Focusing on economic, regulatory and environmental issues, our sixth annual property survey reflects the current pessimism in the UK real estate market.
Conducted a year after the credit crunch began, our annual survey of confidence and business issues highlights the dire state of the UK economy. We surveyed over 180 senior decision makers representing the views of investors, traders and developers, surveyors, architects, lawyers and other professionals in the property industry.
The economy matters
Unsurprisingly, our respondents reported that UK economic performance is by far and away the most significant issue facing them. 93% said that it is one of the five most important issues facing the property industry, and 60% of those believe it to be the single most important issue. Given that economic growth is expected to be flat to negative for the foreseeable future, this cannot be good news.
Just behind UK economic performance, the next biggest issue facing the property world is the ability to raise finance. Over a third (37%) of respondents said their businesses will be constrained in the next 12 months due to lack of finance. The percentage of those looking to raise finance in the next 12 months has decreased slightly (from 42% in 2007 to 39% in 2008). Of those looking to raise finance, the majority regard clearing banks as the best source (figure 1).
In our experience, property businesses sitting on the sidelines holding cash are not yet willing to move back into the market. Sovereign and BRIC funds are likely to be in a position to become active in the market before others are ready or able to return. Most commentators believe a market turn is some way off.
"Worryingly, almost all of this year's respondents who intended to raise finance saw the banks as their primary source at the time of the survey. At Smith & Williamson, we have seen some bank lenders opening up for business again but on a tentative and very different basis in terms of gearing, rates and valuations. Banks are understandably uneasy that valuations are now coming in with disclaimers due to market uncertainty, which is indicative of the fragile nature of the market and the loss of appetite for risk. Until economic conditions and the banks' own balance sheets have improved, many banks cannot lend on property ventures as, frankly, they need the cash themselves," said Nick Cartwright, chair of Smith & Williamson's Property Group.
Confidence crumbles
Our survey confirms a widespread and growing lack of confidence in both the commercial and residential property sectors. A telling development in the property world is the number of property agents setting up insolvency business. Recent movers Cluttons have followed in the footsteps of Lambert Smith Hampton, CB Richard Ellis and DTZ.
The residential sector is particularly pessimistic, with those who are reasonably or very confident dropping from 86% in 2006, to 48% in 2007 and just 7% this year (figure 2).
"Market volatility means that it's a very challenging environment in which to undertake development projects that can take several years to complete. Many developers are not yet able to get projects off the drawing board," explained Nick Cartwright.
"Graham Beale of Nationwide has said that house prices might end up falling by as much as 25% from their peak in the autumn of 2007 and Andy Hornby of HBOS has predicted that the credit crunch, which is restricting lending, would last well into 2010. There are no dissenting voices among our respondents."
Nick continued, "The Government has belatedly announced measures to assist the UK real estate sector, including raising the stamp duty land tax (SDLT) threshold and buying houses at knockdown prices from builders through the Homes and Communities Agency. However, the Government's proposals have been widely criticised for being woefully inadequate. Gordon Brown and Alistair Darling may have done enough to save the banks but they certainly did it too late. We hope they can find some more time for real estate soon."
Confidence in the commercial property sector has also dropped dramatically in the last two years. In 2006, 91% responded that they were reasonably or very confident, in 2007 this percentage declined to 58%, and this year only 18% have said that they are reasonably confident.
This year, not a single respondent said they are 'very confident' about the outlook for either residential or commercial property (figure 3).
Meanwhile, the tables have turned for house builders and registered providers (RPs) – previously known as registered social landlords. Those RPs with strong balance sheets are now in the unusual position of being able to strike hard bargains with house builders anxious to do deals wherever possible.
Furthermore, the number of newbuilds has fallen even further behind the Government's targets, which begs the question of who is going to fund the desired increase in housing stock. Seasoned observers have noted that this under-supply is sowing the seeds of the next speculative boom. Accordingly, how the Government supports affordable housing now could be crucial for the UK residential property market for years to come.
Nick commented, "The UK real estate sector, along with the rest of the economy, is in a downturn. This, despite the compulsion to lend enshrined in the banks' rescue package, is unlikely to have reversed by the time our next property survey results come out and, in reality, the most we can expect by the autumn of 2009 is a few green buds of recovery."
Financial and tax issues
Tax continues to have a greater influence on business decisions than is desirable and frequently acts as a barrier to property transactions. This year, 88% of respondents reported that tax influences their decision on whether to sell a property or not. Last year the equivalent figure was 93% (figure 4).
