- The industry is cautiously optimistic and well positioned to embrace this new development.
Over the last three to four years we have seen growing sophistication in the Australian real estate industry, particularly in terms of how institutional investors look to improve short and long-term investment returns from real estate.
Institutional investors, and notably listed property entities and wholesale property funds, recently looked offshore for diversification in terms of sector and geographical exposure. In doing so, they developed sophisticated tax-efficient structures that managed risks such as withholding tax and foreign currency, so that now the financial risk of an offshore investment is now seen by the market in a similar way as a direct investment in Australian real estate.
At the same time, owners and potential investors recognised that it is increasingly difficult to enter the market and are therefore starting to look for different ways to obtain exposure to the property market and the case of owners, improve returns and not lose ownership of the physical asset.
Development of property derivatives in the UK
The UK real estate market recognised similar trends, and in response in part to the barriers to entering the physical market (and also because of the absence of a REIT market until last year) began to develop a property derivative market where real estate investors can obtain exposure to the market without the need to make a direct property investment. In the first quarter of 2007 trades exceeded GBP 7 billion, an increase from just below GBP 5 billion in the previous quarter.
Under a derivative, an investor can obtain a property exposure by agreeing to purchase a "return" from a person who has a direct property exposure for a fixed period. The seller and the buyer agree an initial price for the anticipated return, taking into account risks of ownership over the fixed period, and the actual return over that period will be assessed against an industry acceptable index reflecting the income and capital return of an agreed pool of real estate assets. The agreement between the seller and buyer will contain mechanisms to pay adjustments between them if, for example, the actual return from the seller’s assets outperforms the industry accepted index.
At the end of the fixed period as the seller has retained ownership, the risk and rewards of ownership revert to it. The buyer has obtained an exposure akin to ownership for the period without the risk and lack of liquidity associated with ownership of the physical asset.
Development of property derivatives in Australia
Two unique Australian market factors are generally thought to have restricted the development of a property derivatives market in Australia.
Transparency and liquidity in the physical market are at once a reason why the market has not developed to date and why the economic circumstances might mean that now is the time.
Before the revolution of the "stapled" listed property trust, the ASX Property Index listed trusts with returns based on what was essentially direct property investments - that is the price at which the LPT stock was traded was largely uninfluenced by the corporate activity of the manager - other than the ability of an external manager to develop the real estate and let up the end product.
As the index became more influenced by the corporate activities of the manager, the LPTs on the index became more affected by movements in the broader equities market and less affected by the actual returns generated from the underlying property assets.
This effect has been generally understood by the institutional investor market which demand transparency to ensure that their asset allocation to "property" is not in fact an "equities" allocation in disguise, but this fact has not openly been recognised in the LPT index.
Development of commercial and residential indexes
The Australian real estate market has considered the indexes maintained by the largest commercial and residential index providers as useful research tools, but not as real indicators of historic movements in the value of the underlying physical assets.
Because movements in the index are likely to be the basis of price adjustments between counterparties to derivative transactions, for a robust market to develop in Australia, the industry and the proposed index providers must ensure the indexes are readily accepted by the market as generally reflective of market movements. This means that all market participants need to be comfortable that the data collected is accurate, can not be distorted or manipulated, and that the methodology adopted by the index provider to produce the numbers which will form the bases for trades is sound and transparent.
What legal issues might affect the development of a market?
So if lack of access to physical assets and increasing demand continue and acceptable indexes are developed so that buying an "exposure" by way of a property derivative is a viable product:
- what are the legal and regulatory issues that might affect the launch and growth of property derivatives in Australia?
- how might these issues encourage the property industry and market makers to participate?
- how might potential sellers and buyers write a "property derivative"?
The key objective in the European market (and closely followed by the US) is to develop standard documents so that all participants in the market are trading property returns based on the same underlying calculation and risk profiles. A working group has been established by the Australian Financial Markets Association to ensure that the Australian market also works to a consistent model.
So what are the legal and regulatory issues?
In our opinion there are probably three key legal issues:
- financial services license requirements to trade derivatives
- whether a "property derivative" is an "investable asset" for all likely participants; and
- tax and stamp duty.
The Corporations Act sets out a complicated regime to test whether a person who is a seller or a buyer of a derivative is dealing in "financial products" or operating a "financial market" but the general position is that counterparties to a property derivative will be required to hold a financial services licence. Sellers are likely to be entities that are already licensed and accustomed to managing the risk associated with writing interest and currency hedges, for example. Buyers are probably less likely to be licensed and potentially less aware of the market issues.
In terms of whether a property derivative is an "investable asset", most institutional investors have existing allocations to derivatives (at least to cash and commodities), however there are restrictions under Australian law in terms of what is an acceptable investment for various entities, including, for example, for life insurance companies. These restrictions do not reflect the modern reality of life insurance companies which write significant superannuation business where investors can prescribe the asset allocation that is optimal for their purposes. This obstacle also existed under UK law and a result of the lobbying this restriction was removed.
The third key legal issue is how a property derivative is treated from a revenue perspective.
In terms of tax, the key driver is not to inadvertently affect the underlying tax position of the seller - unless the seller seeks to price tax risk as part of the "sale". The industry submissions to the Federal Government’s TOFA (Taxation of Financial Arrangements) draft legislation will need to be considered, but like all tax structuring, transactions will need to be carefully managed by a seller and buyer.
The more significant revenue issue is stamp duty. As most property industry participants are aware, despite the promises pre-2000, the introduction of the GST has not meant that the state-based stamp duties on land - including conveyance and land rich duties - have been scaled back.
But a "property derivative" does not create an "interest in land" and properly crafted it does not create an interest "in relation to or in connection with land" that would trigger liability under even the most complicated regimes in Western Australia, Queensland and Victoria.
A property derivative should therefore be able to be written duty-free.
It is this benefit that many market participants see as a key driver for a quick take-up in the property derivative product, particularly in the wholesale market. Recent UK changes to the equivalent revenue law are credited as a significant reason for the huge growth in the product in the UK.
So for the moment in Australia it is a little "wait and see" in terms of how the Australian real estate industry will take the issue up but the industry is cautiously optimistic and well positioned to embrace this new development.
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