All questions
Transactions
i Legal frameworks and deal structuresLegal frameworks
When investors acquire or dispose of real estate in the United Kingdom, the majority of deals do not involve a transfer of title to the relevant property from the seller to the buyer. While smaller deals may involve the direct transfer of real estate assets, for a number of reasons (the main driver is often tax, as outlined below) the acquisition or disposal of real estate assets is made through share purchases of corporate vehicles that own the property in question. It is unusual for there to be a direct transfer of real estate.
Various structures are used to acquire and hold real estate. The optimum structure will depend on, in each case, a number of factors and considerations (including funding, tax and exit routes (for private equity funds)). Typical structures include:
- companies limited by shares: body corporates with a legal personality distinct from those of their shareholders and directors: these companies are governed by the Companies Act 2006;
- limited partnerships: discussed above in relation to private equity firms;
- limited liability partnerships (LLPs): bodies corporate with a legal personality distinct from those of their members. Members have limited liability in that they do not need to meet the LLP’s liabilities. They are governed by the Limited Liability Partnerships Act 2000 and the Companies Act 2006;
- joint ventures: there are no laws relating specifically to joint ventures under English law; their structure will be determined by the nature and size of the enterprise, the identity and location of the parties and their commercial and financial objectives. The relationship between the parties will be subject to, depending on the structure, general common law rules, the legislative provisions of company and partnership law and the provisions of the joint venture agreement;
- trusts of land: any trust that includes land as part of a trust property will be a trust of land. Trustees have the power to sell the property, but no obligation to do so, unless this is expressly provided for. They are governed by the Trusts of Land and Appointment of Trustees Act 1996; and
- REITs.
Deal structures
Share acquisitions with cash consideration remain the predominant form of real estate transaction structure. This is likely attributable to the relative simplicity of completing a transaction structured as a share acquisition and, from a valuation perspective, the certainty of receiving cash consideration.
Fixed-price transactions (often in the form of locked boxes) are the structure of choice for private equity sellers, although they are increasingly used by trade sellers conducting auctions. Earn-outs and deferred consideration are not common features of the UK real estate M&A market.
Post-completion adjustments to the purchase price are also a common feature, particularly where there is a delay between signing and completion (see below). Adjustments are most commonly made to account for variations in working capital and net debt.
The use of escrow structures has also increased in the real estate private equity M&A market as a way to make contractual claims in respect of warranties and post-completion purchase price adjustments.
Acquisition agreement terms
As previously noted, typically real estate assets will change hands through a sale of the shares in a corporate vehicle that owns those assets. As with any share deal, the buyer will take on the target’s existing liabilities and commitments and the seller will provide warranties and certain indemnities. The title to the real estate assets will usually be certified by the seller’s counsel. The extent of the sale and purchase agreement (SPA) provisions will vary depending on the nature of the transaction, the real estate assets in question and the due diligence undertaken. However, there are a number of aspects to consider.
Conditionality
A number of conditions may need to be satisfied before a real estate transaction can complete (such as obtaining planning permission, third-party consents or even practical completion of a property development). Any such conditions must be satisfied or waived before the real estate transaction can complete.
Splits between signing and completion
For any split between signing and completion, several practical matters should be considered, including whether:
- shareholder (or equivalent) approval is required by either party;
- EU merger clearance is required;
- any warranties given at signing need to be repeated at completion;
- rescission is possible between signing and completion;
- any deposit paid at signing should be returned to, or forfeited by, the buyer if the transaction does not complete; and
- management of the underlying properties is required and, if so, whether the buyer will exercise control.
Rescission
Where there is a split between signing and completion, this may affect whether a buyer is able to negotiate a rescission right, as mentioned above, during that time.
Where sellers are required to obtain shareholder approval for a real estate transaction after signing but before completion, it will be difficult for them to argue that during this period the buyer should face the potential risks and be unable to rescind.
In contrast, where the reason for a split is as a result of the time required by the buyer (e.g., to procure debt finance), it is less likely the buyer will be able to negotiate a rescission right for anything other than material breach of any restrictive conduct provisions.
