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Build-to-rent could offer institutional investors a stable asset class and fill a substantial gap in the country’s housing stock, but tax hurdles remain an impediment to the viability of this emerging sector.
Build-to-rent refers to a residential development in which all of the units are retained by an owner or developer and leased out, as opposed to being sold off to multiple owners as per the traditional build-to-sell model. The developer owns and manages the units as long-term income generating assets, typically benefitting from economies of scale when it comes to maintenance, repairs and other general upkeep.
As Australia continues to urbanise and inner-city land values increase, owning a house can suddenly become a more distant dream for many. Confronted with this reality, there is a new generation prepared to rent for longer in order to continue to access the lifestyle, location and amenity-rich environment that they are attracted to, and that build-to-rent can provide.
For institutional investors, build-to-rent provides diversification from traditional asset classes by providing a secure revenue stream with a new and growing customer base. Institutions deploy capital into the build-to-rent sector overseas in order to diversify their portfolios and achieve a low-risk, stable, long-term income return for their investors.
Growth in the sector will be underscored by build-to-rent helping address Australia’s housing supply deficit as the population continues to grow. Unlike other commercial assets, which are generally comprised of a small number of long-term leases, build-to-rent developments are comprised of hundreds of diversely structured rental agreements that turn over on a rolling basis.
The appeal of the sector is based in long-term returns similar to aged care and hotels, which compare favourably with both equity market and commercial returns, along with providing lower volatility. As demonstrated across the US build-to-rent sector, during an economic downturn, rents are more resilient, decline less and improve more rapidly than other commercial sectors.
Similar to commercial assets, profit from a build-to-rent development is derived through rental income. High tenant turnover and long vacancy periods are therefore detrimental to income, and as a result, build-to-rent developments incorporate elements designed to attract and retain tenants.
Build-to-rent’s lack of presence across Australia can largely be attributed to a number of tax-related hurdles the sector faces.
Firstly, a managed investment trust (MIT) is a type of trust in which investors collectively invest in passive income activities, such as shares, property or fixed interest assets.
MIT’s are common structures in the commercial real estate sector. For example, an office building may be purchased by an institution, such as an industry superannuation fund, through an Australian MIT. In turn, this provides the super fund with access to a share of an income stream, such as the rent paid by tenants.
MIT’s are also popular with foreign investors, as income from this type of trust can enable a relatively low rate of tax, and tax simplicity for partial ownership of certain Australian assets.
In the case of an MIT with entirely commercial asset holdings, payments to all investors have tax withheld, generally 15%. However, the withholding tax on residential real estate, including build-to-rent MIT income for foreign investors is 30%.
Alongside the MIT withholding tax on foreign investors are additional surcharges, as well as high land tax costs for institutional investors across the board, plus high upfront GST costs. This is illustrated in the example below.
Matthew Cridland, a tax lawyer and Partner at K&L Gates provided an example of how build-to-rent taxes would rack up in New South Wales.
Firstly, duty applies at a premium of 7% for vacant land purchases above $3 million. If the party acquiring the land is foreign, an 8% ‘Surcharge Purchaser Duty’ also applies, lifting the total duty to 15%.
An MIT is considered a ‘foreign person’ if an overseas company holds a 20% or more interest. On a $20 million vacant residential development site, total duty costs – including premium rate and surcharges – would be $2,940,490, or 14.5%
NSW also imposes a land tax surcharge of 2% on residential land owned by a foreign person, wherein no thresholds apply. Australian-based, foreign-owned developers are exempt from these surcharges, but only if they are developing new homes or residential lots for sale. The exemptions do not apply to foreign institutional investment in new residential developments which will be held for lease – regardless of the economic benefits such projects may provide.
Beyond the aforementioned surcharges, the existing land tax rules also work against institutional investment. In NSW, a premium land tax of 2% is applied to a site with an unimproved land value above $4,231,000. As such, for build-to-rent projects, it is reasonable to anticipate the 2% tax will be applicable.
For an unimproved $20 million development site, land tax would be $372,104. Surcharges would likely increase this by $400,000 to $772,104. However, unlike duty, this is an annual expense that varies as land values fluctuate.
By this point in the example, it should come as no surprise that GST also works against the build-to-rent sector. For a build-to-rent project involving total costs of $110 million, no credit is available for the $10 million of GST. However, an identical project, differing only through the intention to sell rather than lease upon completion, would allow the developer to claim a $10 million credit and have a net cost of $100 million.
These surcharges and taxes may vary on a state level, but the impact they have, in addition to the 30% withholding tax rate, means the sector faces substantial headwinds.
Potential exists for a number of positive flow-on effects from a burgeoning build-to-rent sector.
Overseas capital investment is vital to the success of the build-to-rent sector in Australia. In the commercial sector, foreign capital reached $11.5 billion in 2019, which was a third of all investment activity. A greater level of institutional capital will inevitably lead to more development activity and stock coming online.
It is anticipated build-to-rent developments will be high-density buildings, typically exceeding 200 dwellings in inner city and well-located capital city locations.
In the UK, the average size of build-to-rent developments is growing, which indicates the confidence from investors in the sector. In Q3 2019, the average size of each development was 133 units, while projects under construction increases to 245 units, which grows again to 325 units for those in the planning phase.
Hypothetically, competition amongst build-to-rent providers could create competition to attract tenants. This is the case in the commercial office space, where institutional investment has enabled the delivery of premium amenity to appeal to tenants.
Institutional investment in the residential sector could therefore create better rental conditions, such as more responsive building management, or slower rental increases.
Over a third of the US population lives in private rental accommodation, and of this, 36%, or approximately 10% of the total US population live in multi-unit rental communities. As such, the build-to-rent, or as it is known locally, ‘multi-family’ sector is large, well established and liquid.
According to the National Multi-family Housing Council, the sector is worth a total of US$3.3 trillion, with the majority of this capital provided by banks, life insurance companies, commercial mortgage-backed securities or government-backed lending programmes.
The sector also has a significant economic impact. In 2016, the most recent year comprehensive figures are available, multi-family apartment construction generated over US$150 billion in economic activity, as well as over 750,000 jobs.
In order for Australia’s build-to-rent sector to compete with some of the most successful countries globally, tax conditions must change to level the playing field for foreign investors. The most important change to facilitate the success of this emerging sector would be to reduce the MIT withholding tax to 15% across the board. Additional positives would be revised land tax and duty surcharge revenue and to level the land tax playing field for all residential investors.
The build-to-sell model has dominated the Australian residential landscape for decades, with policy based around this. However, with more people renting, cities growing rapidly and people wanting a greater choice in their housing options, it is clear there is demand for build-to-rent. It is now up to state and federal governments to ensure policy frameworks allow supply to match demand.