Authors: Stuart Cormack, Elias Stephen, Nick Lazarou, Nathan Cahill, Julian Chen, Phil Turner and Brent Thompson
The Australian Build-to-Rent (BtR) market is attracting significant levels of both foreign investment (especially from established UK Build-to-Rent and US “multi-family” developers and funds that are familiar with the sector) and significant investment locally from superannuation funds and other Build-to-Rent funds. Whilst Build-to-Rent projects tend to generate lower yields compared to other real estate assets such as commercial office buildings, there is growing institutional investor appetite for this asset class particularly amongst large global real estate funds who view it as a sustainable long-term market.
Up until recently, tax, duty and planning law hurdles have deterred many investors (especially foreign investors) from investing in Build-to-Rent assets rather than other real estate asset classes (such as commercial, industrial or retail assets). However, some positive change is in the wings on these matters.
Over a series of four articles (of which this is the second in the series), we consider the fast developing Build-to-Rent market in Australia and consider some of the key issues relevant to investors considering an investment in the Build-to-Rent or Build-to-Sell (BtS) market. We consider not only the growth of private rental market housing sector but also social and affordable housing and the funding sources available for such developments.
In our first article 'Build-to-Rent – A Road Map to the Australian market', we provided an introduction to the Build-to-Rent market and considered some of the key commercial issues in a Build-to-Rent project. In this second article in our series, we look at categories of fund investors who invest in Build-to-Rent projects, tax considerations for Build-to-Rent investors, and different Build-to-Rent project structures.
Who is investing in Build-to-Rent - BtR funds, superannuation funds and debt funds?
The role of Build-to-Rent funds
The past decade has seen a number of fund managers venture into social housing funding structures including for affordable and disability housing. A number of these models are effectively Build-to-Rent in substance. Because of that there are now not only fund managers that have the skillsets to operate these models but precedents on how to make them work for investors and how to package them up. There is now high confidence that particular funding models work.
Projects will typically be funded through a mix of equity funding from a fund or co-investment vehicle with debt interests issued that are subordinated behind senior lenders. A mix of terms, priority standing and return/risk will apply to the various investment instruments. This allows different investors to get exposure to the risk and return that meets their targets.
One of the accelerants to funding has been new technology around how to create liquidity for investors and in particular, a more mature global secondary market. The maturity of markets in this respect and dedicated funds that seek secondaries means that long term funds can be established without the pressure to sell assets just to derive liquidity for investors. This allows (for example) 25-year funds to be viable and investors have less concern for getting stuck in a fund.
The role of superannuation funds and debt funds
Given the significant amount of capital managed by super funds, their involvement, particularly in the social and affordable sector should not be underestimated. The most significant challenge for super funds perhaps is to find an investment model which generates appropriate returns for members given that such funds must invest in the best financial interests of members and comply with the sole purpose test . However, we are increasingly seeing super funds investing in this sector, given the long-term stable returns available for members.
Additionally, super funds are increasingly driven by ESG and social aims where they see that there are opportunities to generate sustainable returns and consequently the opportunities are aligned with members’ best financial interests to support social causes such as social housing and housing for key workers. For some funds their members can be direct beneficiaries of such projects.
Cbus Super has agreed to commit up to half a billion dollars over five years to support the construction of new social and affordable homes through the Federal Government’s Housing Australia Future. Cbus is also a regular investor, along with other funds like HESTA, in housing bonds issued by the National Housing Finance and Investment Corporation (NHFIC) (NHFIC bonds will be covered in more detail in a subsequent article in this series).
Cbus as well as debt funds managed by fund managers such as IFM Investors and AXA have made direct debt investments in social and affordable housing projects in Australia and offshore. With the increase in alternative lenders and large superannuation funds also investing in debt, sources for debt funding are expanding.