Buyer protections
In UK real estate acquisitions, buyer protections are particularly important as the buyer is not afforded any statutory or common law protection on acquisition; caveat emptor (buyer beware) applies. Where a buyer purchases a target group and is to inherit all related obligations, liabilities and commitments, a robust package of warranties and appropriate indemnities will be required from the seller. These will normally be limited to the corporate vehicle and taxation matters; the buyer will usually be expected to satisfy itself on title to the real estate assets through a normal due diligence exercise or reliance on certificates of title issued by the seller’s lawyers. Recently we have seen a move towards title insurance as a way for buyers to deal with title due diligence, sometimes in combination with purchaser due diligence or certificates of title, or both of these. A combination of approaches is not uncommon on portfolio deals with properties of various values or significance.
Warranties
Although sellers (particularly private equity sellers) will not want to provide a large number of warranties on the sale of real estate assets, they are important to provide buyers with some contractual protection. An SPA will not generally include long-form property warranties; the buyer’s property enquiries will be answered by the seller in the form of representations.
Buyers are increasingly succeeding in extending the scope of warranty coverage, although sellers often succeed in disclosing all due diligence information against such warranties. Private equity sellers have also conceded business warranties on occasion (however, these tend to be in respect of identified issues that cannot be addressed through further diligence or otherwise reflected in the price).
The repetition of warranties at completion is usually limited to core warranties regarding title to shares or real estate assets and the capacity and authority of the seller to enter into a transaction.
Indemnities
Where a buyer identifies (through due diligence) a particular risk or liability that it is unwilling to assume (e.g., environmental risks or planning liabilities) and that risk is not easily quantifiable, specific indemnities will be sought, shifting the exposure to the seller. Warranty claims are difficult to make in practice, so indemnities are preferable from the buyer’s perspective. Sometimes title insurance to protect against a specific title defect can be obtained.
Seller protections
The limitations on a seller’s liability under an SPA will be dependent on the particulars of each transaction. In practice, however, the parties will agree that certain warranties (i.e., core warranties) will be capped at the overall consideration for the deal. Depending on commercial and competitive pressures, there may be a different cap on liability for other warranty breaches (e.g., 15 to 20 per cent of the overall consideration).
General warranties are likely to have a duration of 18 months to two years, while tax warranties are more likely to have a duration of four to six years. There is also likely to be a de minimis threshold that must be reached before a claim is brought.
As previously noted, the seller’s exposure under the warranties will be limited by the disclosures made in the disclosure letter (which the buyer will ensure are sufficiently detailed so that a view can be taken on its liabilities).
There is a growing tendency for both sellers and buyers to obtain warranty and indemnity insurance in the UK M&A market. Insurers are increasingly marketing their willingness to offer warranty insurance, although they expect that careful due diligence will be carried out in the normal way by the buyer. This trend has been driven by sellers seeking a clean exit – a broader set of warranties can be presented with limited post-completion financial exposure. Similarly, buyers are arranging insurance to supplement or cover gaps in the protection provided by sellers – securing sufficient protection can allow buyers to proceed with a transaction without raising a seller’s exposure and potentially prejudicing the competitiveness of any offer.
ii Financing considerations
Real estate investors are usually backed by a mixture of debt and equity. Lenders will require typical security packages in relation to real estate lending, which will consist of:
- charges by way of legal mortgages over real estate assets;
- charges over rents receivable;
- potential charges over bank accounts into which rents are paid; and
- additional charges over certain contracts (such as leases, insurance policies and development and construction contracts).
Depending on the circumstances, lenders may also seek protection against borrower default through conditions precedent and direct covenants in the facility agreement, property valuations, parent company guarantees and bonds, and cash collateral, and by obtaining floating charges from the parent company.
Where development and construction are anticipated, lenders may also require approval of material development documentation as a condition precedent to drawdown and may expect to receive collateral warranties or third-party rights from contractors, designers and key sub-contractors. Step-in rights may also be sought to take over a contract in the event of default.
iii Tax considerations
Stamp duty land tax (SDLT) is payable by the buyer of commercial real estate in England or Northern Ireland and is a percentage of the purchase price, varying depending on the consideration paid for the property. SDLT is currently payable at 2 per cent on the portion of consideration between £150,001 and £250,000, and 5 per cent on the portion of consideration above £250,000. Similar taxes apply in Scotland and Wales. For investors to avoid paying high tax rates for individual real estate assets, it is generally better for the shares in the vehicles themselves to change hands. SDLT does not apply to the purchase of shares in companies holding real estate assets (at least, not yet – see below). The rate of stamp duty on the transfer of shares in a UK-incorporated company is 0.5 per cent.