"This slight decline may be due to market conditions reducing the importance of tax on profits," Nick commented. "The Brown-Darling partnership has significantly complicated property taxation and it remains to be seen whether they will come up with any meaningful provisions to assist the ailing UK property market directly in its hour of need."
"An indication of just how out of step the Treasury was with the realities of the property market is the abolition of empty property rates relief, which has led companies to demolish buildings rather than suffer the tax. By doing away with this relief, the Government expected to raise in the order of £1bn per annum from the property sector, which is approximately the amount it is proposing to put back in as part of its initial 'rescue plan'."
Our survey also reveals that the community infrastructure levy is slightly less unpopular with our respondents than the planning gain supplement was, with 60% of respondents viewing it as a disincentive to developers, compared to the 79% who felt the same way about the planning gain supplement.
Investment vehicles
As with previous years, Real Estate Investment Trusts (REITs) and the recently introduced Property Authorised Investment Funds (PAIFs) are not yet perceived as key to the property industry.
This year, less than a quarter of respondents thought that REITs will enhance investment opportunities for the property sector, compared with just over half last year. This decline may be due to the reduction in REIT share prices (the majority are back to a significant discount to net assets), or the overall state of the property market. The new PAIF regime offers a superior investment alternative to that of REITs and will hopefully be well received by the market. We discuss the benefits of PAIFs over REITs in our article, 'Driving investment forward' on the back page of this bulletin.
London
With several major construction projects underway in and around London, we asked our respondents a number of questions to gauge opinion on how they thought their businesses would be affected.
Crossrail is expected to have a beneficial impact on the City of London, with Thames Gateway the only direction in which London can expand outwards.
The Olympic Village, though economically less relevant, is very much a talisman and global advertisement for UK project management and construction.
In terms of Crossrail, 55% of those who stated a view thought that the project will have a positive or very positive effect on their business. Only 4% felt there would be a negative effect, while the remaining 41% think that Crossrail would have little impact on them. There are reports circulating that Crossrail will be delayed, again due to lack of finance.
This year only 27% (of those who expressed a view on this matter) think that the Olympic Village will have a positive or very positive influence on their business (down from 40% last year). However, 65% are ambivalent compared to 55% last year. We think that, at the moment, the Olympics are too remote for most businesses unless they are directly involved with it, although building costs have been rising to reflect the draw on materials and labour.
We also asked about the development of the Thames Gateway, as it is the largest regeneration project in Europe. Only 39% of respondents are positive or very positive about this project, with 3% of respondents negative. The remaining 58% anticipated little effect for their own organisation. Other than the fact that the Gateway development has a conspicuously low profile in the public domain, again it seems to be a project that either you are involved in and expect to benefit from, or not.
Overall, our survey suggests that the majority of respondents are largely ambivalent about the impact these projects will have on them. Crossrail is perceived to have the most positive impact on their businesses (figure 5).
A barometer of the London property market is the lack of, or slowing of activity on building sites. The most obvious casualty to date is the Cheese Grater in the City.
Going green
Our survey highlights that although the Government may be focusing more on environmentally-friendly developments, this is not a priority for the property industry in the current economic climate.
Respondents seem to be aware of the environmental legislation that could reduce their profit margins, such as energy performance certificates and carbon emission restrictions. However, there is less understanding of the benefits available from provisions such as enhanced capital allowances, land remediation relief, business premises renovation allowances and SDLT relief for zero-carbon housing (figure 6). As Nick explained, "Environmental tax reliefs can result in significant savings and will be increasingly relevant in a difficult economic climate."
At the moment, the lack of finance is the real pressing issue for property companies and the current perception is that environmental attributes will not add value to a property, only cost. This situation will, we hope, change over time.
Comment
Clearly the property sector is in the doldrums. The lack of bank funding and the parlous state of the UK economy are the key issues. Those with cash to spend on property are waiting for the green shoots of recovery. There was no indication from our survey that the industry was expecting a series of mergers and consolidations, but the next 12 months may see movement in this area. Property agents are already adjusting their cost bases (with redundancies), a trend that we expect to continue. Most of the UK house builders are reporting dire figures and downsizing operations. Cash is king. Land banks and completed units are going for a song but buyers are holding out for even lower prices and an economic recovery, which could involve a long wait. The real estate sector, along with the rest of the UK economy, is in a downturn. We are confident that the property world will bounce back but we are not confident about when.
Your option to tax - A summary of the revised rules
The rewritten legislation regarding the VAT treatment of land and property transactions includes new rules on disapplying the option to tax and REEs.