Key tax considerations for a Build-to-Rent project
Build-to-rent – the changing tax landscape
The Australian residential Build-to-Rent (BtR) market has the potential to attract significant levels of foreign0 investment. One of the barriers to Australia’s Build-to-Rent market has been Australia’s tax laws, which have deterred investors (especially foreign investors) from investing in Build-to-Rent assets. However, in recent times, there have been changes in government policy directed towards incentivising investment in Build-to-Rent projects in Australia. In this article, we seek to summarise the key tax considerations for investors in Australian Build-to-Rent projects and proposed changes to Australia’s tax laws as part of this shift in government policy.
Managed Investment Trusts
Investors can directly or indirectly invest in Australian real estate assets. In Australia, when acquiring real estate assets, trusts are a common choice of vehicle because they can ordinarily be treated as transparent for taxation purposes, which means that the trust itself is not subject to Australian tax. Companies, on the other hand, are subject to Australian corporate tax on any profits they derive but still may be an appropriate investment vehicle in certain circumstances, e.g. the development of property for sale.
Further to the above, Australian tax concessions may be available for foreign investors who invest in unit trusts which qualify as managed investment trusts (MITs).
To qualify as an MIT, a unit trust must satisfy a number of conditions including:
- the trust must be a managed investment scheme as defined in the Corporation Act 2001 (Cth);
- the trust must satisfy ownership tests, which require the trust to be widely held and also not have its ownership concentrated among a small group of investors;
- a sufficient proportion of investment management activities in relation to the trust must be performed in Australia (required to access concessional withholding tax rates as discussed below);
- the trust must be managed by the holder of an Australian financial services licence;
- the trust’s activities must be limited to specified passive investment activities. In the context of investment in real estate assets and Build-to-Rent projects, the trust must only invest in land for the purpose, or primarily for the purpose, of deriving rent. For example, a trust could not be an MIT if it acquired property for the purposes of development and sale.
If a trust qualifies as an MIT, the key tax concessions for investors are concessional withholding tax rates on distributions of certain types of income to foreign resident investors, and an ability of the trust to make a capital account election.
Concessional withholding tax rates
Foreign resident investors may be entitled to reduced rates of withholding tax on “fund payments” made by an MIT. Examples of fund payments are distributions of rent or capital gains from the disposal of interests in Australian real property situated in Australia. Fund payments made to foreign resident investors in a MIT are subject to a final withholding tax:
- at a concessional rate of 15% where the foreign investor is resident in a country with which Australia has an “exchange of information” (EOI) agreement. The 15% rate is reduced to 10% where the MIT holds interests in certain energy efficient buildings. Australia has entered into EOI agreements with over 130 jurisdictions; or
- at a rate of 30% for all other foreign resident investors.
However, an impediment to residential Build-to-Rent projects has been an inability of foreign resident investors to access the concessional 15% withholding tax rate on distributions from a MIT that has invested in such projects. In a welcome development, the Australian Government announced changes in the 2023-24 Federal Budget to the tax treatment of eligible Build-to-Rent projects. In particular, the Government indicated that it would reduce the final withholding tax rate on eligible fund payments from MITs from 30% to 15%. For a Build-to-Rent project to be eligible for this concessional tax treatment, the following conditions must be satisfied:
- construction must commence after 7:30 PM (AEST) on 9 May 2023;
- the Build-to-Rent project must consist of 50 or more apartments or dwellings made available for rent to the general public;
- the dwellings must be retained under single ownership for at least 10 years before being able to be sold; and
- landlords must offer a lease term of at least 3 years for each dwelling.
These measures have not yet been enacted into law. The Government has stated that consultation will be undertaken on implementation details, including any minimum proportion of dwellings to be offered as affordable tenancies and the length of time dwellings must be retained under single ownership. If enacted, the new withholding rate is proposed to apply from 1 July 2024.
This measure aligns the tax treatment of core investment classes and represents a positive step towards encouraging investment and construction in the Australian Build-to-Rent sector. The opportunity to expand Australia’s housing supply comes at a time when strong overall performance of overseas Build-to-Rent assets has produced increased interest in this asset class from foreign institutional investors.
