The debate over whether to domicile offshore or onshore and which jurisdiction to choose is changing continually, as Jan Wagner finds
European property fund managers probably had a far more relaxing summer break than colleagues who manage equity funds, hedge funds and structured products. While their colleagues were plagued by the bruising effects of the US sub-prime loan crisis - panic-driven investor outflows and fund closures - property fund managers could comfort themselves with the knowledge that their business is buoyant.
The stronger European economy is certainly a factor, but the main reason why the managers' business is doing well is because institutional investors are abandoning direct exposure to real estate and embracing funds - particularly those who invest across borders. The motivation of these investors is clear. They want to diversify their portfolios more effectively and, they hope, achieve higher returns.
Yet property fund managers doing business in Europe should not get too complacent, even if they have a good track record. For there is another major challenge which must be met to ensure the win of an institutional mandate: create a real estate fund
which is most advantageous to European institutional investors in terms of tax, regulation and convenience.
In terms of tax, Philip Ingman, managing director at London property consultant Strutt & Parker, says: "Real estate fund providers must make sure that investors, for example pension funds, who are tax-exempt or close to it when they own properties in their home markets are not hit by onerous new taxes when they invest in funds."
As for regulation of real estate funds, investors generally want a regime that is flexible but not so much that there is no legal recourse for them in the event that something goes wrong. Thirdly, real estate fund providers must make investment in their products as convenient as possible, which means, for example, speaking the language of the investor or providing the reporting in his or her language.
How have European property fund providers met the challenge? They have domiciled their products in offshore jurisdictions - which sounds exotic, but can refer to places that are actually landlocked. Generally speaking, the tax haven of the Channel Islands has been used for UK investors, while Luxembourg has been used for investors on the European Continent.
The Irish capital of Dublin, meanwhile, has established itself as alternative to Luxembourg for UK, Irish and, to a lesser extent, continental investors. Some property investment for Irish clients is also being done in the Isle of Man, which lies between
the UK and Ireland. Ingman also says that for investors wanting exposure to the eastern European real estate market, the island of Cyprus is increasingly being used.
Far beyond Europe, the truly exotic Cayman Islands and British Virgin Islands in the Caribbean are being used for some real estate investment from European investors, though Ingman stresses that these places are primarily the reserve of US
Now that the system for domiciling real estate funds for European institutional investors has been explained, is it in their best interest? Could it be that, for example, the Channel Islands offer advantages for German pension funds which usually pick Luxembourg for real estate investing?
Marcus Leese, partner at the Guernsey-based law firm Ogier, points out the islands have carved themselves out a niche when it comes to domiciling property funds.
"Although real estate funds domiciled here are mostly intended for UK investors, we're seeing heightened interest from German and US investors. This has partly to do with a new regulatory regime implemented last year to expedite fund approvals," Leese adds. Yet other property fund experts say that while things are not set in stone, the current system of domiciling real estate funds does in fact serve the interests of European investors with a core strategy.
Luxembourg, for example, is the place of choice for those from Germany and from other parts of western Europe as it offers everything they need. Although no longer a tax haven, the Duchy has tax-efficient investment vehicles, a flexible but still EU-compliant regulatory regime and the necessary fund infrastructure due to the simple fact that nearly all western European banks have a presence there. Comments Robert LaFors, managing director of LaSalle Investment Management in the Netherlands.
"Luxembourg has been a leader in creating tax-efficient investment vehicles like the FCP (Fonds commun de placement) and the SICAV (Société d'Investissement à Capital Variable) whether for real estate or other asset classes."
Being in an EU jurisdiction, Luxembourg also has treaties with EU member-states prohibiting double taxation. Dublin shares these advantages, but Luxembourg goes one better by speaking the native languages of French and German investors.
"Considering all Luxembourg's advantages and its familiarity on the continent, most investors there would ask themselves, why re-invent the wheel?" says LaFors, whose firm has begun using the Duchy for real estate funds.
One of these continental investors is AEVWL, a €7.1bn pension fund for doctors in western Germany. AEVWL recently allocated €600m to a Luxembourg FCP that invests in an array of alternatives as well as real estate. "Following a beauty contest, we came to the conclusion that for investment in European real estate, there was no better alternative than the FCP," says Andreas Kretschmer, AEVWL's managing director.
"Beyond the tax efficiency, which is crucial for a tax-exempt investor like us, the vehicle was far more transparent than other ones. This is what we need as we don't have a huge staff to closely monitor performance."
