs (and who are expecting a considerably higher return from their real estate investment). Such a move could present the German OEFs with a tough challenge, by putting pressure on their capital inflows if investors choose to switch their money into listed REIT vehicles. *

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turing in the banking department of the London office of Dechert LLP. He is grateful to his international colleagues: Michael Hirschfeld, Nadine Yoimg, Richard J Temko, JeanPierre Magremane, Marc Seimetz, Pascal Bouvy, Joseph Smallhoover and Oliver Piatt for their respective contributions and his colleagues in London: Mark Stapleton and Ciaran Carvahlo for their comments. The name may change to reflect the financial structure and the government (in an indication that they may not be happy with PIFs as a name) has welcomed alternative suggestions. After all, it could not have been called a Property Investment Trust (after the Housing Investment Trusts of the 1990s), since one could imagine the take up in a product called a PIT to be relatively low. See http://www.hm-treasury.gov.uk/budget/budget_04/ associated_documents/bud_bud04_adproperty.cfm See Housing Today, 20 February 2004 pi 5. See Property Week, 16 April 2004 p23. The fund will be a Guernsey-exempt investment company with its shares listed on both the London and Channel Islands stock exchanges. It will offer investors a target yield of 6.75 per cent, as well as the potential for income and capital growth. See http://www.nareit.org/researchandstatistics/ See http://virww.nareit.org/researchandstatistics/ Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real Estate Investment Trusts Handbook (Thomson 2004), at p5. Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real Estate Investment Trusts Handbook (Thomson 2004), at p5. Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real Estate Investment Trusts Handbook (Thomson 2004), at p5. Pass, Peter; Shaff, Michael; and Zief, Donald, eds Real Estate Investment Trusts Handbook (Thomson 2004), at p5. Societe Civile Immobiliere, SCPIs, SIIs, societes de location immobiliere transparente or societes immobilieres de copropriete transparentes. Law no. 2002 -1575 of 30 December 2002. Reglement COB No 2001-06, Decree of 26 April 2002. The management company may be either a societe anonyme (corporation) (whose capital must be at least €225,000) or a societe en nom collectif (commercial partnership) with the condition that at least one of its partners is a societe anonyme having a minimal capital of €225,000. Law No. 2003-590 of 2 July 2003.

Andrew Petersen is Counsel specialising in cross border acquisition and real estate financing and corporate restrucButterworths Journal of International Banking and Financial Law - June 2004

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PROPERTY INVESTMENT FUNDS - A REALTY OPPORTUNITY? PART 2 Andrew Petersen, Dechert LLP'

On March 17 2004, the UK Treasury announced a consultation exercise on how property investment funds ('PIFs')l

in the UK should be structured to encourage more efficient

investment in commercial and residential real estate.2 The consultation paper reveals that the UK Treasury is contemplating a tax-neutral vehicle which will be well-regulated and appeal to the small investor by boosting liquidity. In order to ascertain the ultimate benefit of PIFs to the UK economy and potential real estate investors and to try to understand what vehicle we should end up with in the UK, this two part article will examine the characteristics of real estate investment trusts ('REITs') currently operating in the US and throughout Europe and compare their appeal to global real estate investors and how respective government's successes (and failures) hove formed current vehicles. Port 1 of this article, which was published in the June issue of the Journal, looked at REITs in the US, France and Germany. Port 2 examines REITs in Belgium and Luxembourg and makes suggestions as to the kind of vehicle which should be adopted in the UK for a PIF. If readers do have comments on the Treasury's consultation process, the Editor, Hugh Pigott via Ann Phillip at ([email protected]) or Andrew Petersen (andrew.petersen@dech ert.com) would be pleased to hear them. In any event all consultation responses by email should be sent by 16 July 2004 to: ([email protected]).

