Property Industry Update May 2008
Silver linings in a tight market
The current downturn in the financial markets means that commercial property values have generally been falling. While this is bad news for investors, it may present an opportunity for some tax planning by restructuring investments without incurring significant costs now.
The best time to devise a tax-efficient structure for your business is before you buy it, so that on the purchase the right structure is already in place.
However, that often does not happen.
In recent years many buyers have been under pressure to get into contract as quickly as possible, for fear that another buyer was waiting in the wings offering a higher price. In that situation most people are inclined to get on with the deal in as simple a way as possible, as complicated or unusual structures can slow things down or even put the vendor off. Tax planning for property investments often involves transferring the property from one entity to another, often an offshore vehicle, and that usually means that for capital gains tax (CGT) purposes there is a disposal of the property. In a rising market that means a gain is likely to be crystallised, unless the investor puts the tax structuring in place immediately after the purchase, before the property value has increased. Unfortunately, that frequently doesn't happen, and the investor is left holding the property in a tax-inefficient way.
As property values fall, many investors will find that gains which had accrued until a few months ago are disappearing. This gives them a second chance to do their tax planning.
A transfer of property from one entity to another will not incur any CGT if the property value has dropped back to the level it was at at the time of purchase. Once the property is in a more tax-efficient vehicle, the future gains – as the property market recovers – will be sheltered from tax.
The transfer will be between two connected entities, whether the investor retains control of the investment or, for example, decides to take the opportunity to pass some or all of it on to family members at the same time. This means that for CGT purposes, any disposal will be deemed to be at market value, irrespective of the actual transfer price.
Valuation is not an exact science, and it is essential to get a professional valuation to back up the CGT calculations which will have to be submitted to HM Revenue & Customs (HMRC). A mere assertion that your property value just happens to be exactly the same as it was the day you bought a couple of years ago is likely to result in HMRC's own valuers having a close look at your valuation. A professional valuation stands a far better chance of being accepted without enquiry.
So you want a value close to your purchase price, but don't overdo it – a value extremely close to the purchase price might also invite enquiry from HMRC. It is perfectly legitimate to watch the market and get more than one valuation made over a period of time, so that the tax-driven transfer can be made when the immediate tax effect is smallest.
Obviously if the property value has risen overall, so that it is still higher than the original cost plus other CGT deductible amounts such as Stamp Duty Land Tax (SDLT) and indexation relief (an increase in the original cost in line with RPI inflation, which is still given to companies), there will be a taxable gain and a CGT cost. The ideal time to put the tax planning in place is probably when the property value is slightly below the total of the allowable CGT costs. In that case some indexation relief will be lost, but there will be no gain or loss overall and no CGT hit.
If the value has fallen a long way so that a significant capital loss would arise on the tax-driven transfer, the investor should ensure that the tax planning is not storing up a big tax bill for the future. A loss on a disposal between connected persons (which there would be) can only be set against gains in very restricted circumstances, so in effect it is virtually useless. The current value would become the CGT base cost for a future disposal, so on the ultimate sale of the property at a higher price than the current value, the capital gain would be higher than it would have been without the tax planning exercise. Whether or not there would have been a tax saving overall would depend on the type of structure put in place and the taxation of the future disposal. A lower or zero rate of CGT in future could mean that the tax planning was still worthwhile.
SDLT would be an unwelcome cost at this stage. A 4% tax cost now would put most investors off, particularly if they had to borrow to pay it. For most investments it should be possible to transfer the property into the tax-efficient structure without incurring any SDLT.
Overall there is an opportunity for many investors to act now and turn the current property market to their advantage in this way. However, it would be essential for anyone considering undertaking tax planning to take professional tax and valuation advice and to weigh the current and future costs carefully against the tax savings.
Borrowing in a tough market
The current lending market
As has become ever more apparent over the last six months, the credit crunch has had a major impact on lenders across the globe – and this has, of course, passed through to their customers, including commercial property investors and developers.