John Forbes, UK real estate industry leader at PriceWaterhouseCoopers (PWC) in London, points to another competitive disadvantage that tax havens like the Channel Islands and or the Cayman Islands have vis à vis tax-efficient vehicles like Luxembourg's FCP or UK partnerships. "For pan-European real estate funds, the use of tax havens has fallen out of favour, as they can create significant problems if investments into France are envisaged since the use the use of tax havens can give rise to an annual tax of 3% of the gross value of the real estate. Although there are potentially ways of structuring around this, they are complicated and tend to leave a trail of problems on exit," Forbes says.
Despite their disadvantages, investors should not write off places such as the Channel Islands or even the Cayman Islands. The experts agree that they offer a huge amount of infrastructure and competence for property funds. "From what I understand, the Channel Islands are one of the leaders concerning the domiciling of single real estate funds that invest internationally," says Dirk Söhnholz, managing director at FIA which advised the German scheme AEVWL on its recent FCP.
In order for European investors to profit from what places like the Channel Islands have to offer in a tax-efficient way, Ingman says real estate investments can be structured so that jurisdictions like Dublin or Luxembourg are included. "But naturally, the more layers that are added to the real estate fund, the more fees the investor has to pay."
The experts further stress that when providers decide to domicile a real estate fund in any offshore jurisdiction, they must ensure that enough infrastructure is there to ward off tax authorities from onshore jurisdictions.
Matt Batham, partner at the real estate tax division of Deloitte in London, says: "There have been cases in the UK recently where treasury officials have reviewed certain offshore vehicles to ensure that they are truly offshore and can be treated as such from a tax perspective. The worst thing a fund provider can do is domicile the vehicle in the Channel Islands and then have all the manager meetings in London. Happily, though, it's a lot easier for Londoners to get there then say to the more remote Isle of Man."
Another important thing to watch out for, according to Leese in Guernsey, are the great differences between the regulatory regimes of offshore jurisdictions. "It is not the case that regulation in these centres is equal. The regime on the Channel Islands is flexible, transparent and wholly adequate in protecting the interests of investors. The Cayman Islands and the British Virgin Islands (BVI) are, on the other hand, known for their light touch on regulation, so that should be a key concern for investors when considering those domiciles."
Leese says, however, that the main competitive threat to the Channel Islands comes not from the Caribbean but rather from the Isle of Man, which last year changed its regulatory regime to facilitate the domiciling of property funds.
As Batham already mentioned, onshore domiciles in the EU have not just stood still while offshore centres lure fund domiciling business away. In the interest of protecting their revenue base and maintaining their financial centres, EU governments have been closely scrutinising funds that call themselves offshore and, to some extent, begun competing with offshore centres. The competition has come in the form of improving on current investment vehicles for real estate, launching new ones and/or presenting alternatives.
Germany, for example, has fully liberalised its Spezialfonds (institutional funds) in response to the competitive threat posed by Luxembourg's FCP. German Spezialfonds are now no longer constrained by any investment restrictions, though, admittedly, reporting requirements are still more stringent than in Luxembourg or Dublin. Even so, the move should be a boon to Germany's €20bn industry for real estate-type Spezialfonds.
To challenge Luxembourg and Dublin's tax efficient funds head on, the Netherlands recently launched its own variant. Known as the VBI, the vehicle is fully tax exempt from Dutch corporate taxes and Dutch withholding taxes. Said PWC in a report on the new vehicle: "It is expected to stimulate especially the Dutch market for fund-of-funds and feeder funds."
According to the experts, a third way that EU governments have answered the competitive threat from offshore centres in terms of real estate is to launch REITs - quoted real estate firms that are tax-privileged. Indeed, this year has seen the unveiling of REITs in Germany and the UK - two of Europe's biggest real estate markets -while the vehicles have existed in France since 2003.
But Batham says that as they are mainly focused on their domestic markets, the new REITs in Europe will not prove much of a challenge to real estate fund of funds domiciled offshore.
Söhnholz adds: "The latter products offer a much higher degree of diversification which is what institutional investors increasingly want. Another disadvantage that REITs have from the vantage point of the investor is that often they are laden with restrictions. German REITs, for example, are prohibited from investing in residential property."
It seems, therefore, that as European institutional investors continue to step up investment in real estate, offshore domiciles like Luxembourg, Dublin and the Channel Islands will continue to profit. Yet as Forbes from PWC pointed out, it may, however, be in the latter's interest to go away from being a tax haven and begin creating tax-efficient vehicles.