BELGIUM In 1995, Belgium enacted legislation permitting the creation of 'societes d'investissement a capital fixe en biens immobiliers' ('SICAFIs') or closed-end real estate investment companies. Prior to that time, the only publicly-offered collective investment medium for real estate investments in Belgium was the real estate certificate ('certificat immobilier'). The real estate certificate, which continues to be available on the Belgian market, is a type of asset trust certificate which entitles the holder to a ratable share of the net income and gain from an underlying real estate asset (typically, a single building leased to one or more tenants). The major differences between the certificat immobilier and the SICAFl are the latter's greater diversification of risk, its association with the active management of the underlying real estate portfolio and its greater liquidity. REGUIATORY REGIME

The legal framework for SICAFIs was established by the Royal Decree of 10 April 1995 issued under the Law of 4 December 1990, which is the basic Belgian law governing collective investment funds and investment companies. Like other investment funds and companies, a SICAFl must be approved for public offering by the Belgian Banking, Finance and Insurance Commission ('BFIC'). A SICAFl must be established in corporate form and, with limited exceptions, may invest only in 'real estate assets'. Such assets may include not only buildings, but also options, leasehold interests and other rights in buildings, voting shares of real estate companies related to the SICAFl, and real estate certificates. The SICAFI's investments must be diversified in such manner as to assure a spreading of investment risk according to the investment policy set forth in the SICAFI's articles of association. Subject to possible derogations granted by the BFIC, a SICAFl may not invest more than 20 per cent of its assets in any single real estate project. For corporate accounting 262

purposes the SICAFI's assets are appraised periodically by an independent chartered surveyor, based on prevailing market prices; the assets are recorded in the SICAFI's financial statements at their appraised value and are not depreciated. A SICAFl is permitted to leverage its assets by borrowing but its total debt is not permitted to exceed 50 per cent of its asset value (determined at the time each new borrowing is contracted). A SICAFl is also required to distribute at least 80 per cent of its annual net income on a current basis. TAXATION

Although SICAFIs are, in principle, subject to Belgian corporate income tax, like other investment companies their taxable income is limited by Decree to the amount of any non-arm'slength benefits transferred to them by related parties and to the amount of certain miscellaneous items which are not tax deductible. Hence, in practice, SICAFIs are essentially exempt from Belgian corporate income tax. Withholding taxes withheld on dividends paid to a SICAFl may be credited against any tax payable by the SICAFl and any excess will be refimdable. On the other hand, property tax payable by the SICAFl in its capacity as owner of buildings in its portfolio, although constituting in principle a tax-deductible expense, will in practice not generate any tax deduction given the absence of mainstream corporate income tax liability. Dividends paid by a SICAFl to its shareholders are subject to a withholding tax of 15 per cent, except that no withholding tax is payable if at least 60 per cent of the SICAFI's portfolio consists of Belgian residential real estate. Dividends paid to foreign investors can also qualify for a reduced rate of withholding tax under certain double tax treaties. Like other registered investment companies, a SICAFl is subject to an annual franchise tax, currently equal to 0.06 per cent of its asset value (such tax is scheduled to increase to 0.07 per cent in 2005 and to 0.08 per cent in 2007). A SICAFl must also pay an annual fee to the BFIC equal to

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the sum of: (i) 0.0075 per cent of the net assets of the SICAFI as of the end of the preceding calendar year; and (ii) 0.075 per cent of the gross amount of shares of the SICAFI issued in Belgium during the preceding year. CONVERSION

Due to the SICAFI's essentially exempt status insofar as Belgian income tax is concerned, special measures were also taken to prevent existing private real estate companies from converting tax-free to SICAFIs in order to avoid paying capital gains tax on appreciated real estate assets. Tlius, the conversion of an existing real estate company into a SICAFI is assimilated for income tax purposes to a corporate liquidation and gives rise to an 'exit tax' of 19.5 per cent, applicable to any latent capital gains on the company's real estate assets (ie, measured as the difference between the market value of such assets and their tax basis in the hands of the real estate company). A further 10 per cent withholding tax is then imposed on the company's net asset value following payment of the foregoing tax. EVOLUTION OF SICAFIS