Capital account election
The trustee of a MIT may make an irrevocable election to treat gains and losses from the disposal of eligible assets of the MIT as being capital gains or capital losses (rather than ordinary income). Capital gains are only subject to tax in the hands of a foreign investor under the capital gains tax (CGT) regime where the MIT distributes a capital gain from “taxable Australian property”. However, given that taxable Australian property includes interests in Australian real property, the capital account election is not typically of practical relevance to foreign investors in the context of Build-to-Rent investments in Australia.
Accelerated tax depreciation
In the 2023-24 Federal Budget, the Australian Government also announced that the capital works deduction rate would be increased from 2.5% to 4% per year for eligible Build-to-Rent projects. Taxpayers can claim a deduction for capital expenditure incurred in constructing capital works, such as income-producing buildings, under Division 43 of the Income Tax Assessment Act 1997 (Cth).
Currently, the capital works deduction rate of 4% per year only applies in relation to income-producing buildings used mainly for industrial activities and certain buildings providing short-term traveller accommodation.
To access the increased capital works deduction rate, it is proposed a Build-to-Rent project will need to satisfy the same conditions as those set out above in relation to the reduced MIT withholding tax rate.
This measure will ultimately shorten the period over which construction costs of eligible buildings are depreciated (from 40 years to 25 years) and thereby enable investors to benefit from larger deductions each year.
If enacted, the changes will apply to eligible Build-to-Rent projects where construction commenced after 7:30pm (AEST) on 9 May 2023.
Build-to-Rent projects are considered to include all premises that have been built with the sole intention of leasing such premises, and different GST treatments apply depending on the type of premises leased.
Generally, a lease is “input taxed” if it is of residential premises that is occupied as a residence or for residential accommodation. In this regard, the GST cost of acquisitions relating to such a lease (such as costs related to the land acquisition, property development and construction, and tenancy management) cannot be claimed as a GST credit by the investors or developers (as applicable). As such, an additional 10% in costs is effectively incurred.
Duty and land tax for Build-to-Rent projects
In most Australian States and Territories, the duty and land tax that investors pay on their Build-to-Rent projects (and residential land in general) is generally higher than what their counterparts pay for investing in commercial projects. Land tax is generally imposed annually at progressive rates based on the combined value of all ‘taxable land’ owned by a particular taxpayer (except in the Northern Territory). In addition to standard land tax, foreign surcharge land tax of up to 4% applies to land owned by a foreign person (except in Western Australia, South Australia and the Northern Territory). Furthermore, in addition to the duty normally payable on the acquisition of land, an additional duty surcharge rate (either 7% or 8% depending on the jurisdiction) applies to a foreign purchase of residential land except if such land is located in the Australian Capital Territory or Northern Territory, or if an exemption applies. Relevantly, citizens of most foreign countries who are not ordinarily resident in Australia and companies and trusts subject to the Foreign Acquisitions and Takeovers Act 1975 (Cth) are generally treated as foreign.
As both a short term and long-term response to target housing availability and affordability, a number of States and Territories have enacted various revenue measures to provide an incentive for investors and developers to undertake Build-to-Rent projects. Some observations in respect of these measures are broadly summarised as follows:
an exemption from foreign surcharge duty may apply for residential developers generally or for land that is developed into an eligible Build-to-Rent;
- a concession for land tax may apply to reduce the taxable value by half for eligible Build-to-Rent developments. This generally applies during the operation phase and for a specified period only, typically 20 – 30 years;
- an exemption from foreign surcharge land tax may apply during the development phase of a Build-to-Rent project, and in some cases for a specified period during the operation phase; and
- where a Build-to-Rent benefit has been relied upon, ongoing conditions must be met to avoid inadvertently losing the benefit and the resulting claw backs. For example, a subdivision (i.e. a strata conversion) or a transfer within 15 years could result in a significant claw back of the benefits in some States. Where a concession is conditional on continuous compliance, a breach may mean that the project is ineligible for the concessions going forward.