If real estate assets are sold and purchased directly, the default position is that the sale or purchase in the United Kingdom is not subject to VAT, although owners can ‘opt to tax’ a property so that any sale (or letting) becomes taxable at the standard rate of 20 per cent. Generally, most owners opt to tax – the exceptional cases tending to be where the occupational tenant is one with restricted VAT recovery, such as a bank or insurer. Where a property is currently let or a letting has been agreed, VAT can be mitigated by ensuring the sale is treated as outside the scope of VAT as a transfer of a business as a going concern (TOGC), provided the buyer continues to carry on a letting business at the property and itself opts to tax (and so notifies HMRC). Otherwise, even if the buyer can recover all of the VAT charged on the sale, the VAT amount will count as part of the consideration on which the SDLT charge is calculated and thus create an absolute cost in all cases.
Interest charges on borrowings by corporates are, generally speaking, deductible expenses for tax purposes, so gearing will generally result in tax efficiency. Many real estate investors introduce borrowing to achieve this result. In such circumstances, it is important that any shareholder loan arrangement is at arm’s length. To the extent that loans do not meet that commercial threshold, interest on them will not qualify as being deductible.
With effect from April 2017, the UK introduced a new restriction on the deductibility of debt finance for corporation tax purposes, similar to those that have existed for some time in other jurisdictions. The UK regime limits interest deductions to 30 per cent of a group’s taxable earnings before interest, taxes, depreciation and amortisation (EBITDA). The intention is more to discourage groups shifting a disproportionate amount of debt into the UK than to attack debt finance as such. Accordingly, groups that are highly geared on a worldwide basis may benefit from making an election that permits the use of a percentage based on the ratio of the group’s net interest expense to its global accounting EBITDA. There is also an exemption for third-party debt incurred by infrastructure companies that, somewhat generously, extends to companies carrying on a UK property letting business (provided the leases in question are to third parties and do not exceed a duration of 50 years).
With effect from April 2019, non-resident companies became subject to tax on profits and gains arising from holding or disposing of UK real estate in the same way as UK-resident companies. Previously, non-resident investors paid only income tax on rents, and, although disposals of residential property by non-residents have been subject to capital gains tax since 2015, the new tax charge covers all forms of UK property. A more surprising part of this package was that non-residents that dispose of indirect interests in UK property (essentially, shareholdings in UK property-rich companies or collective investment schemes) became in principle liable to UK tax on any gain, subject to any exemption and the terms of any applicable double taxation treaty. A company will be UK property-rich if more than 75 per cent of its gross asset value is attributable to UK real estate (whether held directly or via subsidiaries). A non-resident will be subject to tax on any gain if it holds a 25 per cent or greater interest in the company, or has done so within the preceding two years and with interests held by connected parties being aggregated. However, investors in collective investment schemes (including UK REITs) do not benefit from this 25 per cent threshold unless the vehicle they invest in is widely held and is marketed as being invested as to no more than 40 per cent (by market value) in UK real estate.
The UK had not before attempted to tax non-residents in this way, and this change received much negative comment. It is also widely seen as a precursor to the introduction of indirect SDLT, similar to the German real estate transfer tax, although no formal proposals for this have yet been announced. Rather, the focus in terms of new real estate taxes shifted to the residential property developer tax, introduced with effect from April 2022. This tax has the rather specific object of raising at least £2 billion over a 10-year period in order to fund the remediation of unsafe cladding in residential apartment blocks, a policy brought about following the Grenfell Tower tragedy of 2017 and the realisation that a number of apartment blocks in the UK were fitted with cladding, previously considered to be safe, that was now understood to present a fire hazard. It is in effect a surtax charged at 4 per cent (subject to a £25 million annual allowance) on the profits of businesses undertaking residential property development in the UK, whether for investment or sale.
One noteworthy fiscal response to the pandemic was the decision taken in the 2021 Budget to increase the UK’s corporate tax rate from 19 to 25 per cent, which came into effect from April 2023. This represents a significant reversal of the policy first adopted by the last Labour government in 2007 of reducing the rate from its high point of 30 per cent – at that stage to 28 per cent – and further under the coalition and the current Conservative governments to its previous rate of 19 per cent.