Following the adoption of the SICAFI regime, a number of large Belgian real estate developers either created SICAFIs or transferred assets to existing SICAFIs by way of sale or merger.3 Approximately a dozen SICAFIs are currently listed on the Belgian stock exchange, with aggregate assets of nearly 65bn. Their portfolios fall into four general categories: office buildings, retail properties, semi-industrial properties (warehouses) and residential properties. The largest SICAFIs are active in the office building sector and have portfolios ranging from €260m to ei.Sbn. In most cases, the SICAFI's sponsor or related companies hold a sizeable portion of the outstanding shares and tl\e 'free float' rcmges from 30 per cent to 80 per cent of the total share capital. The level of indebtedness varies from 14 per cent to 49 per cent of total assets, the weighted average indebtedness of all SICAFIs being approximately 41 per cent. Over the past several years, the average net dividend of aU SICAFIs has been in the range of 6 per cent and total annual return on investment has been in the range of 15 per cent to 20 per cent. SICAFIs have thus substantially outperformed the Belgian stock market. A number of SICAFIs are currently trading at substantial premiums above their net asset value, although others trade at a slight discount off their net asset value. In less than ten years of existence, SICAFIs have established themselves as the investment vehicle of choice for private investors wishing to invest in a diversified portfolio of real estate assets. Although the general robust performance of the Belgian real estate market has contributed to this success, the liquidity, tax efficiency and general prudential supervision of SICAFIs by the BFIC are also key factors which have encouraged the relatively high level of investment in SICAFIs.

LUXEMBOURG Luxembourg has long been recognised as an attractive jurisdiction for the setting up of real estate investment vehicles. Over recent years, primarily as a result of stock market growths, Luxembourg's real estate investment funds have benefited from an increasiiig popularity, and this is expected to continue. At the end of 2003, 13 regulated real investment funds were registered in Luxembourg, comprising seven retail funds and

six institutional funds, with an aggregate net asset value of e2.86bn representing 0.30 per cent of the total net asset value of all Luxembourg regulated investment funds. The funds may be classified into two main categories of real estate investment funds: public and private. Both types of funds have separate target investors and consequently the regulations in respect of each are different. PUBLIC FUNDS

These consist of regulated real estate investment funds (ie funds which are undertakings for collective investment ('UCIs')) and which need to be approved and supervised by the Luxembourg regulators.^ Within this category are: (1) unit trust type funds, ie the 'Fonds Commun de Placement' ('FCPs') (which can be open- or closed-ended); and (2) company type funds, ie the SICAF which is a closed-ended fund and the SICAV which is an open-ended fimd. The principal object of UCIs is the investment in real estate. For this purpose, the term 'real estate' comprises: - property consisting of land and buildings registered in the name of the UCI; - shareholdings in real estate companies (including claims on such companies) the exclusive object and purpose of which is the acquisition, promotion and sale as well as the letting and agricultural lease of property, provided that these shareholdings must be at least as liquid as the property rights held directly by the UCI; - property related long-term rights such as surface ownership, leasehold and options on real estate investments. UCIs face a number of restrictions: - in order to achieve a minimum spread of the investment risks, UCIs may not invest more than 20 per cent of their net assets in a single property, such restriction being effective at the date of acquisition of the relevant property. Property whose economic viability is linked to another property is not considered a separate item of property for this purpose. This 20 per cent rule does not apply during a start-up period which may not extend beyond four years after the closing date of the initial subscription period; - should the investors have the right to redeem their shares, the UCI may provide for certain restrictions on this right. These restrictions must be clearly and precisely described in the offering prospectus; - the aggregate of all borrowings of the UCI may not exceed in average 50 per cent of the valuation of all its properties; and - at the end of the financial year, management inust instruct the property valuer(s) to examine the valuation of all properties owned by the UCI or by its affiliated real estate companies. These UCIs pay an amuial subscription tax ('taxe d'abonnement') of 0.05 per cent of their net asset value, which is reduced to 0.01 per cent for institutional funds/ subfunds /classes. PRIVATE FUNDS

These consist of Luxembourg real estate companies, which are not governed by the legislation on UCIs, but by the general company law. Unlike UCIs, their target investors are types of joint venture, whereby the participants enter into private con-

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tracts. Consequently they do not face the same restriction or regulation as a UCI. These companies either purchase real estate directly or, for tax reasons, indirectly through subsidiaries. These companies are fully taxable entities, although dividends received from subsidiaries and capital gains on the participations held in such subsidiaries may under certain conditions be exempt in Luxembourg under the 'participation exemption'.