HM Revenue & Customs (HMRC) has finally rewritten Schedule 10 of the VAT Act in relation to the treatment of land and property transactions. The new legislation took effect on 1 June 2008, and although many of the changes were made only to simplify the language used, a number of important changes were made.
Beware the timing
One of the amendments relates to the rules regarding disapplying the option to tax when the purchaser of a commercial building plans to convert the building (or part of it) into residential accommodation.
Since 1 June 2008, the purchaser has to provide the seller with a form VAT 1614D in order for the option to tax to be removed. This certifies that the building (or part of it) is to be used solely for residential purposes. Disapplying the option may have an impact on the seller's VAT position relating to the property.
The point to be aware of is the timing of issuing the certificate. In order to avoid VAT being applied to the transaction, the vendor must receive the certificate "before the price of the grant in respect of the supply has been legally fixed".
HMRC has provided some examples indicating when the certificate should be issued including "by exchange of contracts, by missives or letters, or the signing of heads of agreement". As any of these can be triggered in the early stages of negotiations, this rule is likely to lead to confusion. It could also potentially lead to disputes in relation to whether a certificate was issued in time. Failure to submit the certificate in time will allow the seller to charge VAT on the sale, as the seller can then decide whether to accept it or not.
This will, at best, create a cashflow disadvantage for the purchaser, and, at worst, a substantial amount of irrecoverable VAT and extra SDLT.
Other changes
The revised legislation also introduced a number of other amendments/new rules.
- Options to tax now apply to land and any existing/future
buildings on the land, with a possible opt-out clause for new
buildings constructed.
- The existing 'cooling-off period' for the option to tax
has been extended from three to six months, with the additional
condition that the land/ buildings not be used or occupied after
the option takes effect.
- An option to tax is automatically revoked if the taxable person
who exercised the option has not held an interest in the property
for over six years.
- It is now possible to make a Real Estate Election (REE). This
means you will be treated as having opted to tax every property in
which you acquire a relevant interest after making the REE.
House of cards - Commercial property in troubled times
Richard Stanley of DTZ assesses the state of the commercial property market.
The commercial property market has experienced a tough six months, with this trend expected to continue into 2009. Investment yields have moved out by as much as 2.5% in some sectors, affecting the capital value of property by as much as 25%. Earlier in the year we had envisaged the Bank of England following the Federal Bank and dropping interest rates further in an attempt to reinvigorate the economy. However, current inflationary pressures make this unlikely in the short term and any suggestion of market sentiment improving in the present environment appears purely speculative.
Unfortunately, the market is in stagflation, with few investment deals surviving the banks' credit committees. Deal volume was in excess of £22bn in the fourth quarter of 2006 compared to under £3bn in the same period the following year. With few comparables available to value property assets, has the market truly re-priced?
Developer difficulties
From a development perspective the market slowdown could not have come at a worse time. Developers have been dealt a cruel double whammy, with waning market sentiment squeezing margins and tender prices for construction work expected to rise much faster than inflation (and little if any capital growth in the short term).
The effect of this is most visible in the regions, where we have seen evidence of sales and capital values collapsing – in some cases by as much as 30% – on certain apartment schemes. Developers are now offering investors incentives to allow securitised ownership of schemes, funded, as always, on the back of ever-hopeful rental demand.
With minimal capital growth and rising development costs, developers may be looking for increased funding from banks. The reality is that plummeting loan-tovalue ratios and general market illiquidity mean this option has almost certainly been extinguished.
Winners and losers So who will be the winners and losers in these troubled times?
The winners, as always, will be those who plan well, hold good credit history and are able to control their build costs in a stressed market. The failures will be those who do not – and it must be broadly recognised that lenders share ownership of this problem.
Challenges ahead
We have often advised in situations where lending has been structured on fixed cost and forecast capital growth. The challenge now will be to advise banks on their options where poor cost control and stagnating capital values mean lack of appetite for further funding. This is set against a backdrop of minimal values for part-built schemes and the potential for substantial write-offs.
Crunch time - Options for lenders
With the much anticipated economic downturn now a reality, we look at the options available to lenders in today's tough property market.
In his article, Richard Stanley of DTZ outlines the challenges plaguing the commercial property market and finds little hope for improvement in the short to medium term. A point worth emphasising is that lenders face substantial write-offs and it is unlikely that a strategy of an immediate sale at the best price will be attractive in many circumstances.
