UK: Investment in the UK Real Estate Market

By Alan A. Samson and Richard Wilkinson

Relative to other classes of investment, real estate in the UK remains strong and continues to outperform equities. At the end of 2001, unleveraged returns were circa 7%. As equity markets continue their decline and interest rates remain low, the UK real estate market remains a sound and popular destination for U.S.investment.

• London's position as Europe's premier financial centre
• High levels of liquidity
• Strict planning controls and building standards which help minimize the risks of falling capital values
• Relatively low taxation and the exemption of foreign investors from capital gains tax
• Institutional, long-term (15 years +) leases which favour landlords, incorporating upward only rent reviews
• Low interest rates, currently 4%

In 2001, foreign investment in UK real estate amounted to £5.7 billion, representing almost 20% of total investment. A recent report determined that US investment in UK real estate dominates, accounting for £2.3 billion or 40%, followed by Ireland, the United Arab Emirates, Australia and Germany.¹ U.S. opportunity funds recently active in the UK market include AEW Capital Management, Apollo International Real Estate Fund, Blackstone Group, GE Capital Real Estate, J E Robert, Doughty Hanson, Lehman Brothers, Morgan Stanley Real Estate Fund, J P Morgan Chase, Praedium Group, Westbrook Partners and Goldman Sachs’ Whitehall Fund. U.S. institutions, while less aggressive, have also been active (including MetLife and Teachers).

Some of the more notable recent U.S. backed deals include:

• Thayer Properties' (a Lehman backed vehicle) acquisition of Burford Properties for £920 million;
• Westbrook Partners' purchase of a mixed portfolio of 20 buildings for £365 million;
• Peabody Global Real Estate's (a joint venture between J P Morgan Chase and the O'Connor Group) purchase of Cutlers Gardens, London, for £300 million; and
• The Blackstone Group’s and JER Partners’ joint venture purchase of an office portfolio for £200 million.

Central London attracts the vast majority of U.S. investment. As rental growth is expected to be limited over the next 18 months or so, well-located assets with secure income streams continue to command a premium. UK insurance companies and pension funds, absent from the buy side in the market for a while, are now back in with a healthy appetite for investment stock. This is largely due to internal weighting requirements, given the poor performance of equities and bonds. With opportunistic funds seeking high IRRs, it remains to be seen if U.S. and other over-seas players will look to become involved in speculative development as an addition to straight investment.

Very much in vogue currently are sale/leasebacks, major "outsourcing" transactions and the privatization of some of Europe’s largest publicly traded, real estate companies – two recent $2 billion+ public to private deals include MEPC (by a GE Capital backed group) and Haslemere (the major equity players being Apollo and Lehman).

As in the U.S., real estate in the UK must be acquired by a legal entity. There is no requirement for the chosen invest-ment vehicle to be UK registered or domiciled nor is there any legal prohibition against a foreign entity owning, charging or leasing UK real estate. As well as direct acquisition of interests in land, some of the more commonly used joint venture acquisition vehicles are:

• Joint venture companies;
• Limited and general partnerships;
• Leveraged and "side by side" leases;
• Securitised vehicles;
• Authorised property unit trusts;
• Profit-sharing mortgages; and
• Open-ended investment companies.

As always, structuring the optimal vehicle from a tax perspective is key. Generally speaking, the UK does not levy capital gains tax on profits arising on the sale of UK real estate by a foreign entity. Subject to transfer pricing rules, UK income tax can be minimized (if not eradicated) using offsets of third party and internal debt. Withholding tax on rents can be avoided by appointing a UK based asset manager. As in the United States, English real estate may be owned freehold (fee simple) or leasehold. Almost all land is now registered at HM Land Registry. The State guarantees title (title insurance rarely being used in the UK).

Stamp duty (transfer tax) is payable by the buyer before it can be registered as owner of a property at HM Land Registry. This tax is charged at 4% of the total purchase price (recently this has risen significantly and compares with a rate of 1% in 1995).

The events of September 11 and the current global downturn have had little effect on investment levels in the UK during the first half of 2002. Many economic forecasts expect overseas investment in UK real estate to remain strong throughout the remainder of the year. DTZ estimates in the region of £4.8 billion.²

The globalization of investment activity, cheap sources of finance and the relative strength of the UK economy should aid the continued strength of the UK market and enable well-leveraged investors to realise high returns on their capital.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Copyright © 2002 Gibson, Dunn & Crutcher LLP