PIF - WHAT VEHICLE SHOULD THE UK ADOPT? From the analysis of REITS across Europe and in the US, it is submitted that consultation should bring a PIF which has a combination of the following: - a safe, tax-efficient environment for people to invest in commercial and residential real estate in a way which is less risky than buying a single residential real estate on a buy-to-let basis. This will reduce volatility in the commercial and residential real estate sector and will meet the government's aim of reducing the sector's exposure to debt and interest rate cycles; - no restriction on external or internal management. Although the US experience has shown that those REFTS which are internally managed are the best performers and internal management clearly helps align the interest of management and investors, PIFs should not be prohibited from being externally managed; - shares which are liquid and freely tradable. The majority of REIT shares can be purchased on major stock exchanges, and orders can be placed through stockbrokers. Financial planners and investment advisers can help to match an investor's objectives with individual REIT investment; - no personal liability for investors; - a structure which allows taxable income to be passed through rather than being independently taxed; - accessibility. Both US and non-US sources invest in US REITs which are owned by thousands of individuals, as well as large institutional investors, including pension funds, endowment funds, insurance companies, bank trust departments and mutual funds. However, the French experience has shown that, in respect of SIICs, the biggest gains have gone to property companies, the state and foreign real estate investors and not to domestic investors or the French public. This may be a warning to the UK; - an attractive rate of return. Dividends should not be so high that they prevent development or refurbishments of properties or subsidies for low rents; - a free market approach to restricting the PIF's development activities. No restrictions on development would certainly help PIFs play a role in urban regeneration and assist the government's much wider post-Barter approach to affordable/social housing. It is notable that the property industry, post consultation, has highlighted this area as one of the major concerns for the success of PIFs; - a free market approach to gearing and leveraging. In this article, we have seen that some jurisdictions, for example Belgium, restrict gearing where the SICAFI is based on a regulated investment vehicle, whilst other major economies, such as the US and France do not restrict gearing or leveraging, although in practice the market typically appears to gear up to 50 per cent of asset value. In the US 264

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for geared REITs, interest on debt is a deductible expense, but principal amortisation is not; this imposes a practical limit on gearing. On the question of how much borrowing should be allowed, the Treasury appears to favour a low level of borrowing in order to increase scrutiny and market stability. However, a note of caution should be sounded, as with debt currently at a cost which is extremely low, it could prove an expensive way of raising finance to force a PIF to turn to the capital markets for funding for each proposed activity. Indeed if the Treasury were to limit a PIF's borrowing powers and combine this with a requirement for high income and capital distributions then a PIF's constant visits to the equity markets could prove unattractive to those listed property companies who would be considering converting to become a PIF. Further, debt finance need not be costly. With a credit facility the debt servicing costs are disclosed up front and, through hedging instruments, can remain the same throughout the term of the facility. Also, when considering vehicles which are complementary to PIFs, such as CP185 funds, in respect of retail investors, new tax rules allow authorised property unit trusts to gear up to 100 per cent of gross asset value and up to 50 per cent of the fund can be in development. As it is important that PIFs can compete if they are to be successful, from the analysis of REITS across Europe and in the US, it is submitted that the UK should not attempt to restrict the gearing on PIFs, but instead allow a market approach to gearing levels. The US model provides the form of investor scrutiny required by HM Treasury as the REITS there have to issue capital and then the analysts decide if it is a good or bad deal; a portfolio as diverse as possible providing a wide but straightforward choice for investors wishing to invest in an onshore regulated property investment vehicle. This may in turn lead to a lowering of the cost of capital, and provide a reliable source of capital to buy real estate, so enabling the developer to recover its invested capital and take out its entrepreneurial profit, which in turn may spur development^ and lead to a more stable and efficient real estate market. Although this does raise a concern as to whether the small investor, ie the public, is ready for such a vehicle. The small investor should ideally be educated as to what a PIF investment entails, and thus its risks; a fair conversion charge. The Treasury appears to be adamant on a tax-neutral position. Any entry or exit level conversion charge must serve its purpose and should not prohibit the conversion of property-owning vehicles which may wish to convert to PIF status. A charge set too high could easily discourage conversion and not raise any money for the Inland Revenue. One-off stamp duty charges based on a percentage of net asset value have been proposed, as have exit charges based on CGT liabilities (following SIICs in France and SIC APIs in Belgium). However, the trouble with CGT exit charges is that most UK companies have low CGT liabilities and so this would not favour the tax-neutral position; the ability to encourage investment by non-UK residents: at present, non-UK resident investing direct in UK property can receive their income gross and are exempt from capital gains tax on the disposal of UK property." It is submitted

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that non-UK residents investing in a PIF should also be treated in the same way as if the non-UK residents were investing direct in UK property and thus able to receive their income gross. The Treasury is not yet convinced of this, and has asked for suggestions as to hovi' the concepts inherent in the non-resident landlords' scheme could be satisfactorily adapted to investment made in PIFs by nonUK residents. The proposal to treat potential distributions of realised capital gains of non-UK residents taxable in the same Vk^ay as income distributions may act as a disincentive for non-UK residents to invest in a PIF. Introducing a system of sourcing rules to establish the factual composition of distributions to distinguish between distributions arising from capital gains and distributions arising from income should not be dismissed by the Treasury as 'too complex'.

residential market (which, given the scope of the consultation paper, is looking increasingly unlikely), or face too great a restriction on the development projects they can undertake, or are forced to have an element of residential stock in their portfolio, then it is more than likely that they wUl go the way of the BES and HTTs. The goveniment though seem determined not to make these same mistakes. A key feature of a PIF is to prevent this exercise being wasted and once again to attempt to align the after-tax returns from holding real estate indirectly with those obtained from holding property directly. Given this incentive, the consultation paper and process is both vital and timely, if we are to follow the examples of the countries set out in this article and introduce a UK REIT (there I said it, much better than PIF) which will succeed and ultimately benefit the UK economy.

PUBLIC VERSUS PRIVATE?

The consultation paper envisages that a PIF would be listed on the Stock Exchange to ensure the widest possible access for small investors to operate in a well-regulated environment. The Treasury highlights the greater regulatory regime that applies to listed companies. However, the take up of investment in approved investment trust companies is not great and it is submitted that this would be a mistake. It is clear that there are both advantages and disadvantages to being listed. Clearly there are advantages for investors if their units can be traded on a recognised exchange; similarly there is also room for private REITs, as we have seen from the successful private REIT market in the US. Thus a PIF should be capable of being listed but should not have to be.

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EMPEROR'S N E W CLOTHES?

The consultation paper has raised a number of important questions which require answering. The form that a PIF should take (including its name, although on a personal level what was wrong with REITs or Realty Investment Funds ('RIFs')?) is now in the hands of those that respond to the consultation, the Treasury and the Inland Revenue. It should be remembered, however, that we have been down this road before. For example, during the last housing boom, the government of the day extended the reliefs available in the Business Expansion Scheme ('BES'), which were originally intended to help small businesses, to include private landlords. TelUngly, the scheme was described in 1993 by the then shadow Chancellor, Gordon Brown, as 'a tax avoidance opportunity for top-rate taxpayers and the banking establishment'. It was shut down soon after. The next attempt to boost private renting, the Housing Investment Trust ('HIT'), went to the other extreme. HITs were launched in 1995, but had so many limitations and restrictions, that running a HIT was virtually impossible and, accordingly, the market ignored the scheme. If PIFs are confined to the

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Andrew Petersen is Counsel specialising in cross border acquisition and real estate financing and corporate restructuring in the banking department of the London office of Dechert LLP. He is grateful to his international colleagues: Michael Hirschfeld, Nadine Young, Richard J Temko, JeanPierre Magremane, Marc Seimetz, Pascal Bouvy, Joseph Smallhoover and Oliver Piatt for their respective contributions and his colleagues in London: Mark Stapleton and Ciaran Carvahlo for their comments. The name may change to reflect the financial structure and the government (in an indication that they may not be happy with PIFs as a name) has welcomed alternative suggestions. After all, it could not have been called a Property Investment Trust (after the Housing Investment Trusts of the 1990s), since one could imagine the take up in a product called a PIT to be relatively low. See http://www.hm-tieasury.gov.uk/budget/budget_04/ associated_documents/bud_bud04_adproperty.cfm Given the substantial real estate transfer tax applicable in Belgium, contribution of existing real estate to a SICAFI by way of merger or capital contribution in kind is a particularly attiactive route since it generally enables the parties to avoid such tax on the transfer of the property to the SICAFI. Law of 19 July 1991 (institutional funds) or by part II of the Law of 20 December 2002 (retail funds). Analysts at Citigroup Smith Barney beUeve that the UK real estate sector's market capitalisation could double to £40bn if the regime changes. This is on the assumption that PIFs wOl be able to invest in both the residential and the commercial real estate markets. Unless the disposal falls within scope of s 10 or 10a of the Taxation of Chargeable Gains Act 1992.

This Journal should be cited as follows:

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