Common problems Some of the widespread issues in the current property market include:
- incomplete residential developments with projected sale values
significantly lower than original expectations
- small, owner-managed property companies with negligible
cashflow and illiquid assets unable to meet construction costs and
interest payments
- land banks with planning consents but doubtful economic
development potential in the short to medium term
- related services, such as struggling estate agencies and
contractors.
Decision time for lenders
Lenders are facing insolvency issues not encountered in the property market for years. Add to this the growth in the buyto- let market, which was negligible at the time of the last recession but now accounts for some 20% of UK mortgages, and we have a whole new set of challenges.
Lenders must decide whether to restructure debt, agree sales in the short term or warehouse distressed assets – perhaps in conjunction with joint venture partners – until market conditions begin to improve.
Step up the insolvency practitioner
Insolvency practitioners have an important role to play in terms of advising on and implementing strategies, which may include formal insolvency procedures.
The range of problems in today's market makes it difficult to generalise. However, it is clear that insolvency professionals working in conjunction with property agents, contractors and other property specialists will need to devise inventive solutions to help lenders deal with their current problems – and those that will no doubt arise in the coming months.
Housebuilders beware - VAT adjustments for letting
Letting newly developed property instead of selling at a loss might seem like a good idea for housebuilders in the current economic climate. But have you considered the VAT implications?
In view of prevailing economic conditions for residential property sales, many housebuilders are looking to let new dwellings they have built or converted (from non-residential to residential), where it is not yet possible to achieve a suitable sale. But letting, as opposed to selling new/converted dwellings, results in a different VAT scenario.
Selling or granting a long lease (over 21 years) in new or certain converted dwellings is zero-rated, giving rise to full VAT recovery for the builder. However, letting residential property is VAT exempt and input VAT is not normally reclaimable on expenditure attributable to exempt business activities. Thus, short-term lettings of unsold dwellings may affect the housebuilder's ability to recover input VAT on construction and other costs. In situations like this, the builder may be required to do one or more of the following:
- restrict input VAT recovery on current and future VAT
returns
- repay input VAT previously reclaimed on returns already
submitted (a one-off clawback adjustment)
- agree to a special method with HMRC for recovering future input
VAT.
HMRC has recently published information on two possible calculation methods for the clawback adjustment. The housebuilder must calculate it as soon as temporary letting starts and must base it on a realistic expectation of the letting period or eventual sale value. HMRC may also require the housebuilder to provide evidence to support the estimates used in the calculations.
The first, preferred method calculates reclaimable input tax based on the estimated eventual sales value as a percentage of the sum of the estimated sales value, plus estimated exempt rents. The second method uses the expected period of letting as a percentage of the deemed ten-year economic life of the dwelling, but HMRC strongly discourages this calculation. It is also unlikely to provide housebuilders with a higher VAT recovery rate than the first method.
In addition to repaying VAT reclaimed on direct construction costs, receiving exempt rental income may also require businesses to restrict VAT recovery on past and future overhead expenses, particularly if there are VAT return periods where exempt rent is the only income.
However, if housebuilders plan ahead, they may be able to restructure their property ownership prior to granting a temporary letting so that a VAT clawback does not arise.
Driving investment forward
PAIFs provide property businesses with an enhanced alternative to REITs. We compare the two regimes and highlight the improvements.
On 6 April 2008, PAIFs, an improved alternative to REITs for UK property businesses, were introduced. The PAIF regime is less restrictive than that of REITs, as the following comparisons indicate, and we expect them to be more popular than REITs once the UK property market improves.
- A PAIF's tax-exempt property business must represent at
least 60% of total assets and income, compared to a more
restrictive 75% for a REIT.
- PAIFs can invest in REITs within their tax exempt property
business, including those which are listed foreign equivalents of a
UK REIT. REITs are not allowed to include such investments in their
exempt business.
- PAIFs can have multiple classes of distributing and
accumulating shares, whereas UK REITs can only have one class of
ordinary shares and non-voting fixed-rate preference shares. This
affords much greater flexibility for capital structuring.
- There is no charge for entry into the PAIF regime. REITs have a
2% entry charge.
- There is no requirement for a PAIF to have a stock exchange
listing, but it must be an open-ended investment company
incorporated in the UK and subject to regulation by the Financial
Services Authority.
- Where tax does apply to PAIF profits it is at 20%, compared to
28% for a REIT. Thus a property development business (which would
not qualify as a tax exempt property business in the REIT or PAIF
regimes), could be more favourably taxed in the PAIF regime. Again
this is a clear enhancement and tax benefit.
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.