Deep-seated concerns over market liquidity, combined with negligible intervention by the Bank of England, has meant that banks remain broadly unwilling to lend among themselves, leading to the unusual disconnect we see now between Base Rate and LIBOR. After the boom years, liquidity and cash now come at a premium.
The rush of commercial mortgage backed security lending, which saw many more lenders willing to take on large loan commitments in the expectation of laying off risk through securitisation, has all but disappeared. This has reduced the amount of funds available to be borrowed, and the number of lenders willing to fund high-value transactions.
Implications for borrowers
Given the banks’ continuing concern at the lack of liquidity in the money markets, what does this mean for borrowers? Put simply, lending terms have become a lot tighter.
Many banks have pushed up their prices to try to ensure that they are only funding transactions with a strong likelihood of success and which are guaranteed to produce sufficient income to repay the loan.
A big change is that new loans are now almost exclusively linked to LIBOR rather than Base Rate, and in the few cases where the banks will still lend linked to Base Rate, this will inevitably be subject to an increased margin. Either way, borrowers are paying more for their money.
Together with increased costs and more stringent credit terms, availability of funds against value has been squeezed, so that where, for example, an investor might have expected to quite readily obtain funding at much higher ratio of loan to value twelve months ago, today most banks have retreated to positions of 75% or less.
This is probably a more realistic expectation of available debt as we retreat from the overheated and ultra-competitive market of recent years – and these levels are likely to be the norm for some time to come, notwithstanding any recovery in the market.
This will have further implications for some borrowers as there is a general feeling that commercial property prices are set to drop over the next 18 months, making the maintenance of tough LTV covenants tougher still. In fact, some banks are actively seeking to make it very difficult for existing clients of weak covenant to refinance with them, with the aim of improving their lending books.
The irony of where we are just now is that the cautious attitude of the banks in many ways serves to exacerbate the general liquidity problem, at least in the shorter term. If wealth generators find it difficult to borrow on attractive terms, they will delay borrowing, reducing economic growth and promoting a continuation of the cautious approach to new lending.
Given that many banks are battening down the hatches rather than trying to compete with each other, there is much less room for negotiation of terms. It is often now very much a case of take the terms on offer, or not at all. However, it’s not all doom and gloom and there are positives out there.
Alex Innes, Head of Semple Fraser’s Banking & Finance Group, comments;
“What we have seen is that some lenders are looking at the current market as an opportunity to sweep up new lending or refinancing business simply by maintaining their rates rather than pushing them up. If you shop around, you might still be able to get a good deal.”
Tips when borrowing
Given the tougher market, if you are looking to borrow, what can you be doing to make the process as successful as possible?
First of all, it pays to be organised. If you are required to satisfy certain conditions before a bank will offer a facility, don’t put them off. In the current market there will be no room for negotiation or postponement of conditions precedent just because you are not in a position to have them satisfied.
Also, think seriously about what terms you are prepared to accept from the lender. If you get near this, be prepared to accept what is on the table as it may not be on offer for long – the market is fluid and banks are sticking to tight acceptance periods so that should you miss a deadline you may find that terms are harsher next time round.
If possible, it’s worth negotiating an option to withdraw from your finance deal without too much pain, so you can react when the market turns again and find better terms elsewhere (or with the same lender).
Finally, remember that banks don’t make any money if they are not lending, so if you are prepared to shop around there are still decent terms to be found (at least for some borrowers).
The Banking & Finance Team at Semple Fraser has established contacts with all of the major commercial lenders and would be delighted to help you to obtain the finance you need to develop your business in these difficult times.
Distress Remedy being abolished in England and Wales
Most landlords and managing agents dealing with commercial properties in England and Wales will be familiar with the ancient self-help remedy of distress.
Distress is a powerful tool and an efficient way to recover unpaid debt without the need to pursue your tenant through the Civil Courts.
Distress can be used for non-payment of rent. In addition, if the lease with your tenant reserves service charge, insurance, VAT etc as rents, then the self-help remedy of distress can also be used against these sums.
