The UK real estate investment trust (REIT) is experiencing a revival. Recent changes to the UK REIT regime, and the imminent increase to the UK corporation tax rate, have made the UK REIT an increasingly attractive holding structure for real estate funds.
Additionally, the new UK-Luxembourg Double Taxation Convention now expected to come into force in April 2024 removes protection from UK nonresident capital gains tax and so is causing existing pan-European real estate funds holding UK investments through a Luxembourg corporate structure to take another look at the efficiency of these structures and how use of a REIT (including the ability to ‘rebase’ assets in a REIT) might impact modelling for deals and fund economics as a whole. Consequently, we are seeing an increasing number of real estate funds taking the proverbial plunge and looking to reorganise existing UK portfolio investments into a REIT entity to be held by the fund.
Undertaking a reorganisation can often be an arduous affair, consuming valuable management resources, and so planning ahead and looking around the corners is definitely worthwhile.
Below are some key considerations we have accumulated from recent experience:
The reorganisation process will need to take into account the REIT regime requirements as well as any possible tax leakage as a result of the reorganisation itself. To ensure an efficient reorganisation and limit wasted costs, tax advisers should be appointed as early as possible in the process. A tax structuring report will inform the legal implementation of the reorganisation, and it is important for REIT and fund level tax advisers, legal advisers, and the fund manager to work in tandem to finalise the tax structuring report and identify and remedy any structuring issues. This is an important phase in the process, as the REIT qualification rules as they apply in the context of fund structures and economics are complex to navigate and require a detailed understanding of fund structures, terms, side letters, and economics. Specific investor requirements, such as real estate quota compliance for German investors, as well as obligations to minimise tax filings in the fund documents and side letters, are often critical in determining the optimum structure. Fund managers are also advised to consider the impact on the fund economics as a whole and whether any conflicts of interest are anticipated.
2. Due diligence
A legal due diligence exercise will be required to establish which, if any, third-party consents (for example, investor, co-investor, joint venture partner, or lender) are required to implement the reorganisation, and whether there might be any holders of excessive rights (see the section “Holders of excessive rights and fragmentation” below). Fund documents, loan documents, and any joint venture or co-investment documents should be reviewed as part of this exercise. Any required consents or fragmentation could impact the timeline of the reorganisation, thus early investigation is recommended.
3. Holders of excessive rights and fragmentation
A holder of excessive rights (HoER) is a company or body corporate that is beneficially entitled to at least 10% of the distributions or at least 10% of the share capital, or controls at least 10% of the voting rights of the REIT (taking into account various attribution rules). Where the REIT pays a dividend to a HoER, a penalty tax charge can arise to the REIT.
A common solution to this issue is for a HoER to ‘fragment’ its shareholdings to remain under the 10% limit. Any fragmentation of investor interests might require that investor’s consent and an agreed suite of legal documentation, and so fragmentation requirements should be assessed early in the reorganisation process.
Fund managers, particularly for open-ended funds, must also put in place systems to ensure compliance with the HoER requirements on a go-forward basis.
4. Investor engagement
Investor communications, particularly where investor consent or fragmentation of investor interests is required, will be key to ensuring a smooth reorganisation process. It is important to approach investor communications dynamically; investors should be approached with a proposed reorganisation plan that has been suitably due diligenced while being mindful that investors may have internal or regulatory requirements that may require modifications to the proposed reorganisation plan. Fund managers are advised to carefully consider the optimal stage to approach investors for views and consent, if required. Any communications with investors might helpfully include financial modelling demonstrating that the proposed reorganisation is in the best interest of the investors. It is worth noting that figures used in the financial model (see the section “Valuations and accounts” below) should reconcile with the accounts.
5. Valuations and accounts
Reorganisations will typically reference the latest property valuations and book values, in particular if distributable reserves are required to carry out any step of the reorganisation, so having the current valuations and up-to-date accounts to hand will minimise delay and assist with preparation of the funds flow. A definitive understanding of the capitalisation of all affected entities (e.g., share capital and intragroup loans) is essential to informing the structuring steps, and designing funds flow, to minimise cash movement.
6. Project management
Reorganisations tend to be administratively demanding processes, and REIT reorganisations are no different; where fragmentation and consent processes are required, REIT reorganisations risk becoming long, drawn-out processes. A major contributor to a smooth REIT reorganisation process is the alignment and coordination of advisers, and having legal counsel that understand the fund structure, the relationship with investors, and the REIT tax regime is crucial for efficient implementation. Legal advisers can effectively coordinate advisers and third parties, and assist with investor communications and queries. This ensures that input from investors, any joint venture partners or co-investors, tax advisers, and legal specialist teams is coordinated, that the legal documentation is prepared and tailored appropriately, and that various work streams are completed on time and in the correct order.