At the time of publication, most jurisdictions other than the Northern Territory and Australian Capital Territory have some form of duty and land tax concessions for Build-to-Rent. The criteria for the application of such concessions and the clawback triggers (if any) vary in each of these jurisdictions. Currently, the key features of a Build-to-Rent project that qualifies for a concession or exemption in these jurisdictions typically include the following:
- a development of a new building, or a conversion of a building for residential use;
- a minimum number of self-contained dwellings;
- a parcel of land that is held within a unified ownership or co-ownership structure;
- proportion of labour sourced from local and or particular classes of workers;
- with the exception of affordable and social housing, a single management entity for the Build-to-Rent development i.e. for the management of leases, tenants, common areas and facilities;
- fixed term leases (i.e. at least 3 years, unless tenants have opted for a shorter term);
- residential tenancy agreements made available to the general population; and
- affordable or social housing components.
Tax - Closing comments
The taxation landscape for Build-to-Rent projects is clearly shifting as Australia seeks to encourage investment in those projects. Given the evolving and varied statutory regimes and administrative practices of Australian taxation authorities, it is important to obtain advice at the beginning, and at the various phases, of a Build-to-Rent project to ensure that its tax implications are appropriately considered and that conditions are satisfied to qualify for available concessions and exemptions.
Structure of a Build-To-Rent Project
On the back of this government support and regulatory change, we are seeing two different structuring models to facilitate the successful delivery of Build-to-Rent projects; a developer led model and an investor led model. Each of these structures involve many different contracting parties during the project lifecycle, from the raising of debt finance, to the acquisition of the land, to the development and construction of the building and ultimately to the operation and property management. We have set out below a description and diagram of each of these contracting and structuring models.
Developer led approach
A common approach to a Build-to-Rent project undertaken by a developer is described below:
- A developer (Developer) will acquire the land on which the Build-to-Rent building is to be constructed. The Developer will enter into a building contract with a builder (Builder) which may in turn enter into subcontracts with various sub-contractors.
- Once the building is complete, the Developer is likely to contract out management obligations in respect of the Build-to-Rent building to an operator / manager (BtR Manager) under a management agreement who will be responsible for the ongoing management of the Build-to-Rent building (including maintenance, leasing, capex investment etc.).
- If debt is required, the Developer will enter into lending arrangements with a lender (Financier), who will take a mortgage over the land and security over other assets. The Financier will generally require tripartite deeds with each of the Builder and the Build-to-Rent Manager under which it will acquire certain rights in respect of the building contract / property management contract.
- On completion of construction, the apartments in the Build-to-Rent building will be marketed by the Build-to-Rent Manager (sometimes with a 3rd party letting agent) and the Developer will enter into residential tenancy agreements with individual tenants in the building (which tenancies will be facilitated managed by the Build-to-Rent Manager).
These arrangements are shown in the diagram below:
Investor led approach (Fund Through)
An alternative (albeit similar) structure can be used where the Build-to-Rent project is being driven by an investor - it is similar to the “Developer as owner” structure described above but with additional contractual arrangements being put in place. This structure is often referred to as a “fund through” structure.
Under this structure, an investor (Investor) appoints the Developer under a development agreement to develop and deliver the Build-to-Rent project. The Developer then contracts with a builder (Builder) to construct the building. The Investor, Developer and Builder will enter into a tripartite deed to govern the arrangements under the Development Agreement and Building Contract as between the 3 parties. Again, the Investor is likely to contract out management obligations in respect of the Build-to-Rent building to an operator/manager (BtR Manager) under a management agreement. If debt is required, it will be the Investor who will enter into lending arrangements with the lender (Financier), who will take a mortgage over the land and other securities and enter into relevant tripartite deeds. On completion of construction, the Investor will enter into residential tenancy agreements with individual tenants in the building (which tenancies will be initially marketed and managed by the BtR Manager).
These arrangements are shown in the diagram below: