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This article from
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The boom in bricks and mortar funds
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ANDREW DANN
Managing partner, Ernst & Young
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‘A man’s house shall be his own castle,’ stated Justice Story (US Supreme Court Judge) in 1833 and it seems many institutional investors have also come to the conclusion that property is indeed where their money should be.
Low to medium risk investments, generous yet stable yields (based on rental income) and tax-efficient income distribution in comparison to equities has attracted over £100 billion of investment into UK property funds over the past ten years. Further billions are predicted to enter the property or real estate market in 2004; between just three investment houses £2 billion is earmarked for investment this year. Investors are generally private equity houses, pension funds and institutional investors although the market is opening up to the retail market. Britain has Europe’s largest commercial property market and currently there is no lack of investment opportunity. The level of growth in the industry has not escaped the attention of the UK Inland Revenue. In a two-pronged approach, the UK are attempting to attract a breadth of investor to the property market and to provide an incentive for continued development including urban regeneration and, at the same time, maximise tax returns. Property Investment Funds (PIFs) are their chosen vehicle for encouraging investment while introducing a 4% stamp duty on transfer of interests within UK partnerships, is their method for cracking down on what could be viewed as a tax loophole within the UK.
As the recent Financial Times headline ‘Property Funds Flee to Jersey’ (24 May) outlined, the process for the introduction of stamp duty on partnerships and the consultation period, ending on 16 July, for introducing PIFs has not been altogether smooth. Issues remain in determining the criteria for being classified as a PIF. Sticking points revolve around the levels of profit distribution required (likely to be 90%) and the likely impact on reinvestment (if all profit is distributed then there is no potential for growth). The entry tax for becoming a PIF could easily discourage participants and the potential loss of capital allowances could actually reduce overall profits. In addition the government’s apparent desire to over-regulate in the UK could deter investment. All this is good news for Jersey.
Such uncertainties and increased tax liabilities for partnerships have resulted in a significant number of new property funds in Jersey, particularly during the past three months. As at 31 March 2004, the total asset value of the 37 properties funds administered in Jersey amounted to £5.6 billion. Jersey has benefited from the buoyancy and growth of this industry and has positioned itself to obtain its share of new and existing property funds.
Registration of these investment vehicles has been attracted by Jersey’s reputation as a highly respected and well-regulated offshore jurisdiction. The tax regime in place has also played its part; property funds are not subject to capital gains tax, corporation tax, stamp duty, VAT or inherent tax, and this increases the distributions to investors as the tax burden is lighter and profits are accordingly higher.
There are a number of structures available to investors to allow sufficient flexibility for their project be it for commercial letting, private letting or property development. Structures used include limited partnerships, unit trusts and limited companies. For example, in addition to the tax benefits, there are a number of other benefits in using a limited partnership structure, including limited liability, tax transparency, ability to gear, clear fee structure and a lighter UK regulatory burden.
The continued wellbeing of the industry is of importance to the growth of the Jersey economy through job creation, increased administrative revenues and additional tax revenues.
With public anxiety over equities and the solid performance of property in the UK, the US and in Europe since the early Nineties, investment in commercial property is booming.
However, Bank of England Governor Mervyn King warned investors on 15 June to consider current interest rates and property prices before investing. Certainly, the cost of borrowing has mounted for individuals and corporations alike with interest rates increasing four times since November to 4.5%.
Profits may be adversely affected for highly geared property funds, especially those whose loans are floating rather than fixed. However, with average yields of 8% and only part of the property investment financed through loans, there still remains capacity for interest rates to increase while rental income will continue to cover costs. Property prices have increased by 20% over the last year and have doubled in the past five years. This leads to the question of whether properties are overpriced and unlikely to retain their value. Experts are seldom unanimous and this area of debate is no exception. The industry appears to have forgotten negative equity and the crises of the 1990s and investment seems likely to continue unabated.
It is not only the UK Inland Revenue that is struggling with the current focus on property funds. Conversion to International Financial Reporting Standards (IFRS) by 1 January 2005 for EU listed property funds has caused consternation among fund managers and administrators. Those who prepare the accounts, whether under IFRS or United Kingdom accounting standards, require a working knowledge of the applicable accounting treatments in a number of technical areas. Subjective areas include the valuation of properties (what can be capitalised?), the treatment of operating leases, accounting for leasehold properties, deferred tax and derivatives. As many property funds use SWAPS to reduce interest rate fluctuations knowledge of the controversial IAS 39 is key.
Bricks and mortar seem to be where more and more capital is headed. The impact of rising interest rates and the possibility of a property market correction do not seem to be putting off investors. On 15 June an 86-year leasehold interest in Marble Arch Tower was bought for £74m, demonstrating continued confidence in the property market.
Recent changes in the UK tax regime are having a short-term impact on the location and structuring of these vehicles and are encouraging them to move offshore, to the benefit of the Jersey finance industry.
Compliance with both regulations and accounting requirements are an important area for both fund managers and administrators as there is a significant impact on the net asset values and the level of profit.
Jersey’s service providers need to continue to provide the quality and value for money service that promoters and investors have come to expect to ensure that Jersey continues to benefit from the growing property funds sector.
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