A quick recap of the current procedure:
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The landlord does not have to give notice to its tenant before exercising the self-help remedy;
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The landlord does not need to apply to Court or use any Court procedures, thus avoiding costly litigation;
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The landlord can “seize” goods to the value of the outstanding rents and then sell them to cover outstanding arrears; and
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The landlord can exercise the remedy itself or by a bailiff (who must be a certificated bailiff).
A summary of the new procedure:
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The remedy will be called Commercial Rent Arrears Recovery (CRAR);
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A notice must be served before “taking control” of goods;
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The remedy must be carried out through an enforcement agent. The enforcement agent must hold a certificate;
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The remedy will still be available for non-payment of rent (and VAT/interest); and
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The remedy will no longer be available for unpaid service charge, insurance or other sums due under the lease even if these sums are reserved as rent.
Although the relevant legislation on this (the Tribunal, Courts and Enforcement Act 2007) received Royal Assent in July of last year, the provisions relating to CRAR have yet to be brought into force. In addition, the information on how the procedure will work in the future will be set out in regulations. These regulations have yet to be made.
Until the 2007 Act comes into force, landlords and managing agents can continue to use the current procedure.
In many ways the new procedure is similar to distress. However, it is important to remember that the remedy will only be available for arrears of rent (and VAT/interest). There has also been an element of criticism relating to the requirement for service of a notice before taking any action, as this may allow tenants time to remove their goods from the premises.
Semple Fraser will be monitoring the implications for landlords and managing agents following the Act coming into force.
Restrictive covenants comeback - don't be caught out!
In the not so distant past, it was often thought that restrictive covenants in employment contracts were easily challenged and often not worth the paper they were written on. That has certainly changed and the commercial property industry should take note of the decision in Christie Owen & Davies plc –v– Walton.
The facts of the case were relatively straightforward (and not uncommon).
Mr Walton was employed by Christie Owen & Davies, surveyors. He had specialised in the healthcare sector, including the appraisal, acquisition and sale of nursing homes, care homes and children's day nurseries.
His contract of employment contained fairly detailed provisions on confidential information, company property, non-competition and non-solicitation.
Between September and November 2007, he had a series of meetings with CB Richard Ellis regarding a possible move to them – and he started employment with CBRE in December 2007.
Following the end of Mr Walton’s employment with Christie Owen & Davies, Christie Owen & Davies applied for interim interdict to enforce the restrictions in Mr Walton's contract. Interim interdict was granted on 24 January 2008.
Mr Walton sought to have the interim interdict recalled insofar as it related to non-competition and non-solicitation of business, primarily on the basis that the contractual provisions were too wide to be enforced.
The Court of Session decided that the restrictions were enforceable.
The Court gave specific consideration to the way in which the restrictions had been drafted, and noted that:-
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the definition of "Prohibited Business" was limited to the type of business in which Mr Walton had been "directly and materially" involved during the 18 month period prior to termination of his employment, and
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the definitions of "Restricted Customer" and "Prospective Customer" had been limited to those persons with whom Mr Walton had personal contact.
Taking this into account, the Court decided that the restrictions did not prevent Mr Walton from being employed as a commercial surveyor outside of the healthcare sector, and they did not prevent him from dealing with persons with whom he had not dealt with during his employment at Christie Owens & Davies. Accordingly, the Court of Session decided that the restrictions were reasonable in the circumstances with regard to the legitimate business interests of Christie Owens & Davies and were sufficiently precise to be enforced.
There has been something of a renaissance in restrictive covenant cases in the last 18 months or so, and the courts in Scotland and England are showing an increased willingness to enforce well drafted restrictions.
The Walton case concerned a commercial surveyor, but the case has implications for everyone working in the commercial property industry. Each case will turn on its own facts but all firms can take comfort in the decision, knowing that if they have good contracts in place there is a good prospect of restrictions being enforced following a termination of employment. On the other side of the coin, any firms looking to expand through lateral hires should be aware that a "following" might not be what they had hoped.
FOR FURTHER INFORMATION PLEASE CONTACT: ROLAND SMYTH