UK inward investment into commercial real estate continued to underline the country’s prevalence as the location of choice for overseas entities over the last year. Despite the challenging circumstances, the sustained appetite directed at the UK from overseas investors continues to provide evidence of just how coveted the sector remains.
Will this pattern continue once travel becomes easier later this year and, both locally and internationally, the vaccine programme reaches a tipping point? One would assume so, with market indicators pointing to a recovery in 2021 followed by a return to pre-pandemic norms by 2022. This is also borne out, at least anecdotally, by conversations we are having with our clients. One thing is for sure though – the future looks a lot brighter than the very recent past.
Why invest in the UK?
In the same way the rationale behind the choices made by investors will vary depending on factors including strategic objectives, track record, experience and appetite for risk, no two transactions will be the same. However, jurisdiction will always be a major factor in driving investment decisions, with reasons for investing in the UK being that it offers:
- one of the most stable economies in the world;
- a mature and sophisticated commercial real estate market;
- high demand for prime commercial stock coupled with low supply;
- fewer restrictions on overseas companies acquiring real estate;
- the established nature (and security afforded) by a robust and transparent legal system, which includes characteristics such as a wide choice of investment vehicles;
- lease structures designed to safeguard income (FRI leases), as well as achieve income growth through rent reviews (whether through the likes of fixed/market/index linked or turnover models);
- with an average seven-year term, lease structures that are generally longer than many other countries;
- the availability of strong covenants driven by the desire for occupiers to have a presence in the UK; and
- the availability and relative ease with which the debt markets are able to support investment.
When considering the UK market as an investment destination, an investor will also need to be clear about what they want to achieve in terms of returns, both from changes in asset value and the cash flow generated from the underlying asset. Investment strategies can therefore be direct or indirect.
Direct investment
The acquisition of bricks and mortar can present significant opportunity for high returns. However, a potential buyer will need to consider the nature and extent of the return they are seeking, bearing in mind the potential “flexibility” of the asset. This will be different for development opportunities where the purpose is to build out the land to maximise the capital return or to acquire a steady (but increasing) income stream. Either way, it is essential that a thorough legal due diligence exercise is undertaken.
For development opportunities, the buyer will not only need to understand what their market will be, but also what constraints the development presents to funding, construction and ultimate sale. It is important therefore that, in undertaking due diligence, the following issues are investigated:
- title – freehold or leasehold (freeholds generally offer greater flexibility), restrictive covenants on use or development, rights and reservations impacting the site (footpaths, services and utility pipes) and right to light issues from adjoining buildings;
- planning – local plans, impact on use of adjoining land, change of use, sustainability and planning conditions;
- infrastructure and accessibility, particularly important for logistics;
- environmental considerations/liability and clean up;
- construction procurement methods and management; and
- tax – the corporate structure of the owner/developer, stamp duty land tax on entry, capital gains on exit, VAT, the construction industry scheme and grant funding opportunities.
For asset management opportunities, the considerations will be more centred on the strength of the current and potential occupational interests and how that can impact on the potential for income and capital growth. Investors will need to consider title issues – for example, if leasehold, what sort of constraints are there on lettings and use and what are the opportunities for refurbishment and renovation? It will also be important to ensure an appropriate tenant mix and covenant strength. And then there are issues around lease terms, where an investor may want to pay particular regard to the following sort of covenants:
- length of term – shorter terms may be more beneficial if the aim is to refurbish and renovate, longer terms for more guaranteed income streams;
- full repairing and insuring – where are the gaps, eg schedule of conditions limiting tenants’ obligations during the term or dilapidations / reinstatement opportunities at the end of the term?;
- service charge and caps – this could limit recovery of the cost of any works carried out by the landlord under its service charge obligations but also ensure compliance with ESG funding requirements;
- exclusivity covenants against competing uses, which could limit flexibility of tenant mix;
- security of tenure, which could impact on refurbishment / renewal opportunities, giving tenants an automatic right to renew or requiring the landlord to pay compensation if the tenant can establish the necessary grounds to oppose a renewal;
- break clauses which, if exercised, could generate voids;
- upward only rent reviews;
- concession letters/deeds of variation, which could impact on the landlord’s liability or recovery of income;
- rental deposits/parent company guarantees; and
- sustainability requirements, likely to be high on the political agenda and in the interests of incoming tenants.
On top of this, other considerations will be around historic litigation and insurance claims, as well as tax considerations such as income tax (status of the non-UK investor, transparency and beneficial ownership disclosure, special purpose vehicles), VAT savings, capital gains and trading as a going concern.
Indirect investment
There are, of course, also a number of advantageous opportunities and vehicles for indirect investment (collective investment) which involve considerably less capital outlay in terms of due diligence, depending on the degree of investment, as well as shared costs, less risk, limited control over the investment and a longer period in which to realise a return on investment. The more commonly used investment vehicles in the UK include listed and non-listed funds, property unit trusts, limited companies where the investor is acquiring shares, real estate investment trusts and property authorised investment funds.
There are also different considerations for investors looking at indirect investment opportunities than for a direct investment. For example, the due diligence will focus more around the structure of the proposed vehicle than the investment property itself. So, when making investment decisions, the investor will need to consider issues such as:
- the diversity of property interests owned by the partnership/fund;
- track record of the fund/partners;
- the investors’ targeted returns and the time frame;
- the amount to be invested and any limitations or minimum levels;
- income versus dividends;
- tax status of the investor and tax treatment of the vehicles;
- level of control;
- liquidity;
- lock-ins/restrictions; and
- regulation.
The future is bright
The fallout from last year undoubtedly had an impact on investment decisions, in the UK and globally. However, as we now tentatively venture out of our lockdowns and look forward to a more sustained period of stability, it is exciting to see the opportunity that now exists in the UK real estate market. The increasing importance of ESG considerations, the evolution of office space, the rise of online shopping and the changing role of our high streets are just a few examples of how the pandemic has accelerated change and permanently altered how we use our real estate. And whilst that means risk and challenge to some, it offers opportunity and reward to others, and as confidence in UK real estate begins to return, investment strategies can once again move into a growth phase and we can all begin to look forward to an exciting future.
Joseph Mazzucca, Jo McGuinness, and Alan Corcoran are partners at Shoosmiths
